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How To Build A Strong Dollar Emerging Markets Equity Index

By Christopher Gannatti At WisdomTree, we have written extensively regarding how the movement of currencies can have the potential to impact equity investments. Within emerging markets, the approach of currency hedging, which has become quite popular within developed markets, is currently expensive. 1 That’s why we created a new approach, the WisdomTree Strong Dollar Emerging Markets Equity Index , which seeks to mitigate the potentially adverse impact of a strengthening U.S. dollar against emerging market currencies . Does a Stronger U.S. Dollar Impact All Emerging Market Equities Equally? Our answer is no-a strengthening U.S. dollar (and weakening emerging market currencies) does not create an equivalently negative impact across all emerging market stocks. Some important considerations could include: Geographic Revenue Distribution: Companies that derive more of their revenues from the United States actually see their goods and services become less expensive to U.S. consumers as the dollar strengthens. Commodity Sensitivity: Since many commodities are priced in USD, a strengthening U.S. dollar is usually accompanied by declining commodity prices. Certain emerging market companies are commodity sellers, thereby having the potential to see revenues increase as commodity prices rise. Of course, others are commodity buyers, so they have the potential to see their costs decrease as commodity prices fall. Debt Levels: For the most part, emerging market corporate debt issuance is in U.S. dollars. If the dollar is strengthening compared to a company’s home currency, and the majority of that company’s revenues are in that home currency, a scenario in which it is tougher for that company to continue to pay for its debt obligations can develop. These represent just some of the considerations to think about when looking at how companies within emerging markets may respond to a stronger U.S. dollar. Zeroing In on Strong Dollar Emerging Market Constituents The WisdomTree Strong Dollar Emerging Markets Equity Index steers around companies that may be the most at risk to respond negatively to a strengthening U.S. dollar by virtue of its annual screening process: Sectors Excluded at the Annual Screening 2 : Energy, Financials, Materials, Telecommunication Services and Utilities. We believe that the companies within these sectors, in aggregate, could be at greater risk of responding negatively to a strengthening U.S. dollar. Sectors Included at the Annual Screening: Consumer Discretionary, Consumer Staples, Health Care, Industrials and Information Technology. We believe that companies within these sectors-given that they also must derive a minimum of 15% of their revenue from the United States-could be at a lower risk to respond negatively to a strengthening U.S. dollar. In the chart below, we look to explore these premises, utilizing blends of MSCI Indexes to represent included sectors 3 and excluded sectors 4 . Within this chart, the U.S. dollar is measured by the U.S. Federal Reserve Trade-weighted Major Currency Index. Last Five Years: As U.S. Dollar Strengthened, Blend of Included Sectors Outperformed Blend of Excluded Sectors (click to enlarge) Overall Upward Trend of the U.S. Dollar: Over the five years ended September 30, 2015, the U.S. dollar strengthened 4.6% per year, creating a potential headwind for any unhedged exposure to emerging market equities. But we see that the ratio of the performance of the blend of the included sectors compared to the performance of the blend of the excluded sectors tended to increase. That means that the blend of included sectors outperformed that of the excluded sectors-showcasing our initial point that emerging market equities do not all respond equally to a stronger U.S. dollar. Positive Returns Even While Not Hedging: What we also find interesting is that over the three-year and five-year periods, the blend of included sectors exhibited positive returns. This occurred as the dollar was getting strong, AND it is important to note that this blend is NOT currency-hedged. The performance of the underlying equities was enough to more than offset the currency headwind during these periods. While there is no way to know if this performance will continue, if an investor believes that the U.S. dollar has the potential to continue to strengthen and that U.S. short-term interest rates will remain lower than the short-term interest rates seen within many emerging markets for a considerable time, WisdomTree’s Strong Dollar Emerging Markets Equity Index could be interesting to consider. References Bloomberg, as of 9/30/15. Subsequent to Index screening it is possible that a current constituent may spin off a subsidiary company that may be classified as a Consumer Staples, Health Care, Telecommunication Services or Utilities sector firm. Spin off firms that remain within the Index do not get removed between Index rebalances due to their sector classification. Blend of included sectors: Represents the eligible sectors of the WisdomTree Strong Dollar Emerging Markets Equity Index, while maintaining sensitivity to the country exposures of this Index as of 9/30/15. Includes the MSCI Taiwan Information Technology Index, 24.7%; MSCI Taiwan Consumer Discretionary Index, 12.0%; MSCI Taiwan Industrials Index, 9.5%; MSCI South Korea Information Technology Index, 15.2%; MSCI South Korea Consumer Discretionary Index, 13.9%; MSCI South Korea Industrials Index, 7.6%, MSCI South Korea Health Care Index, 6.3%; MSCI India Information Technology Index, 5.7%; and MSCI India Health Care Index, 5.1%. Blend of excluded sectors: Represents an equally weighted blend of the sectors excluded from eligibility for the WisdomTree Strong Dollar Emerging Markets Equity Index and includes the MSCI Emerging Markets Energy Index, the MSCI Emerging Markets Materials Index, the MSCI Emerging Markets Financials Index, the MSCI Telecommunications Services Index and the MSCI Emerging Markets Utilities Index. Important Risks Related to this Article Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Christopher Gannatti, Associate Director of Research Christopher Gannatti began at WisdomTree as a Research Analyst in December 2010, working directly with Jeremy Schwartz, CFA®, Director of Research. He is involved in creating and communicating WisdomTree’s thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Christopher came to WisdomTree from Lord Abbett, where he worked for four and a half years as a Regional Consultant.

