This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by K. Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.
When evaluating emerging markets, we believe it is important to consider them not as a whole, but rather more granularly at the country and regional levels. The point is that while emerging markets share similar traits and characteristics, they all offer investors different flavors of risk and reward.
Over a market cycle, countries and regions behave differently; with that in mind, ETFs can help investors target the right emerging market exposure at the right time.
The fact that commodities appear to be in a secular bear market leans toward a market weight or underweight of emerging markets.
However, once one begins to analyze the underlying countries, it becomes easier to identify economies that are poised for growth. It’s important to recognize that emerging markets play a part in a diversified portfolio, but the addition of too much emerging markets exposes the portfolio to geopolitical risks often far above and beyond those of developed nations.
The quick takeaway is that Asia seems to be worth the risks, especially in China, with funds like the SPDR S&P China ETF (GXC | C-33). But first a bit more on what’s attractive and what’s not in the emerging markets, and why.
Global Themes Affecting Emerging Markets Today
We believe that while emerging markets are cheap on a broad valuation basis, an intelligent breakdown is needed to weed out the losers from the potential winners. For instance, investors who want to capture major growth opportunities in Asian countries such as China, India, Indonesia, Taiwan and Korea could benefit by avoiding other areas that are likely to be less prospective.
Those less attractive options include countries in Latin America and elsewhere that struggle with the financing of their current accounts and that could be hit by currency crises at any time—think Brazil, Turkey, South Africa and Russia.
In addition to zooming into the individual country level to pick the best opportunities within emerging markets, hedging currency exposure can also reduce volatility inherent in international investing.
Commodities On Defense
We also believe commodities are in a new secular bear market.
Thus, the commodity-based countries are struggling, and the strong dollar is hurting those with current account-financing issues. Energy-sensitive countries such as Brazil, Russia, Colombia and Mexico have been hit hard by the commodity weakness. The weakness has affected the countries’ currencies and their local economies.
Meanwhile, countries that are net energy importers, such as China and India, have benefited from lower-priced oil.
More broadly, the S&P 500 Index, as of April 30, had a forward price-to-earnings multiple (P/E) of 17.7, while the MSCI EAFE Index had a forward P/E of 16.48 and the MSCI Emerging Markets Index had one of 13.09. Investing in emerging markets is comparatively cheap, and the underlying growth rate is high.
One other observation worth noting is that frontier markets have a forward P/E of 10.78, according to data compiled by Bloomberg. That’s cheap, and frontier markets offer genuine diversification and lower correlation than emerging markets. They are a genuine diversifier but, of course, have their own extreme political risks.
Political Risks Not Compensated
Political risk and currency risk are extreme, and lately investors have not been compensated for the higher emerging market volatility.
Here are a few examples of material political risk that occurred just in the first quarter of 2015:
Officials at state-owned Petrobras have been accused of corruption in their dealings with construction companies. The government has ambitious plans to improve the nation's fiscal and monetary framework, but a rapidly declining approval rating is hampering the administration's ability to implement effective measures.
Market sentiment suffered as a result of public hectoring of the central bank by the political leadership, along with other political tensions. A plan to replace the parliamentary system with a presidential system is creating rifts with the ruling party. Due to the deteriorating macroeconomic outlook, the government suggested it could miss its 4 percent growth target in 2015.
The struggle continues with Greece and its creditors to recraft a bailout package. It has yet to produce a revised economic plan that satisfies its creditors.
Important Changes In China
It’s difficult to write about emerging markets without specifically discussing China.
Investor sentiment has become bullish as investors are speculating on further monetary easing. There has been a concomitant increase in Chinese retail investor participation in the equity markets, and more than 10 million stock accounts have been opened since the beginning of December 2014 and the end of the first quarter of 2015.
That’s equivalent to the total number for 2012 and 2013 combined.
Emerging Market Currencies Vs. The Dollar: Potential Structural Changes
- BRICS Development Bank is expected to be fully functioning by the end of 2015, with reserves of approximately $100 billion. It will serve as a pool of money for infrastructure projects in Russia, Brazil, India, China and South Africa.
