By The ETF Professor
Emerging markets equities and the ETFs that house them have had a dismal year to this point.
Most investors know that and the point is highlighted by an average year-to-date loss of about 14.3 percent for the Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) and the iShares MSCI Emerging Markets (NYSEARCA:EEM), the two largest emerging markets ETFs by assets.
Those glum performances did not stop Citigroup from forecasting 27 percent upside over the next 12 months for the MSCI Emerging Markets Index, the index EEM tracks.
"Our main reasons for optimism: consensus is too bearish/underweight emerging markets, liquidity is ample, economic surprises are improving, earnings are outperforming developed markets, and valuations look cheap," said the bank in a note obtained by CNBC.
From current levels, 27 percent upside for EEM would imply the ETF trades up to $47.50 in a year based on the Citi forecast. EEM trades around $37.40 at this writing. EEM has shown a mere 0.41 percent in annualized tracking error over the past decade, according to iShares data.
Assuming that tracking error holds true over the next year and Citi's forecast for the index proves accurate, EEM could still be in significant for upside. Still, the valuation call on emerging markets can take a while to materialize for investors and it is far from guarantee. Some of the most deeply discounted developing markets have been among the worst performers this year.
Cheap For Good Reasons
Finding emerging markets ETFs that trade at discounts to EEM is not difficult. Nor is explaining why these funds and their holdings have become inexpensive.
Interestingly, the iShares MSCI Brazil Capped ETF (NYSEARCA:EWZ) with a P/E ratio of 19.5 trades at a slight premium to EEM. Interesting because EWZ is by far the worst performer this year among the four major country-specific ETFs tracking BRIC nations, down 24.4 percent.
It can be argued that EWZ has effectively priced in the worst news regarding Brazil's economy, including rising inflation, increasing unemployment and a sagging currency. However, a case can also be made that the ETF has only priced in past news, not the possibility of further downward GDP revisions or problems with Petrobras (NYSE:PBR), the ETF's largest holding.
Then there is Russia, a market that is almost always trades at a discount to the broader emerging markets universe. That is to say it is not new news that Russia is cheap. The Market Vectors Russia ETF (NYSEARCA:RSX) had a P/E of just over five at the end of May, but discounts have not stopped the ETF from falling 14.4 percent this year.
Russia does offer some catalysts in the form of possible dividend increases and benefiting from higher oil prices. However, there are still obvious reasons, few of which are positive, why Brazilian and Russian shares are cheap. Those countries combine for 16.5 percent of EEM's weight, potentially positing a threat to Citi's ambitious forecast.
Citi is overweight Asian countries over the Middle East and Latin America with a preference for China, South Korea and Taiwan in the region, according to CNBC. Regarding China, claims the market is cheap are not new.
Yes, the iShares China Large-Cap ETF (NYSEARCA:FXI) has a P/E of just 12.7, well below EEM's. Part of the reason might be that FXI has an almost 51.6 percent weight to financial services stocks and if there are deeper liquidity problems in its banking system than China has let on to this point, investors should not be forced to pay up for the privilege of being long China.
With regards to South Korea, Citi is not alone in its bullish view of the country. Goldman Sachs recently sang the same tune and with a P/E of 15.6, the iShares MSCI South Korea Capped ETF (NYSEARCA:EWY) is cheaper than EEM.
No one is saying it is not possible that EWY and South Korean stocks offer some upside, but being long this market requires fighting significant headwinds that South Korea itself has confirmed as major risks. Those being the weak yen and the Federal Reserve tapering quantitative easing.
South Korean bankers and policymakers have publicly confirmed those risks so to be long EWY, investors are merely hoping that either the yen rises or the Fed does not taper. Asking for one of those scenarios to play out is probably asking for too much and getting both seems improbable.
China and Taiwan combine for over 32 percent of EEM.
The bottom line is that it is not out of the realm of possibility that EEM, VWO and related ETFs offer upside from here. These funds are battered and some investors will take the valuation bait. On the other hand, asking for 25 percent upside or more when Brazil, China, and South Korea, are afflicted with macro headwinds that will not disappear overnight is asking for a lot.
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