ETF.com: What are you seeing for the rest of 2014 in terms of a big pullback in the S&P?
Tsai: We think that the bull market is very much intact. In fact, all bull markets in the U.S. have ended with some sort of burst of euphoria, and we have not seen any semblance of that yet.
Institutional investors remain wary, concerned that the market has run up too quickly without supporting fundamentals, and retail investors still have so much cash on the sidelines. Those are very bullish signs. We do think we are at the latter stages of the bull market, but the bull market still has legs, and it’s going to surprise on the upside.
That’s not to say we will not have a pullback from time to time, but I will note that every such pullback that we have had recently—and by “recently” I mean over the past year or so—it’s been muted.
ETF.com: Any tinkering you’re doing to your portfolio to position yourselves going forward?
Tsai: We take a directional approach to the short book, so, going forward—as long as we believe that the bull market environment remains intact—we plan on keeping a moderate exposure to the short side comprised almost entirely with EEM. Actually, we’ve sold short EEM not only as a hedge against our long book, but also because we see some worrying signs in emerging markets.
ETF.com: What sort of red flags are you seeing in EM?
Tsai: Emerging markets—including Brazil, China, South Africa, Turkey, among others—are slowing. And that’s despite positive growth from the U.S. and Europe, which are two very large areas of the world that affect the performance of emerging markets. So when the U.S. and Europe are growing and emerging markets are slowing, to me that’s a worrisome sign.
The return on equity and the return on capital for nonfinancial emerging-market-listed companies have fallen considerably. Per-share earnings for EM small- and large-cap and nonfinancial companies have flattened or are contracting.
We’re also seeing a rise in the yield, the interest rate of U.S.-dollar-denominated emerging market debt, particularly high-yield corporate bonds, and we’re also seeing yields rise in local currency government bonds. If that continues, we think another recession is possible in that area of the world, including Brazil, China, South Africa and Turkey.
I would add that the interest rate on high-yield corporate bonds has surged in China, particularly for three-year BBB+ bonds. The yield spread of a BBB+ bond in China over a comparable duration government bond has also soared. Elevated corporate yields and spreads for BBB+ bonds in China is a sign that borrowers are distressed.
And lastly, I should point out that emerging market private-sector external debt is very high in a number of countries, including Malaysia, Chile, Korea, Peru, Poland, Turkey, South Africa, Brazil, Russia, India, Mexico and Taiwan in particular.
This is borrowings by companies and banks from foreigners in foreign currency. Private sector external debt in South Africa is currently about 21 percent of GDP compared with 12 percent in 1996. Emerging markets as a whole, excluding China, are at about 20 percent of GDP. This is as high as the peak of the 1997-1998 Asian financial crisis.