3 Reasons to Underweight South Africa

| About: iShares MSCI (EZA)

In my opinion, investors should consider minimizing their exposure to emerging markets in Europe, the Middle East and Africa, otherwise known as EMEA.

The big reason: Emerging markets in EMEA generally have close economic ties to the eurozone, which as we all know is going through a rough spot and is likely to experience at least a mild recession this year.

Drilling down to the stocks of specific emerging market countries within EMEA, I’m particularly focused on South Africa as it’s the largest country in the MSCI Emerging Markets EMEA index. In fact, while I’m not making an official call on emerging EMEA overall, I’m now initiating an underweight view of South African stocks for three reasons.

Relatively Expensive: First, as the chart below shows, South African equities are relatively expensive compared to other emerging markets. They are currently trading at 2.5x book value vs. an emerging market average of 2.2x.

Click here for definitions: Price to Book and Credit Default Swap.

Relatively Risky: Second, as the chart above also shows, while credit default swap spreads for South Africa are down since late last fall, they are still above those of all Latin American and Asian emerging market countries, making South Africa a riskier trade. This is partly because South Africa, along with the rest of EMEA, is more exposed to the continuing economic drag from the eurozone than other parts of the emerging market world.

Economic Conditions: Finally, certain economic conditions in South Africa aren’t all that great. South African inflation is a bit high and up from six months ago at 6.1%. In addition, the country has a persistent current account deficit and a very high unemployment rate.

To be sure, South African stocks do have some things going for them and a lot of smaller EMEA countries look worse. South Africa’s growth prospects actually seem pretty robust with the IMF predicting 2012 real GDP growth for the country of 3.6%. South Africa also has relatively high corporate sector profitability.

Still, in my opinion, the negatives outweigh the positives and I believe there are better emerging market plays out there than South Africa such as countries in Latin America (potential iShares solution: ILF).

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

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