What's Working In Emerging Markets

When it comes to investing in emerging markets, not much has been working. Sure, the last month has been solid; the two major emerging market stock indexes gained nearly 13% in March, while emerging market currencies had their best month in 18 years in the period.

But from a longer-term perspective, it's been anything but rosy for the space. In fact, you'd have to go all the way back to 2007 to see emerging market equities at their highs. That's when the two largest broad emerging market exchange-traded funds—the Vanguard FTSE Emerging Markets ETF (VWO | B-95) and the iShares MSCI Emerging Markets ETF (EEM | B-100)—peaked.

The two ETFs crashed during the financial crisis in 2008, but quickly rebounded along with the rest of the financial markets during the next few years. They reached a lower secondary peak on April 21, 2011. From there, it's been a steady drip lower for emerging market stocks, with the sell-off picking up steam in 2015.

VWO & EEM Price Charts Since 2007

By now, the reasons for the woes facing emerging markets are well known. From the slowdown in China to the global commodity bust to political crises to terrorism and war, there has been no shortage of downside catalysts for the space.

Moreover, all of these bearish factors are largely still in play, creating major head winds for VWO and EEM going forward, and calling into question whether the recent bounce in emerging market stocks can continue.

Bright Spots Working For Investors

Given this downright gloomy outlook, it may come as a surprise that there are some bright spots within emerging markets. Believe it or not, there are some emerging market ETFs that are trading at levels higher than where they were in 2011 or even 2007.

At the top of the pack is the iShares MSCI Philippines ETF (EPHE | C-98), which gained 51.1% since April 21, 2011 through April 6, 2016.

Compare that with VWO and EEM, which are down 23.4% and 26% from their 2011 highs, respectively.

Returns For EPHE, VWO

Currency moves often have a big impact on U.S.-dollar-denominated emerging market ETFs, but in this case, they haven't been much of a factor. The greenback gained about 7.4% against the Philippine peso in the time period in question, reducing returns only modestly.

The linchpin for Philippines stocks has been a strong domestic economy, which insulated the country from the slowdown in China and Asia more broadly. Gross domestic product in the Philippines expanded by 6.3% in the fourth quarter of 2015, the fastest pace in a year.

And unlike other governments that are cutting back, the Philippines is increasing its fiscal spending to record levels on everything from defense to infrastructure.

Part of the strong performance in the Philippines economy is due to the policies of President Benigno Aquino III. Under his leadership, the budget deficit fell to less than 1% of GDP in the last two years; however, elections in May will usher in a new administration―which may or may not be as business-friendly as Aquino’s.

Fastest-Growing Economy In The World

Another emerging country that has a business-friendly leader is India, where Prime Minister Narendra Modi came to power in 2014 amid promises of economic reform. In local-currency terms, the Indian stock market has performed quite well in the last several years, but unfortunately, U.S.-dollar-denominated India ETFs have struggled due to a consistently falling rupee/dollar exchange-rate.

Since April 2011, the iPath MSCI India ETN (INP | D-96) shed 15.4%, weighed down by a 50% increase in the dollar against the rupee.

Returns For INP, VWO

Interest rate cuts totaling 1.25% last year by the central bank, and another 0.25% cut in April to a five-year low, relatively high inflation near 6%, and a budget deficit at more than 3.5% are all serving to keep pressure on the Indian currency.

Nevertheless, the stimulative policies of the government are certainly doing their part to aid economic growth. India is the only economy in the world expected to grow by more than 7% this year.

Longer-term, favorable demographic trends may keep India at the top of the heap when it comes to growth. If the rupee eventually stabilizes or declines more slowly, that could finally translate into gains for dollar-denominated India ETF investors.

Thailand Upgraded To ‘Overweight’

The third emerging market stock market that's shown signs of life amidst the carnage elsewhere is Thailand. The iShares MSCI Thailand Capped ETF (THD | B-97) edged up by 4.2% in the comparison period.

Those gains come despite a 15.1% increase in the U.S. dollar against the Thai baht.

Returns For THD, VWO

Analysts at J.P. Morgan Asset Management recently upgraded Thailand stocks to an "overweight," citing the potential for more monetary easing and government spending. They also cited high dividend yields―THD currently has a 30-day SEC yield of 2.7%―and low equity allocations among domestic institutions as reasons to buy.

Thailand's GDP grew by a little less than 3% in 2015, up significantly from the sluggish levels of the year before.

Dollar-Denominated Sovereign Bonds

Of course, emerging market investing opportunities aren't limited to just equities. In the fixed-income markets, U.S.-dollar-denominated emerging market debt has delivered impressive returns.

The PowerShares Emerging Markets Sovereign Debt ETF (PCY | B-60) delivered a total return of 36.3% since April 2011, while the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB | B-58) had a return of 29.5%.

Returns For PCY, EMB

Currently, PCY has a 30-day SEC yield of 5.6% and EMB has a 30-day SEC yield of 5.1%.

Because they are dollar-denominated, investors in these ETFs don't have direct currency risk. However, declining emerging market currencies make it harder for the governments to pay interest on the bonds―effectively increasing credit risk (rising emerging market currencies have the opposite effect).

Up until now, that hasn't been a problem, and even the lowest-rated governments continue to pay interest on their dollar-denominated debt.

Two newer entrants into the space are the Vanguard Emerging Markets Government Bond ETF (VWOB | B-34) and the iShares Emerging Markets Corporate Bond ETF (CEMB | D). CEMB takes a slightly different tack by holding corporate bonds rather than sovereign bonds like the other ETFs mentioned.

PCY, EMB, CEMB and VWOB are all solid options to access higher returns in the emerging market space without wading into the volatile equity markets.

Contact Sumit Roy at [email protected].