Blog

Do Emerging Markets Really Need Higher Oil?

“Emerging markets are getting crushed: The oil crash raises the risk of a full-blown crisis in the emerging market world.” – CNN Money, February 2016

It’s a tale as old as time. Emerging Markets stocks “need” higher oil prices. Oil is said to be their lifeblood; without it, they are doomed to a state of perennial crisis.

In markets, investors prefer simple narratives, and lumping all Emerging Markets into one bucket with one driving factor (Crude Oil) makes investors feel good. For as long as they can predict which direction Crude Oil is going, they can predict Emerging Markets.

There are only two minor problems with this logic:

1) Investors cannot predict the direction of Crude Oil any better than they can predict the direction of the dollar, interest rates, or the S&P 500.

2) Crude Oil is only one factor among many influencing the direction of Emerging Market stocks.

Going back to 1986, the monthly correlation between Emerging Markets (MSCI Emerging Market Index) and Crude Oil is 0.36. In plain English, that means they often move in a similar direction. The key word in that sentence is often, which is far from always.

On a monthly basis, Emerging Markets and Crude Oil have moved in the same direction only 60% of the time, which means that 40% of the time they are moving in opposite directions (Crude up, EM down or Crude down, EM up).

Over the past year, this is precisely what we’ve seen, with the 1-year correlation dropping to record low of -0.58.

Comparison between Emerging Markets and Crude Oil in 1 year rolling correlation

In 2017 thus far, Emerging Market stocks (EEM) are up over 16% while Crude Oil is down 14%.

2017 total returns of Emerging Markets and Crude Oil graph

What gives? This was not “supposed to” happen; Emerging Markets were “supposed to” be down.

Indeed, but they’re up. And as we know from history this is not the first time this has happened (remember, 40% of the time they are moving in opposite directions).

Why don’t they always move together? Good question. Perhaps it’s because the Energy sector is not even close to the most important sector in Emerging Markets. Financials and Technology far outweigh energy exposure the two most popular Emerging Market ETFs (EEM and VWO). Additionally, the Consumer Discretionary sector, which is often said to benefit from lower Oil prices, is roughly the same size as Energy.

Table showing Emerging market sector weights

Digging a bit deeper, only one major Emerging Market country has Energy as its highest weighted sector: Russia, at just under 50%. Unsurprisingly, Russia (ERUS) is down 7% this year and has a much higher monthly correlation with Crude Oil of 0.65.

List of major emerging market countries with different sectos

If all Emerging Markets looked like Russia, the false narrative that Emerging Markets need higher Oil might have some element of truth to it. But alas, they do not. Emerging Markets may move with Oil more often than not, but that is not the same thing as saying they are dependent on it. Do not confuse correlation with correlation. Just because something moves with something else does not mean something is moving because of something else.

The lesson here: don’t invest based on stories, no matter how good they sound. Do the work, evaluate the evidence, and think for yourself.

***

Related Posts:

Storytelling Animals

Does the S&P Really Need Higher Oil

An Emerging Divergence in Central Bank Policy

When Bond Kings Short Emerging Markets

To sign up for our free newsletter, click here.

This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO

Charlie-Bilello

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University. He has also done a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

Facebooktwitterredditpinterestlinkedinmail

Comments are closed.