CONTRIBUTORS
Nicholas Hardingham, CFA
Portfolio Manager, Franklin Templeton Fixed Income
Stephanie Ouwendijk, CFA
Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income
Robert Nelson, CFA
Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income
Joanna Woods, CFA
Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income
Sterling Horne, Ph.D
Research Analyst,
Franklin Templeton Fixed Income
Carlos Ortiz
Research Analyst, Franklin Templeton Fixed Income
Jamie Altmann
Research Analyst, Franklin Templeton Fixed Income
Samantha Higgins
Analyst,
Franklin Templeton Fixed Income
Preview
On April 3, the Organization of the Petroleum Exporting Countries (OPEC) surprised the market by announcing a significant increase in planned production of oil. The timing of this announcement coincided with a sharp repricing of global growth expectations, following the US “Liberation Day” tariff announcements a day earlier. In combination, this led to a drop in Brent crude from US$75 to US$60 per barrel. Emerging market (EM) spreads widened sharply over the same period. EMs have long been regarded as an asset class highly sensitive to commodities. Given the prominence of EM commodity-producing countries, we believe it is intuitive to expect both sovereign spreads and emerging markets foreign exchange (EMFX) will likely respond to movements in the prices of their key exports. In certain cases, similar dynamics could be expected for importers. However, as the composition of key EM debt markets changed over time (see Exhibit 1), one wonders if this sensitivity has moderated or even broken down entirely.
In this paper, we explore the primary drivers of commodity prices and assess their continued relevance as drivers of EM debt (EMD) and EMFX. We focus on three commodities: oil, copper and gold, which represent the highest notional trade values (USD) across the EM universe. Our findings show that oil most significantly impacts spreads, though the strength of this relationship varies across countries. Copper and gold’s influence is significantly less clear.
Takeaways for EM debt investors
Our analysis indicates that there is one overriding commodity that still impacts EM debt, namely oil. Crude continues to dominate as a driver of EM spreads, with surprisingly little effect coming from copper or gold, despite the significance of these two commodities within the EM trade landscape. We believe that the structural characteristics of the various commodity sectors influence the extent to which they drive EMD. Major oil-producing countries tend to have a larger share of economic output tied to oil, and a high degree of government involvement, which strengthens the link between oil prices and sovereign credit worthiness.
EM is a heterogenous asset class and so looking at individual countries will continue to be key, in our opinion. Overall, we can conclude that there is a strong relationship between oil prices and credit spreads for oil exporters, while importers are less affected. Furthermore, those countries with a higher share of oil exports as a percentage of GDP, and those with lower credit quality, are most vulnerable to oil price shocks. In general, EMFX returns are not influenced by moves in the underlying commodity prices, though the CLP does have a significant correlation to copper prices.
In conclusion, we believe investors should closely monitor the fundamentals of oil exporting countries as well as their overall portfolio exposure to oil exporting sovereigns, as a downturn in energy prices will likely impact performance of these exposures.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Commodity-related investments are subject to additional risks such as commodity index volatility, investor speculation, interest rates, weather, tax and regulatory developments.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Investments in companies in a specific country or region may experience greater volatility than those that are more broadly diversified geographically.
The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.
The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results.
Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt.
WF: 5540082