Can Service-Oriented Sectors Manufacture A Healthy Bull In Stocks?

Perma-bulls have dismissed the manufacturing slowdown as little more than noise. Yet weakness in the energy, materials and industrials sectors played a larger-than-life role in the August-September meltdown across the entire stock landscape. Can the same narrow leadership from the technology, health care and consumer discretionary segments push stocks significantly beyond the peak that investors salivated over in May? The Institute for Supply Management (ISM) reported that its services index climbed to 59.1 for October. Any reading above 50 represents economic expansion. Meanwhile, the ISM’s manufacturing index limped to the barn with 50.1. Not only is the percentage teetering on the brink of contraction, but the nine point disparity represents the widest divergence between the two indices in 14 years. Perma-bulls have dismissed the manufacturing slowdown as little more than noise. Yet weakness in the energy, materials and industrials sectors played a larger-than-life role in the August-September meltdown across the entire stock landscape. Can the same narrow leadership from the technology, health care and consumer discretionary segments push stocks significantly beyond the peak that investors salivated over in May? Keep in mind that, at this point, three-quarters of S&P 500 companies have reported Q3 results. Trailing 12-months earnings are on target to come in near $93.8 per share. That represents a 7.5% decline from the $106 per share witnessed in 2014. And the news on earnings may be worse than anyone would like to believe. At the height of the previous bull market (10/02-10/07), as investors were rounding the bases to close out the fourth quarter of 2007, trailing 12-month (TTM) P/Es hit 22.2. Where are we today? 22.5. Granted, we can choose to blame the poor data on the beleaguered energy sector. However, there are at least two big problems with doing so. First, treating an entire sector of the economy as an outlier because it does not fit an upbeat narrative is no different than wiping out an entire sector because it does not accentuate a negative story. Ex-energy S&P 500 earnings may look “less bad,” though ex-healthcare earnings would unfairly paint a ridiculously ugly landscape. Second, investors blamed the financial sector for the elevated valuations seen in the S&P 500 circa Q4 2007. We already know what happened to those who dismissed tech in 2000 and financials in 2007. It follows that ignoring the energy sector’s warnings about waning global demand and manufacturer stagnation is foolhardy. Either the global economy improves and sectors rally across the board or, conversely, the over-reliance on “services” via tech/healthcare/consumer will end badly. At present, investors are enjoying a near-term feel-good associated with worldwide stimulus. There’s no doubt about it – the promise of lower rates alongside increased liquidity still have the power to pump stocks up. The iShares MSCI ACWI Index ETF (NASDAQ: ACWI ) successfully retested August lows in September and has been looking to re-establish a longer-term uptrend by rising above its 200-day trendline. On the flip side, the hope that Europe, China and Japan will all intervene with monetary policy actions may or may not be enough to offset Federal Reserve tightening in December. Should the Fed choose to raise overnight borrowing costs, albeit modestly, the directional shift is likely to push the dollar higher. The U.S. Dollar Index is already 22.5% higher than it was last July; it is already a major headwind for earnings of U.S. multinationals and is partially responsible for a slew of job cuts. Even more troubling for stock investors is the 21st century relationship between the S&P 500 and the U.S. Dollar Index. In bull markets, the S&P 500/U.S. Dollar Index price ratio has moved steadily upward. In 1999, about a year prior to the 2000-2002 tech wreck, the ratio flatlined. The S&P 500/USD price ratio then moved sharply lower during the 2000-2002 bear. Similarly, in mid-2007, roughly a year prior to the 2008-2009 financial collapse, the ratio stalled again. The S&P 500/USD price ratio then moved sharply lower during the 2008-2009 financial crisis. Might there be cause for some concern that the flattening in this price ratio is back? After all, if a bull market is healthy, one should anticipate the S&P 500 to experience more momentum than the world’s reserve currency. In contrast, when the large cap benchmark is declining relative to the U.S. dollar, safety and capital preservation are often more important to folks than capital appreciation. Fed Fund Futures are currently projecting a 60% probability of a rate hike at the Federal Reserve Open Market Committee (FOMC) in December. Should it happen, chairwoman Yellen will emphasize service sector strength and downplay manufacturing weakness. The goal? Inspire investor confidence in the central bank’s decision making. In truth, downplaying the difficulties in manufacturing and/or over-stating the strength of the services sector is a mistake. The rapidly rising costs/premiums associated with health care not only misrepresent the well-being of the consumer, but those costs/premiums reflect a diversion in spending at the pump. Does anyone expect health care costs/premiums to plummet the way prices at the pump have? For that matter, if energy prices creep higher, where will the consumer spending power come from? Not from borrowing… those costs are set to move higher. Not form wages… wage growth is going nowhere. While our current allocation to stocks for moderate growth and income clients remains at 60% (mostly large cap, mostly domestic), and while our current allocation to bonds remains at 25% (mostly investment grade, entirely domestic), we’re still holding roughly 15% in cash. And while the 10-year treasury bond via the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) appears as though it might capitulate alongside a Fed hell-bent on leaving zero percent rate policy after seven years (if only to say that they did so), I would not be surprised to see buyers step in. Who would buy intermediate-term treasuries when 2-year yields recently hit 4-year highs? Those that favor dollar-denominated debt over debt in faltering currencies. Those that see relative value where comparable sovereign debt is yielding less. And those that anticipate ongoing economic concerns where short-term yields rise in response to Fed action, while longer-term yields do not move appreciably. To wit, the remarkable stock market rally of October did little to alter the yield spread between “10s” and “2s.” Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.