Emerging Markets Still Stuck on Oil

Developing-world assets aren't ready to decouple from oil.

OPEC's failure to agree on a production freeze offers the perfect opportunity for emerging markets to show they have decoupled from oil. That's unlikely to happen.

Optimists have reason for believing that developing-world stocks and bonds are ready to break the unusually high correlation they've shown with crude prices in the past year. Bears have retreated from equity markets, with the MSCI Emerging Markets Index climbing 22 percent from its January low, while high-yield bonds have started to move less in lockstep.

Short interest in the largest exchange-traded fund tracking developing nation dollar-denominated bonds has fallen to 2.2 percent of shares outstanding, near the lowest level since 2012, from 13 percent in mid-February, Bloomberg News reported. At the same time, the 21-day correlation between Bank of America Merrill Lynch's High Yield Emerging Markets Corporate Plus Index and Brent crude futures has dropped to 27.2 percent from more than 60 percent earlier this year. The current level is much closer to the five-year average of 24 percent. 

Back to Normal?

The correlation between emerging market high-yield bonds and oil is back near its five-year average

Sources: Bloomberg; Bank of America Merrill Lynch indexes

There's another key tailwind for emerging markets: China has fired up all stimulus cylinders, with the broadest measure of new credit rising far more than estimated in March. Beyond that are the dovish sounds from Fed Chair Janet Yellen and the easiest monetary policy in history at the Bank of Japan and the European Central Bank.

So with Brent crude down as much as 7 percent today, might this be the ideal time for emerging markets to show they've detached?

Restrain your enthusiasm. Short interest on the iShares MSCI Emerging Markets Index ETF has been a poor predictor of performance. In the past five years, whenever short interest peaked, the index began to rally; when short interest fell, the index weakened. The opposite should happen.

Bearly Credible

Short interest has been a poor prediction tool for emerging market stocks in the past

Source: Bloomberg

As for the bond universe, investors are about to be reminded of how painful low oil prices can be. Standard & Poor's said on Friday that there were 46 defaults across the globe so far this year, the highest number for the period since 2009. Peabody became the latest big energy company to file for bankruptcy last week. As losses mount, junk debt investors are likely to reconsider their exposure to emerging markets or simply sell to raise money for fund redemptions.

As Gadfly columnist David Fickling noted, the last time Saudi Arabia drove oil prices sharply down it helped bring about Black Monday, which in turn prompted a severe crisis in emerging markets. While such a doomsday prediction may seem far-fetched this time around (for one thing, China's economy is vastly larger than three decades ago), investors are probably wise to remember the potential for disruption. 

Emerging markets may still offer value in the long run. Right now, they look ripe for a correction, courtesy of oil prices.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at clangner@bloomberg.net

    To contact the editor responsible for this story:
    Matthew Brooker at mbrooker1@bloomberg.net

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