Monday, January 17, 2011

The emerging markets-commodity disconnect

There has been a lot of angst about inflation lately:
As we can see from the chart of the R/J CRB Index, commodity prices continue to rise:

In particular, rising food prices have pressured emerging market economies. In Tunisia, what began as food riots morphed into popular riots eventually brought down the government, which raised concerns about which country might be next. Meanwhile in India, the cabinet met last week to address the problem of surging food prices, as the prices of basic staples like onions have skyrocketed (also see analysis here).

As a result, emerging market equities have began to weaken, but a look at EEM, the emerging markets ETF, shows that its technical uptrend remains intact.

EM equities and commodities are the same macro trade
We may be at a setup for emerging market stocks compared to commmodity prices here. After all, emerging market stocks and commodities are the same side of the coin of the macro "risk" trade, the same side of the coin of the macro "reflation" trade and the macro "growth" trade. Consider this chart below of EEM compared to the CRB Index. Emerging market stocks appear to be near the bottom of a trading range compared to commodities.

Long EEM/Short XLE and XLB
How to play this? After all, it's difficult to get exposure to the R/J CRB Index. One way is to buy EEM and short XLE, the Energy sector ETF, as a pair trade.

We can see a similar pattern of EEM against XLB, the Materials sector ETF:

If emerging market stocks and commodities are still the same side of the coin of the risk/reflation/growth trade, then either EEM has weakened too much or commodity prices and commodity stocks are ahead of themselves. There is, of course, the possibility that the relationship is breaking down - which is a good idea for anyone who enters such a trade to put on a fairly tight stop in order to define their own risk-reward comfort zone.

1 comment:

coreyconard said...

Nice blog!!!!! Have explain emerging markets concepts very nicely. Graphical representation is very useful to understand this concept

Emerging Markets