Parametric White Paper July 2013 : Emerging Markets Are Not a Substitute for Commodities Timothy Atwill, Ph.D. Managing Director Investment Strategy Parametric 1918 Eighth Avenue Suite 3100 Seattle, WA 98101 T 206 694 5575 F 206 694 5581 www.parametricportfolio.com Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. In recent years, many investors have considered adding an allocation to the commodity asset class in order to tap its known portfolio diversification and inflation-fighting properties. In many cases, investors have been advised by market pundits to consider emerging markets equity as a proxy for commodities, with some going as far as to claim that emerging markets equity gives investors all the commodity exposure that they need. The logic here is that emerging market economies rely primarily on the exports of minerals, crops, or energy resources, and therefore emerging market equity must be heavily exposed to commodity price movement. We will call this theory the proxy argument. The proxy argument predicts that rising commodity prices should have a positive impact on emerging market equities because their commodity-based economies benefit. On the other hand, an equally prominent argument is that emerging economies (in particular China and India) are responsible for driving up commodity prices due to their growing consumption of minerals and foodstuffs. This argument instead puts forth that rising commodity prices should have a negative impact on emerging market stocks. Given this seeming contradiction, we examine the relationships between emerging market equity returns and commodity returns, and we use import/export data to better understand the potential impact of commodity prices on emerging market economies. We also investigate the commodity/equity price relationship for particular emerging market economies that would seem to provide a clean exposure to a single commodity. With so little evidence in support of the proxy argument, we find emerging market equities indeed are a poor proxy for commodities futures in an investor s portfolio. For Informational Purposes Only; Not an Offer to Buy or Sell Securities.
COMMODITY PRODUCERS ARE NOT COMMODITIES At its root, the proxy argument is based on the equivalence of commodities and the equities of companies which are reliant on commodity production. This link however, is not as robust as many investors think. Numerous studies have shown that investing in commodity related equities does not result in a commodity-like return stream. 1 This may at first seem counter-intuitive why wouldn t the price of copper be the largest factor in determining the price of a copper mining stock? There are some elementary reasons that explain this. First, all equities demonstrate a large correlation with the overall equity market, i.e. they have an equity beta. While this seems straightforward, what is not as apparent is how the impact of the overall equity market can overwhelm the commodity price impact on a commodity-related stock. Second, equity represents ownership in a company, and because of this, its price is impacted by many factors that have no parallel for the underlying commodity. Earnings multiple expansion, dividend policy and corporate actions are all factors which will impact the price of a commodityrelated equity, but have little impact on the price of the underlying commodity itself. Third, many commodity-related companies are aware of their commodity exposure, and actively hedge away this risk through the use of forward price agreements or other long-term pricing mechanisms. While this does not immunize them from the price impacts of the underlying commodity, it diminishes the relationship between a company s revenue stream (and profitability) and the price of the underlying commodity. 2 Setting aside the dynamics of emerging markets for the moment, we note that there are many examples of commodity-linked companies whose stock performance diverges widely from its associated commodity. For example, Figure 1 shows the cumulative value of a $100 investment in both ExxonMobil and Chevron shares, compared to a similar investment in WTI crude, over the course of 2009. Figure 1: Cumulative value of $100 over 2009, Price Returns Only $200 $180 $177.94 $160 $140 1 E.g. Atwill [2011], Accept No Substitutes: Why Natural Resource Stocks are a Bad Way to Get Commodity Exposure, Journal of Wealth Management, Spring 2012, Vol. 14, p 87-92. 2 On a related front, while equity proxies for the energy and metal sectors are readily available, there are no such clean exposures for the grain and soft commodities. Many equity index providers attempt to use seed or fertilizer companies for these sectors, but the ties between the prices of these equities and the underlying commodities are especially tenuous. $120 $100 $80 $104.08 $85.42 $60 $40 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Crude Oil Chevron ExxonMobil Source: Bloomberg, Parametric, as of 12/31/2012. Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 02
