Impact of crude on emerging markets

Most emerging economies beyond a handful of crude producers are suffering from record oil and food prices, with Asian markets in general and China’s in particular likely to be notable losers.

South Africa and Turkey also stand out as being vulnerable, while Russia and the Gulf States, which should be the main beneficiaries as crude prices soar, will still struggle with high inflation and the risk of economic overheating. Emerging markets have proved largely “decoupled” from the Western credit crunch but inflation is proving a global problem.

Until late May 2008 emerging equities in particular had been doing relatively well, more or less recovering losses earlier in the year when worries over Western banks sparked global risk aversion. Some investors even moved into emerging markets, seeking diversification from a developed world downturn. The credit crunch was very much a Western phenomenon covering global, US and emerging markets. Inflation is much more global.
Fund flows into emerging markets had been broadly positive this year but have now turned negative everywhere except the Middle East and Africa. Index provider Standard & Poor’s says that by their indices emerging equity markets lost 10.07 percent in June, putting them down 12.5 percent so far this year.

Developed markets were also hit, but S&P says they lost slightly less, down 7.90 percent in the year to date. Benchmark MSCI emerging equities are down almost 17 percent so far this year, against 14 percent for the equivalent global index.

Emerging markets have in some ways been a victim of their own success. Their resilient and ever-growing demand for natural resources, particularly food and fuel in India and China, has prompting price rises that have in turn sparked inflation.

Investment bank Morgan Stanley says Asia stands to lose out the most from oil’s rise as the region, especially China, is more energy reliant than other emerging markets. Moreover, higher oil prices may also prompt Western buyers to seek suppliers closer to them due to higher delivery costs.

The monumental energy price increases will be a ‘game change’ for Asia. While there is some scope for remedial policy action, Asian currencies outside Japan will likely weaken against the dollar and assets should under perform in the period ahead. Some central banks such as Brazil have been praised for their quick reaction but few have managed stem inflation.

The good side of the rise in emerging markets is that the world economy is now much less reliant on just one economy — the United States — and this may be the first time in history a global recession has been avoided because of emerging markets.

But it is important we adapt to this rise in demand. In the short term, most analysts predict oil prices will rise beyond their current records above $145 a barrel. OPEC President has predicted prices could hit $170 in the next few months, although they might fall later in the year.

Some investors say recent falls in emerging assets have left them looking good value. However, most agree such an oil price move would be likely to punish emerging markets even more by fuelling inflation and hitting demand and activity.

Markets such as South Africa and Turkey already have high current account deficits and domestic political problems. That is a particularly unappealing combination. If the oil price rises further they are the ones that are going to suffer. Managing around $2 billion, India’s stock market has now fallen enough that it is offering good value. But other key picks are the Gulf and Russia, both taking advantage of higher oil prices.

Other managers are following suit. Most of the world’s provable remaining oil reserves are in emerging markets. So what you are seeing is a huge flow of money into emerging markets. Russia should be a key beneficiary, but its stock market is down 3.71 percent so far this year as investors and ratings agencies warn that its economy risks overheating and is struggling with inflation.

Even the popular Gulf economies will see their new oil wealth, as well as the higher fuel costs their own consumers will pay, stoking inflation and straining their economies even as money pours into their coffers.
This story is negative for everyone. There will be a direct reverse of the decoupling story. It’s going to be a rough ride.