- The number of increases in Chinese bilateral swap agreements will facilitate trade in renminbi without the U.S. dollar medium.
- The newly formed, China-led, $50 billion Asian Infrastructure Investment Bank has been established with wide international support.
Opportunities In Asia?
To cut to the chase, one of the emerging market countries with relative strength is China, which can be accessed with solid funds such as the SPDR S&P China ETF (GXC | C-33) and the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-54). Also exhibiting strength are Hong Kong, Taiwan and South Korea, which are investable with the iShares MSCI Hong Kong ETF (EWH | B-100), the iShares MSCI Taiwan ETF (EWT | B-93) and the iShares MSCI South Korea Capped ETF (EWY | B-93).
India—a market well canvassed by the iShares MSCI India ETF (INDA | C-95) and the WisdomTree India Earnings Fund (EPI | C-81)—had substantial relative strength in 2014, and there is evidence of a strong secular growth trend.
However, recently, its relative strength faded, and valuations are cheaper than those of the U.S. and EAFE, but not as cheap as the rest of Asia.
China’s forward P/E was an attractive 12.62 as of April 30, 2015. Taiwan’s forward P/E is 13.33, and South Korea’s was cheap, at 10.78.
We believe those cheap valuations, along with strong growth in Asia in general, make them attractive. Investors looking to capture the region as a whole in one ETF should look at the iShares MSCI All Country Asia ex Japan (AAXJ | B-85), which would capture much of the region, including India.
Currency-Hedging EM Exposure
In our view, currency-hedged emerging markets exposure makes a lot of sense from a risk/return point of view—at least partially so—as currency volatility has been extreme recently.
As far as that goes, the Deutsche X-trackers MSCI Emerging Markets Hedged Equity ETF (DBEM | D-68) does fare well in our ranks. The fund captures emerging market exposure while hedging away the currency risk.
In our opinion, it makes sense to stick with the commodity consumers (China, India, Taiwan and Korea) and wait for trend confirmation with the producer countries such as Brazil, Russia and South Africa—each of which can be accessed through the following ETFs:
- iShares MSCI Brazil Capped ETF (EWZ | B-97)
- Market Vectors Russia ETF (RSX | B-74)
- iShares MSCI South Africa ETF (EZA | B-95)
The risks in the emerging markets are many, and include higher volatility in broader emerging markets without higher return. Additionally, the risk of a strong dollar causing a currency-funding crisis in Mexico, Brazil, South Africa and Turkey are real.
In China, many point to a credit bubble in housing. Our research indicates there is indeed a bubble in that sector, but we don’t believe it will affect long-term China growth rates to the point that its growth would be greatly slowed.
Further energy price weakness is, of course, a risk (and the current trend) in broader emerging markets. Since commodities are so strongly weighted in emerging market indexes, broader emerging market exposure is not a recommended overweight.
What To Watch For Now
We think it makes sense to watch the currencies of commodity-producer countries. When the long-term relative strength (versus the dollar) in commodity-producer country currencies improves, they may have less trouble financing their current accounts. Conversely, if their currencies remain weak, then they may be subject to currency crisis.
For now, it’s our opinion that investors should stick with the Asian growth economies; namely, China, Taiwan, South Korea and India, and hedge a portion of the currency where possible. That posture should remain in place until there’s confirmation that, with stronger emerging market currencies, a broad emerging market long-term relative trend has begun.
At the time of publishing, the author’s firm owned shares of AAXJ and GXC in client portfolios. Clark Capital Management Group is an independent investment advisory firm providing institutional-quality investment solutions to individual investors, corporations, foundations and retirement plans. Clark Capital was founded in 1986 and has been entrusted with approximately $3 billion in assets. For more information about Clark, contact Advisor Support at 800-766-2264 FREE or [email protected]. Please click here for a complete list of relevant disclosures and definitions.