While the two oil company stocks show relatively similar performance, crude oil s return pattern is markedly different. It is hard to make an argument that either of the two oil companies would have served as a proxy for the price of oil over this time period. Over longer time periods, we can observe that the price of oil and the share prices of the two oil companies exhibit times of similar and dissimilar return patterns. However, the long-term patterns again point to the power of the equity beta. Over the course of 2003-2012, the correlation of Chevron and ExxonMobil was 0.79, while their average correlation with the price of oil was 0.44. That is, the stocks of the two oil companies had nearly twice the correlation with each other than they did with their supposed common driver of returns. EMERGING MARKET EQUITIES ARE NOT COMMODITIES We have discussed why the price of a commodity-related company s stock does not need to move with the price of its associated commodity. We now examine whether such a relationship exists at a broad level, using the MSCI Emerging Markets Index to represent the broad emerging market equities and the Dow Jones UBS Commodity Index Total Return ( DJ-UBSCI ) to represent commodities. Figure 2 shows the annual returns for these two benchmarks over the last twenty years. Figure 2: Annual Returns: Dow Jones-UBS Commodity Index Total Return vs. MSCI Emerging Markets Index 100% 80% 60% 40% 20% 0% -20% -40% -60% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Bloomberg as of 12/31/2012. DJ-UBS MSCI EM Early in this time period, there is little relationship between commodity returns and emerging markets equity returns; in fact, they often moved in opposite directions. However, starting in 2003, directionally both indices line up and demonstrate a seeming increase in correlation. Could this be proof that, at least in recent years, emerging markets equities and commodities have proven to be proxies? Closer examination shows otherwise. Below, we compare the annualized risk and returns for the two indexes between of the period of 2003 and 2012. Source: Bloomberg, as of 12/31/2012. DJ-UBSCI MSCI EM Return (ann) 4.1% 16.9% Volatility (ann) 18.5% 24.1% Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 03
The two indexes clearly have different risk/return profiles, with the risk and returns for emerging markets equity being much higher than those for commodities. In addition, even if one allows a proxy to simply mean a high correlation between two return streams, it is still hard to make an argument for emerging markets equities to be a proxy for commodities. The below graph shows the rolling 12-month correlations between DJ-UBSCI and MSCI EM, and between Russell 3000 and MSCI EM. Figure 3: Rolling 12-Month Correlation, 1991-2012 1.20 Source: Bloomberg, as of 12/31/2012. 1.00 0.80 0.60 0.40 0.20 - (0.20) (0.40) (0.60) Dec-12 Dec-11 Dec-10 Dec-09 Dec-08 Dec-07 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Dec-99 Dec-98 Dec-97 Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 DJ-UBS vs MSCI EM Russell 3000 vs MSCI EM Source: Bloomberg, as of 12/31/2012. While the correlation between emerging markets equities and commodities has been persistently low, the correlation between the two equity indices has been consistently much higher than that between emerging markets equities and commodities, and has maintained generally high levels. Said another way, if one argues that emerging markets equities is a proxy for commodities based on correlation alone, the above graph suggests instead a stronger argument for saying emerging markets equities is a proxy for U.S. equities! This is an important observation, as many investors are choosing to invest in commodities due to its low correlation with U.S. equities, and the above graph clearly refutes considering emerging markets equity as a commodity proxy on this basis. WAS THE PROXY ARGUMENT EVER TRUE? Another curious fact brought up indirectly by Figure 3 provides further evidence that commodity and emerging markets equity performance are not linked. The proxy argument assumes that if a country s economy increases its exposure to commodities, then its equity markets should show a corresponding increase in correlation with commodity price movements. From 2002 to 2012, the aggregate weights assigned to India, Brazil, and China in the MSCI EM Index has doubled from 20% to 40%, as shown in the below graph. Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 04
Figure 4: Weight to India, Brazil & China in MSCI EM Index 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 China Brazil India Source: MSCI, as of 12/31/2012. At the same time, an examination of the trade data shows the economies of these countries have diversified their economies away from commodity production, and into manufacturing. For example, the below graph shows the WTO trade sector data for China, Brazil, and India, combined. Figure 5: Exports - Imports ($bn), for China, Brazil, and India combined $800 $600 $400 $200 $0 -$200 -$400 -$600 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Agriculture Fuel / Mining Manufacturing Source: World Trade Organization, as of 12/31/2011. That is, while the index weights for China, Brazil and India in the MSCI EM Index increased over the last ten years, their economies exported an increasing amount of manufactured goods and imported a growing amount of fuel and mining products. At an index level, this combination results in the MSCI EM Index having less commodity exposure in recent years. If the commodity proxy argument had been correct, the expected result should have been a decline in the correlations between commodities and emerging markets equities in recent years, as measured by broad indexes. Instead, the correlations between commodities and emerging markets equities have increased over the last decade. We point out that Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 05
