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November 15, 2016

Commodities and Emerging Economies: Flying High or Feet of Clay?

What does the fate of the BRIC countries and the launch of the latest acronym for investors tell us about today’s commodities businesses? Michael Schwartz at EKA Software Solutions takes a look.
Forget the BRICs and the MINTs; it appears that there is a new acronym in town. In October, market research firm, Absolute Strategy Research (ASR), launched CARBNS, a new commodities-dominated grouping, consisting of Canada, Colombia, Australia, Russia, Brazil, Norway, and South Africa. 
This mix of developed and developing economies is ASR’s attempt to address the shortcomings of the traditional emerging market groupings that have dominated investment portfolios and benchmark indices for the past fifteen years. These groupings – which are often erroneously assumed to have a strong positive correlation with commodities – have attracted criticism because they have implied some kind of equivalence between very disparate countries.
The ASR argument is that market groupings can only be truly useful and relevant when members share common characteristics and a common driver. In the case of the CARBNs, the common driver is commodity prices, and so the fortunes of the group are highly correlated with commodities indices and the overall resource cycle.

Building From BRICs

The history of the BRIC countries shows why this new thinking has merit. First coined in 2001 by Jim O’Neill, then chief economist at Goldman Sachs, the acronym BRIC (for Brazil, Russia, India and China) has become a standard part of the investment lexicon. The term caught on, suggesting as it did a recalibration of the global, post-cold war economy towards emerging markets, and their higher than average growth trajectories.
Only China, still a rapidly urbanizing powerhouse that built its success on its manufacturing and export prowess, really lived up to the growth hype to become the world’s second biggest economy – despite its current slowdown. Inevitably, that slowdown has had strong ripple effects across the global economy, and in particular the commodities markets that were buoyed by demand from one of the biggest consumers of energy and other raw materials on the planet.
The consequent fall in worldwide commodity prices has benefited commodity-importing nations (both rich and poor) but it has hurt big commodity producers and exporters like Russia and Brazil – both of which were in full-blown recession by late last year.
Russia, regarded by many economic analysts as too dependent on its oil and gas industry, has also suffered from the drastic fall in the price of oil. The value of the ruble has plummeted due to lower oil exports and oil revenues are thought to be down about $30 billion in the five years to March 2016. Meanwhile, Brazil’s economy deteriorated as the prices of commodities – its main engine of growth – crashed, and corruption scandals engulfed politicians and business owners.
As huge consumers and producers of commodities, the relationship between the economies of China, Brazil and Russia and wholesale prices of any number of raw materials is a complex one. The commodity markets of Brazil, China and Russia have experienced – and even driven – both the highs and lows of the past decade and a half.

Newly MINTed Economies

As an illustration of how far BRIC countries had fallen, by the end of 2015 Goldman Sachs had quietly closed down its BRIC fund, which had lost 88 per cent of its asset value since 2010, and folded the investments into its larger emerging market funds.
By that point, a new acronym was being bandied about by the investment community. In early 2014, O’Neill was championing the MINTs (Mexico, Indonesia, Nigeria and Turkey) – a name first coined by analysts at Fidelity. This time, the new grouping represented a shift in attention from emerging markets to so-called “frontier markets.”
Like the BRIC countries before them, this next generation of emerging market pace-setters has superficial similarities: helpful demographics in the form of youthful and growing populations; and a strategic location that enables them to engage with larger neighboring markets. Indonesia is close to China. Mexico is on the U.S.’s doorstep. And as every Istanbul taxi driver will proudly inform you, Turkey straddles both Europe and Asia. Only Nigeria’s physical advantages are less immediately obvious.
But again, the assumption that these are similar, commodity-dominated markets, is wide of the mark. Mexico, Indonesia and Nigeria are all leading commodity producers, but Turkey is not. Mexico has a substantial manufacturing sector that is becoming integrated in U.S. supply chains. It is also attracting foreign investment that is driven by a new ‘anywhere but Brazil’ sentiment in Latin America.
Turkey’s manufacturing sector has also grown recently but, in contrast to Mexico, is still focused on the lower end of the value chain. In both Indonesia and Nigeria, manufacturing, and consequently demand for raw materials is still relatively underdeveloped – oil production is a far more important factor in both countries’ economies.
Like the BRICs before them, the MINTS are demonstrating that being a strong consumer of raw materials or commodities producer is not enough protection against other external or internal factors. Nigeria still suffers from corruption and theft of natural resources. Indonesia, whose plentiful supplies of coal supplied China when demand was soaring, has seen a knock-back in its key market. Newly built real estate in Istanbul appears to defy gravity, but currency shocks, terrorist attacks and IMF intervention have brought the economy down to earth. The recent attempted coup in Turkey has added another dent to the stability and security on which president Recep Tayyip Erdoğan and his AK party have built their own power base and Turkey’s economic growth.

The End of the Acronym?

