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Differentiating Between Emerging Markets For Better Returns

Summary Emerging markets are often grouped together, but it’s better not to. Changes in monetary policies may be upon us and some countries should do better than others. Countries with sizable deficits are more likely to experience problems and should be avoided. The year 2015 has been a forgettable one so far for many emerging markets. For instance, the iShares MSCI Emerging Markets ET F (NYSEARCA: EEM ), which is the leading ETF for emerging markets is down by 11 percent this year when it comes to liquidity. By comparison, stock markets in countries such as the U.S. and Japan are at record levels. Some people may therefore feel that emerging markets are more of a bargain and have more upside still left in them. A long position in emerging markets is an option worth exploring from this standpoint. On the other hand, some may argue that the worst is not over for emerging markets and there is still some downside left. Avoiding long positions or even initiating short positions in emerging markets is the way to go if one agrees with this viewpoint. A third option is to break down emerging markets into smaller groups and pick the one that is most likely to do well in the future. The group that is most likely to underperform is to be avoided or even shorted as an alternative or as an addition to long positions in emerging markets. How to differentiate between emerging markets While they may be grouped together under a single name, the fact remains that emerging markets are more often than not very different from one another. Some countries have little if anything in common with other emerging markets despite all of them being referred to as emerging markets. It may therefore be a good idea to think of emerging markets not as a single group, but rather as several distinct groups. There are many ways one could divide emerging markets into separate groups. For instance, some may be democratic countries, while others are more autocratic. Some rely heavily on the export of raw commodities, while others depend on the export of manufactured goods. There are lots of options if one wants to break down emerging markets into smaller groups. However, one way that should be given extra consideration is to divide countries based on whether they run a surplus or a deficit. More specifically, does a country run a current account surplus or a current account deficit and why should it matter? Why it matters whether countries have a current account surplus or deficit Countries with significant current account deficits tend to borrow heavily relative to the size of their economy, usually from foreign sources of capital. For many years, this wasn’t such a big issue due to the prevalence of very low interest rates in the U.S. This forced many to look at alternative places with higher yields. Many emerging markets offered such a destination. However, the Federal Reserve is widely expected to begin raising interest rates, which will make it more expensive to borrow. Monetary conditions have actually already tightened even though the policy of zero interest rates is technically not yet over. Capital outflows have picked up in a number of emerging markets as foreign capital is anticipating the next move by the Fed. In this environment where borrowing is increasingly problematic, countries with a current account surplus should be more resilient to higher interest rates than those with chronic deficits. The latter will have to make more adjustments to the existing structure of their economy than the former and this may cause a divergence in how countries perform going forward. Deficit countries do have a number of options when it comes to dealing with higher interest rates. For instance, they could try to reduce their imports and the need for hard currency to pay for these imports. Large reserves can also provide relief. Even so, surplus countries should have a much easier time as their transition period should be shorter and less complicated than those that have to fix or at least try to reduce their deficits. A major advantage for the former in comparison to the latter. Emerging markets ranked by surplus or deficit The table below lists 15 of the most prominent emerging markets, starting from those with the largest current account surplus to those with the biggest deficit. These countries combined make up 96.33 percent of EEM. Based on these numbers, Taiwan should have the least amount of trouble dealing with the Fed raising interest rates. South Africa is the one that looks the most vulnerable as of right now. Mexico may have a bigger deficit, but it’s also a bigger economy. Country GDP Current account surplus/deficit (USD) Taiwan 489B 19.67B South Korea 1410B 10.61B Russia 1861B 5.4B Thailand 374B 1.56B Malaysia 327B 1.21B Philippines 285B 0.95B China 10360B 0.63B Turkey 800B 0.09B Poland 548B -0.96B Chile 258B -2.59B Indonesia 889B -4.01B Brazil 2346B -4.17B India 2067B -6.2B South Africa 350B -8.68B Mexico 1283B -8.86B How to position yourself with regard to emerging markets One drawback of an ETF such as EEM is that it can get dragged down by a few bad apples. Some countries may do very well within the basket, but their performance can get negated by other countries that are doing poorly. A possible solution to this issue would be to take out the bad apples and leave only the good ones. If someone agrees with the thesis that emerging markets with big deficits will have a harder time with higher interest rates, then it’s best to avoid these countries and stick with the ones that run sizable surpluses. The latter are much less likely to experience any setbacks resulting from changes in global monetary policies. As such, they’re more likely to outperform resulting in better returns.