in the 1991-2002 period, correlations were between -0.20 and 0.40, while in the 2002-2012 period they remained roughly between 0.20 and 0.80. This results in the observation that for periods when the emerging markets countries had more of their economy based on commodity production (1991-2003), there was little correlation at the index level between emerging markets equities and commodities. But when the emerging markets countries diversified their economies away from commodity production (2003-2009), correlations at the index level increased between emerging markets equities and commodities. While one can conjecture the reasons why this may be the case, what remains clear is that there is only a limited connection between an economy s reliance on commodity production and the correlation of that country s equity market with the commodity market. TINKER, TAILOR, IMPORTER, EXPORTER At the root of the commodity proxy argument is the belief that emerging economies are dominated by commodity exports. Figure 6 presents the top importers and exporters of eight major commodities, all of which have representation in the major commodity indices. The countries in bold are emerging market countries. Figure 6: 2009 Trade Data Source: UN Comtrade database, as of 12/31/2011. Two important themes are demonstrated in Figure 6. First, the list of top exporters for a given commodity is not necessarily dominated by emerging markets countries, and the list of top importers is not necessarily dominated by developed economies. For example, the biggest wheat exporters are the U.S., Canada, France, and Australia, all developed market countries; and the biggest importers are Nigeria, Algeria and Egypt, all emerging market countries. Indeed, every commodity listed has an emerging markets country among the top 5 importers, and at least one developed nation as a top 5 exporter. Second, many of the emerging Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 06
market countries that are top exporters for one commodity show up in the table as top importers for another commodity. For example, Nigeria is shown as a larger exporter of crude oil, but is also the single largest importer of wheat. Similarly, Indonesia is a top exporter of copper ore, but is also a top importer of cotton. This runs counter to the proxy argument, which naively labels all emerging markets nations as simply exporters of raw materials. The proxy argument is based on the supposition that emerging markets economies are boosted by an increase in commodity prices, but this is an overly simple representation of their economies as a group. Emerging countries have a diverse profile of commodity import/export patterns, and because of this, it is difficult to make a sweeping generalization about commodity prices and their effects on emerging markets economies. Further, due to the relatively low correlation in the price movements for various commodities, it is a rare case when all commodity prices move together. Given this, and the wide variety of import/export profiles in emerging markets countries, one needs to carefully specify which commodity prices went up before one could confidently quantify whether the rise in prices was beneficial for the emerging markets economies as a whole. Does a rise in copper help Chile and Indonesia s mining sectors more than it harms Chinese and Korean manufacturing? Or does a rise in the price of cotton harm Bangladesh and Vietnam s textile industries more than it helps the cotton growing regions of Uzbekistan, India, and Brazil? Understanding the intertwining relationship between commodity prices and the various emerging markets countries underscores again, that the commodity proxy argument is a remarkable oversimplified representation. SINGLE COUNTRIES AND THE COMMODITIES THEY PROXY The evidence so far leads us to reject the commodity proxy argument in the context of the broad emerging market country and commodity markets. Perhaps this grouping of countries in index-level data clouds some important possible linkages between commodity prices and the stock markets of individual emerging market countries. To investigate this possibility further, we track three commonly referenced proxy country/commodity pairs namely, Copper and Chile, Gold and South Africa, and Crude Oil and Russia. Figures 7, 8 and 9 show the relative performance between these three country/commodity pairs over the last five years: Figure 7: Cumulative Return of $100, 2008-2012, S&P IPI Chile and Spot Copper 200 180 160 140 120 100 80 60 40 20 0 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 MSCI Chile Index Spot Copper Source: Bloomberg, Parametric, as of 12/31/2012. Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 07