Certainly the global economic position has changed hugely since the BRICs first caught investors’ imaginations – and all the countries involved have played their part in shaping and re-shaping the resulting political and economic climate. Besides, no single country can sustain double-digit growth forever – even in the most encouraging environment. The very premise on which emerging market groupings are created – that they will deliver substantial returns above those experienced in more developed neighbors – is by definition, time limited.
Given recent experiences, it’s not surprising that capital markets have become wary about treating what are actually very diverse countries as a single bloc. Whereas emerging markets were once seen to be rising and falling as a group, the countries involved have actually diverged from each other, as have the asset classes involved.
This is a view that most players in the commodities markets have long understood. Asset and commodity classes are what drives activity, and not necessarily the countries producing or consuming them. Which suggests that ASR is on to something with the new commodities-focused CARBNs mix of extremely advanced and still-developing economies.

Interconnected Markets

Does it make sense to group mature and developing countries where commodities are a sizable component of GDP? First, many commodities businesses are truly global – oil, agriculture and soon natural gas with LNG. There is little to be gained by focusing purely on the Middle East or West Africa, for example, or by viewing them as entirely separate domains. These are closely correlated, inter-connected markets. And what happens in one most certainly affects what happens in another. We may not know whether the flap of a butterfly’s wings in Brazil sets off a tornado in Texas, but we do know that oil production in Brazil is affected by hurricanes in the Gulf of Mexico. For commodities businesses, a global view is a necessity.
The second, and no less obvious point, is that nothing lasts forever. The centers of demand and production for any given product can and do move around the world. Demographics change the nature of markets – and markets change demographics. What were once strong centers of manufacturing excellence can go from sure thing to yesterday’s news relatively quickly.
Understanding the causes of these changing patterns with hindsight may be intellectually satisfying, but it doesn’t help the business. On the other hand, having insight into possible market directions and understanding the possible implications of factors as diverse as the Colombian referendum on the FARC peace deal or the certifying of the Panama Canal for LNG transportation, is the source of sound decision-making. Fundamental analysis of national economies, industrial conditions, as well as the financial status and even management capability of individual companies has to be a key part of the decision-making process.

Correlated with Capital

The third point is that commodities businesses are not the only participants in commodities markets. Large financial houses and even hedge funds take positions in a variety of markets which in turn can move prices and risk very quickly.
For businesses that are equipped to take advantage of volatility to increase their margins, the overlap with financial markets can be advantageous. For manufacturers of consumer goods that simply want to maintain a steady input cost for raw materials, their presence is much less welcome. Technical analysis of all statistics generated by market activity, including past prices and volumes, plus effective risk management to protect against market fluctuations and counterparty and credit risk is needed.
The story of the BRIC and MINT countries also shows us that unexpected and often unpredictable external factors play a considerable role in the commodities markets. At the time of writing, President Putin and head of Rosneft, Igor Sechin, were discussing capping production as part of a possible deal with OPEC, in order to support oil prices – which promptly ticked up. Nonetheless, Russia’s economy remains sub-par thanks to international sanctions in place following its annexing of the Crimea.
At the same time, sterling was experiencing a vertiginous plunge as the reality of Brexit hit the markets, pushing up the price of the country’s imports of raw materials and finished goods – with certain consumer favorites vanishing from the shelves of the biggest retailers. When the Federal Reserve eventually raises US interest rates, it will inevitably strengthen the dollar, and many countries with dollar-pegged economies and dollar-denominated debt will come under pressure – as will the price of the commodities they produce or import. As ever, exchange rates remain a key risk factor.
As do meteorological conditions. Back in 2015, wildfires in Indonesia, floods in East Africa, active hurricanes in the eastern Pacific, and a subdued monsoon season in India were all attributed to that year’s El Nino. The long-term effects of short-term devastation can be hard to calculate, as can the more sustained impacts of global warming. Nonetheless, for industries with global supply chains, tight margins, complex logistics and a heavy reliance on international shipping, these are just extreme examples of the day-to-day challenges that the weather presents.

Data Deluge

Above all, the changing nature of commodities markets and emerging economies show that this already information-intensive business is at risk of becoming overwhelmed with data – with no concomitant gain in insight.
The breadth and depth of understanding that is now required, the connections that must be made, and the correlations that must be recognized is far too much for non-specialist tools to handle. Hindsight and historical analysis only gets you so far. Predictive and prescriptive analytics are now essential – and that means an analytics solution, like those developed by EKA, that have commodity-specific algorithms that merge data from multiple systems, analyze huge amounts of information, and instantaneously turn them into actionable insights.
The global picture is vast and intricate. Commodities businesses have always been aware that it cannot be reduced to a single grouping or a catchy acronym. But they should also be aware that it cannot be reduced to a page on a spreadsheet either.  
Courtesy of www.ekaplus.com via Commodities-Now (More from Commodities-Now Here
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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