5 Broader Emerging Market ETFs Surging This Quarter

Emerging market investing has gone dour recently on slowing growth, a potential decline in foreign direct investment on a likely cease in cheap money inflows from the U.S. (post lift-off), a stronger greenback and slouching commodities. No doubt, this time around, emerging markets are more hardwearing to the Fed blows than they were in 2013 when taper talks resumed, but threats of underperformance still persist. Investors should note that several market researchers hinted at weak global growth for the coming years and cut their estimates. For example, the Organization for Economic Cooperation and Development (OECD) slashed global growth estimates twice in three months . The organization now projects that the global economy will expand 2.9% in 2015 and 3.3% in 2016, down from the prior guidance of 3.6% for both years. For the emerging markets, protracted slowdown in the largest region China has been a huge concern and its ripples in the other parts of the bloc are souring the sentiments over the region. Moreover, China accounts for a gigantic portion of the global commodity market. Thus, a long drawn out weakness in this economy has weighed heavily on commodities. This in turn dealt a blow to two other commodity-rich emerging markets, Brazil and Russia, which are now facing recessionary threats. IMF expects the Russian economy to contract 3.8% this year and 0.6% in the next, while Brazil’s economy is expected to shrink by 3% in 2015 and 1% in 2016. However, the OECD expects both the struggling economies to return to growth by 2017. Within the bunch, India seems to be a winner, though it has its share of problems in the form of political complexity and the resultant delay in application of pro-growth reforms by Prime Minister Narendra Modi. In such a backdrop, iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) has added about 6.6% so far this quarter (as of November 20, 2015) after the MSCI Emerging Market Index lost about 19% in Q3 – the largest quarterly retreat in four years – instigated by the Chinese market upheaval, per Bloomberg. But investors should note that not all emerging market ETFs have delivered lower than 10% gains so far this quarter. In fact, Chinese ETFs returned superbly after the stock market rout in Q3 when the market had a bloodbath. Several China ETFs, especially A-Shares ones, returned more than 20%. Several Latin American ETFs too have given stellar returns, some on political hopes while others on compelling valuation. However, since particular country-ETF investing looks risky in the present market backdrop, which might not sustain returns at any point of time on any single issue, below we highlight a handful of broader emerging market ETFs that have given impressive returns even in a tough operating environment. Broader market options appeared better picks as the strength of one economy often compensates the weakness of the other. Emerging Markets Internet & Ecommerce ETF (NYSEARCA: EMQQ ) – Up 23.5% The Internet and e-commerce industry is developing fast with the increased use of social networking sites and online trading as well as the growing adoption of smartphones and other mobile Internet devices. So, this product has more to do with technological expansion in the emerging markets rather than reflecting the slowing potential of those economies. In fact, EMQQ can succeed on the back of a fast-expanding middle class population of emerging nations. This $11.7-million ETF considers companies from Asia, Latin America, Africa and Eastern Europe. Country-wise, China takes the highest allocation in the fund. EMQQ charges 86 bps in fees and is up 23.5% so far in the fourth quarter (as of November 20, 2015). First Trust BICK Index ETF (NASDAQ: BICK ) – Up 16% This $8.3-million product considers securities from Brazil, India, Mainland China and South Korea. The recent rally in the Brazilian market following its Congress decision to cut on government expenditure to boost the waning economy favored the fund. The product charges 64 bps in fees. WisdomTree Emerging Markets ex-State-Owned Enterprises Fund (NYSEARCA: XSOE ) – Up 14.3% The $2.2-million fund can entice investors having less faith in the state-owned emerging market companies, but still intending to tap the region’s growth story. According to the issuer, the MSCI emerging market index generated 80% less returns than the U.S. markets over the past five years and this was due to the anemic performance of the SOE. In terms of geographic exposure, China (23.5%), South Korea (16.5%) and Taiwan (10.9%) have a double-digit exposure each. The fund charges 58 bps in fees. Guggenheim BRIC ETF (NYSEARCA: EEB ) – Up 12.9% As the name suggests, the $90.6-million fund considers BRIC (Brazil, Russia, India and China) economies. It charges 64 bps in fees and is heavy on IT (up 25.44%), while energy (19.30%), financials (17.38%) and telecom (12.9%) round out the next three spots. SPDR MSCI Beyond BRIC ETF (NYSEARCA: EMBB ) – Up 11.6% The $2.5-million ETF put double-digit weight in South Korea, Taiwan, South Africa and Mexico. The fund has returned over 11.6% so far in Q4 (as of November 20, 2015). Original Post