Figure 8: Cumulative Return of $100, 2008-2012, S&P IPI South Africa and Spot Gold 160 140 120 100 80 60 40 20 0 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 MSCI South Africa Index Spot Gold Source: Bloomberg, Parametric, as of 12/31/2012. Figure 9: Cumulative Return of $100, 2008-2012, S&P IPI Russia and Spot Oil 160 140 120 100 80 60 40 20 0 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 MSCI Russia Index Crude Oil Source: Bloomberg, Parametric, as of 12/31/2012. While there is a rough equivalence between the two return streams over certain time periods, there are also numerous periods of disparity. For example, during the financial crisis of 2008 gold prices rallied while South African equities fell. Similarly, in early 2008 copper prices rose, but Chilean equities did not respond. Moreover, in many ways these cumulative value graphs disguise the degree of the differences between the individual country returns and their associated commodity. Figure 10 better outlines some key differences: Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 08
Figure 10: 5-Year Correlation, Return, and Volatility for Commodity/Country pairs as of 12/31/2012 5-yr Correlation 5-yr Return (ann) 5-yr Volatility(p.a) South Africa 0.29-13.1% 29.7% Gold 3.0% 21.2% Chile 0.59 8.1% 26.4% Copper 3.5% 33.7% Russia 0.77-10.3% 41.9% Oil -0.9% 35.0% Source: Bloomberg, FactSet, Parametric, as of 12/31/2012. All three country/commodity pairs demonstrate low correlation, which again indicates that these countries equity markets would not be a good proxy for the associated commodity. This conclusion is further reinforced by the very different risk/return profiles demonstrated over this time period. Specifically, an investor who was seeking gold exposure by owning South African equities or oil exposure by owning Russian equities ended up with a proxy that did not give them the return pattern they were seeking. Instead, they received significantly lower return with higher volatility. CONCLUSION Our study rejects the proxy argument that emerging market equity exposure provides commodity exposure. Investors should recognize that equity returns have many drivers which do not affect commodity returns, and that many commodity-related companies hedge the impact of volatile commodity prices. There is also scant evidence that commodity prices impact emerging markets equity returns at the broad level. Examining trade data, we find that the proxy argument s underlying assumption that emerging market countries are mainly exporters of commodities is false. Actual import/export patterns in emerging markets are varied and complex, making it problematic to trace the impact of a single commodity price change on the overall market. A closer examination of emerging market country/commodity proxy pairs shows a similar lack of proxy-like qualities. Given the breadth of the evidence discussed, we conclude that investors should not expect their emerging markets equity exposure to act like a substitute for commodity exposure. This assumption is especially dangerous for investors looking for portfolio diversification. To diversify properly, investors should invest directly in commodities through futures and not through any purported equity proxies. Copyright 2013 Parametric Portfolio Associates, LLC. All rights reserved. For Informational Purposes Only; Not an Offer to Buy or Sell Securities. 09
About Parametric Parametric, headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies and implementation services to institutions and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT (home to Parametric affiliate Parametric Risk Advisors, LLC, a registered investment adviser). Disclosure This information is intended solely to report on investment strategies and opportunities identified by Parametric. 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As a result, the tabulation of certain reports may not precisely match other published data. Data may have originated from various sources including but not limited to Bloomberg, MSCI/Barra, Fact- Set, and/or other systems and programs. Please refer to the specific service provider s web site for complete details on all indices. Parametric makes no representation or endorsement concerning the accuracy or propriety of information received from any other third party. The value of commodities investments will generally be affected by overall market movements and factors specific to a particular industry or commodity, which may include weather, embargoes, tariffs, health, and political, international and regulatory developments. Economic events and other events (whether real or perceived) can reduce the demand for commodities, which may reduce market prices and cause their value to fall. 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