Seeing the future through green coloured glasses

The future relationship between commodities and emerging markets (EMs) stocks will no longer be one that is strictly determined by the price of commodities.  EM composite indices are now dominated by tech stocks, consumer stocks, and communication stocks. Many EMs have, over the past two decades, diversified and the main growth driver is domestic consumption of goods and services. However, the relationship between EMs and commodity stocks, particularly metals, energy, and agricultural commodities, is still extremely significant given the critical role they play in EM economies as sources of taxation, employment, currency reserves, and as custodians of a nation’s natural resources. So how may investors think about EMs and commodities?

Politics and the pandemic provide a bumpy ride

The outlook for commodities and EMs in the short term is heavily dependent on a number of factors including progress in containing the COVID-19 pandemic both domestically and in developed markets and  a slowdown in Chinese growth which may lead to a reduction in capital intensive investment in China and the consequent fall in demand for some commodities such as steel, iron ore, and lead. In addition, supply chain disruptions that may be more permanent than anticipated due to domestic labour shortages and pervasive inflation, stemming from global demand and supply mismatches and continuing shipping and other transport bottlenecks, will affect the short term outlook.  

There is also a mixed story for commodity markets when it comes to the US and European post-pandemic recoveries. Since commodities tend to be US dollar priced, much will also depend on how quickly the US Federal Reserve decides to normalise rates as this will affect dollar strength vis-a-vis EM currencies. Fiscal policy, particularly in the US, will also play a key role in terms of demand. As noted by the World Bank in April 2021, a faster withdrawal of stimulus could pose a downside risk to commodity prices. However, if the bipartisan $1 trillion infrastructure bill is finally adopted in the United States, which House Speaker Nancy Pelosi has said would happen by 27 September, it could prove to be supportive for metals, including aluminum, copper, and iron ore.

We’ll always have Paris

Looking at the medium to longer term, prices of commodity stocks will likely be affected by how environmental, social and governance (ESG) friendly or sustainable they are perceived to be.  In May 2021, Armando Senra, the head of iShare at the world’s largest asset manager, Blackrock, said that he thought ESG investments could become a $1 trillion category by 2030. This potential growth may be attributable to three key factors: 1. the increasing global awareness of climate change 2. changes in financial and non-financial reporting regulations and 3. changes in government agreements and policies. As global scientific groups such as the Intergovernmental Panel on Climate Change (IPCC) in their August 2021 report make clear the relationships between the rise in global temperatures, human activity, and specific weather events, there will be increasing levels of pressure by investor groups and society at large, particularly unified behind social media, for commodity producers and governments to be as ESG friendly as possible. The scientific establishment of direct linkages between commodity harvesting activities, for example mining and erosion, the formation of sinkholes, loss of biodiversity, and contamination of soil, groundwater and surface water by chemicals from mining processes, puts these commodity producers under great pressure. We have already seen this in the energy sector as large players like BP and Shell were forced to write down the value of their assets in 2020 due to the financial impact climate change could have on their operations. The influence of social media allows activists to create real reputational risk issues with the consequent share price impact for commodity producers who are not deemed to be ESG-friendly. However the biggest explanation as to why ESG friendly stocks may grow substantially in the near future is due to regulatory drivers such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and global political commitments by nations to achieving “net zero”, i.e. the 2015 Paris Agreement goal of achieving net zero emissions by 2050.

It is the commitment by some countries to reach net zero even earlier, e.g. Austria, Germany, Sweden and Finland are targeting 2045, which is helping to intensify the global energy transition. This may further strengthen the demand for some commodities that are used in renewable energy products such as batteries or in building green infrastructure. 

And it is this point on energy transition, the move towards “green” products such as renewable energy  and transport, e.g. the UK government banning the sale of new petrol and diesel cars by 2030, and insisting on electric vehicles (EVs), that will boost certain commodities in the longer term. Among these are highly likely to be cobalt, copper, iron ore, lead, lithium, nickel and zinc as they are all needed to build things such as EV charging points or are used within batteries for those EVs. 

A problem of intersectionality 

However, as is always the case with EMs, geopolitics will be the deciding factor when considering the prospects for commodities. As countries seek to reach net-zero, there may be rising tensions over the ownership and trading rights of these strategic commodities.  There will also likely be political conflicts, particularly between China, the US and Europe, related to the ethics of accessing these strategic commodities from certain regimes, like the Taliban in Afghanistan who now control access to what may be the world’s second largest source of Lithium in addition to other rare earth metals and copper. 

The volatility we are seeing now across commodity markets will likely last until the Coronavirus pandemic is better contained and a clearer picture emerges of the permanency of domestic supply shifts. The fact that commodity stocks are no longer strictly aligned with EMs economic performance puts the onus on the investor to focus on market structure differentials and domestic regulatory policy response to ESG concerns.  

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