BRICs, PITs, And PIGS: Go Ugly

In my research and investing, I stress three things: people, structure and value. I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests, and trade at valuations that are below fair value if not outright cheap. This blog is somewhat aligned with valuation and yet another example of how investing in beaten down, unpopular and ugly markets can lead to better returns. Usually, valuations are low in markets that are not very attractive. Stocks can look very inexpensive, and prices seem to reflect all the negative news, but who knows when the news can get even worse? And it can take even greater will power to stay invested when nobody around you sees your point of view, friends and peers are calling you crazy, and well-educated, respected and slick I-bank analysts and traders are negative (think negative of your point of view?). It’s a lot easier to invest in markets when (where) there’s a lot of good news and the future looks very bright. The problem is that these markets tend to be expensive and future returns tend not to be as good. To contrast these two points, let’s look at two emerging market acronyms – BRICs and PITs that originated about the same time. BRICs stands for Brazil, Russia, India and China. The acronym is attributed to Jim O’Neill in a paper he wrote for Goldman Sachs in November 2001. In it, he argued that these four countries should be included in high-level government groupings such as the “G7” because their size and growth would make them increasingly influential. The acronym came out not long after the tech crash. Wall Street was ripe for a new story, and over the next few years, the term became more popular. Goldman Sachs and many others launched BRIC funds and ETFs. There are now over 200 of them, according to a very expensive database. The term took on a life of its own and the four appear to like the grouping. Just a few months ago the four countries and South Africa formally launched the BRICS Development Bank ( link here ). About the same time BRICs was coined, traders and analysts who survived the late 1990s Asian financial crisis were referring to the ASEAN countries as PITs. The term stood for Philippines, Indonesia and Thailand: the three of the hardest economies and markets. Unlike BRICs, I don’t think anybody has come forward to claim responsibility for it. Calling your home market a degrading term soon after your clients lost money would not likely make one popular. Investing in the four BRIC countries when the phrase was coined would have been smart. The four countries’ headline indexes are up 302% since late 2001 for a CAGR of some 10.5% (return figures are based on equally weighted headline indexes, in USD, dividends not included). In contrast, and despite the acronym’s negative connotation, one would have done considerably better by investing in the three PITs markets than the four BRICs markets. An equally weighted investment in the three grew by 675% over the same time period, which means the PITs investor would have made more than double the money than the BRICs investor. All three PITs indexes did better than even the best performing BRIC index. Thailand, the worst performing PITs country, rose by 229%, a bit more than the best performing BRICs country, which rose by 611% from November 2001 to November 2015. The outperformance of the PITs countries continued after the expression was coined. In July 2006, Goldman Sachs launched a BRIC fund. From launch to close, the fund’s performance was just under 20% and almost exactly in line the four countries’ equally weighted performance. Over the same time period, the three PITs indexes increased by 157%, meaning that one would have made almost eight times more money by investing in the markets that were unloved rather than the ones that were popular by investment funds and advisors. Are PIGS Today’s PITs? PIGS stands for Portugal, Italy, Greece, and Spain and was supposedly coined by traders. These are of the world’s worst performing economies and equity markets since the 2008 global financial crisis. Like PITs it is not a flattering grouping and member countries have reportedly renounced the term (more information on PIGS is here ). I suspect PIGS could be an up-to-date version of PITs. The origins of both are the same and they describe markets that are having problems and are out of favor. Also, like PITs, the countries in the grouping are geographically close and have a lot in common in terms of economic integration, language, and culture. This is more than can be said of BRICs. Except for their size, I don’t really see much that binds them like PITs and PIGS. Since July 2012, the four PIGS headline indexes are up 9% on average. Not very impressive for two-and-a half-years. However, these could be some of the better performing markets in the next 10 to 15 years if similar to the PITs. Back to BRICs Ironically, now may be a good time to consider investing in BRIC equities. Russia has some of the world’s least expensive large companies and is one of my biggest exposures. Brazil is starting to look interesting with its currency down some 40% in the last two years. There are some exciting and inexpensive companies in China, and at 7x PE, the Hang Seng China Enterprise Index does not seem very expensive. Weren’t US equities trading at the same level in the early 1980s just before that market’s 18-year bull run? There’s also a good contrarian signal. Big banks have a good habit of closing operations and products just when things start turning around. HSBC closed its South East Asian equity research offices in 2001 – just before those markets went on a multi-year bull run. Goldman’s closing of its BRICs fund may be a similar signal. Go Ugly This short piece is meant to show that going against the grain and doing what is uncomfortable and unconventional many times leads to higher returns. The best place to find value is typically in ugly sectors and geographies. Are there other places that appear to be ugly and warrant catchy phrases such as PIGS? How’s “RUKs”, for Russia, Ukraine and Kazakhstan, three ex-Soviet countries whose currencies are down and some of the highest interest rates in the world. Or “PCB”, for Peru, Columbia and Brazil, three of the worst performing equity markets this year for US dollar investors? Or “JOBQE”, for Jordan, Oman, Bahrain, Qatar and Egypt which are amongst the world’s least expensive equity markets likely due to the large amount of uncertainty in the Middle East?