In our previous update on the state of the EM world in 2016, we outlined our bearish case for both of the major EM ETFs due to our central premise of a consumer led slowdown for much of the coming year - a slowdown we believe will be concentrated primarily in the consumer technology space. Both Apple (NASDAQ:AAPL) and Samsung's (OTC:SSNLF) latest earnings have only hardened this view, with both tech giants using their latest earnings reports to warn investors of a sluggish outlook for the first half of 2016.
Apple forecasting first quarterly earnings decline in over a decade
As a result of this sluggish backdrop, Apple is forecasting next quarter earnings to decline on a QoQ basis for the first time in over a decade. Hardly something to take lightly, and while there is a debate to be had as to how much of this slowdown is related to product fatigue, and how much to dwindling growth in some of the world's largest markets, the fact remains that if Apple is sees a slowdown in its own sales going forward into the first half of this year, then the major EM ETFs will suffer regardless due to their heavy technology weightings.
Samsung sees bleak conditions until the second half of 2016
Apple is not alone of course. Samsung's recent fourth-quarter results while in line with expectations, contained weak first half guidance for 2016, with the company warning investors that it expects earnings to slow in 2016 as a result of various "economic issues and a softer IT market." Sales of Samsung mobile phones generated a 2.23 trillion won profit in the fourth quarter, a 7.3% decline QoQ and further evidence of how a slowdown in global consumer demand and increased competition in the Android space is eating into sales of the company's flagship products.
The iShares MSCI Emerging Markets ETF (EEM) and the Vanguard FTSE Emerging Markets ETF (VWO) overly exposed to Greater China and Technology
Our major gripe with both of the major EM ETFs is their over exposure to Greater China and the technology sector in general. Looking at the holdings of both funds in more detail highlights just how China and Tech heavy the EM funds have become.
EEM's top 10 holdings include Samsung, Taiwan Semiconductor (NYSE:TSM), Tencent Holdings (TCHEY), China Mobile (NYSE:CHL), China Construction Bank (OTCPK:CICHY), Naspers (NPANY), Industrial and Commercial Bank of China (OTCPK:IDCBY), Alibaba Group (NYSE:BABA), Hon Hai Precision Industry (OTC:HNHAY) and Infosys (NASDAQ:INFY).
VWO's top 10 holdings include Tencent Holdings, Taiwan Semiconductor, China Construction Bank, China Mobile, Naspers, Industrial and Commercial Bank of China, Taiwan Semiconductor ADR, Bank of China, Hon Hai Precision, Infosys. VWO has 25% weighting to financial services, (the majority of which are located in China) and 18% of assets in Technology. EEM has similar levels of exposure with 24% weighting in financial services and 23% in technology.
Chinese financials, along with consumer technology companies are not places we would want to be for the next six months. On the technology front, Taiwan Semiconductor (TSMC) is one of the prominent components of both VWO and EEM and one of the company's most at risk to any significant slowdown in consumer tech. TSMC derives roughly 20 percent of their earnings by supplying components to Apple, and would be hard hit should the Cupertino giant suffer a weaker quarter than already expected. As a result, TSMC has already issued weak first-quarter guidance, calling on revenue to decline by as much as 11 percent on an annualized basis due to the ongoing slowdown in consumer demand. With the stock trading near record highs, gaining exposure via either of the two major emerging market ETFs is not an appealing proposition in our view. We have reservations about VWO in particular given the fund has exposure to both the local listing (2.19 % of assets) and via the ADR (1.25% of assets), resulting in a combined 3.44% exposure of fund assets to a single company at risk of a serious correction in our view.
The same goes for Samsung, who not only supply critical Apple components, but also compete with Apple in the global smartphone space. If Apple sees a tough first half of the year on the horizon, then it seems certain that Samsung will find themselves in the same boat. Samsung shares are down 7% year to date, and we believe the stock could easily test the 2015 lows in the coming weeks and months ahead which would be a drag on EEM which has the company as its largest holding.
Strong dollar will continue to weigh on EM consumer
While much of the concern for EM performance in the months ahead focuses on slowing demand, sustained currency depreciation will also generate a significant drag on the sector. Apple's latest earnings are a great case in point. Up to two thirds of Apple's revenue is generated outside of the U.S. - and while a good share of this will originate from developed markets such as the U.K., Europe, and Japan - a sizeable portion also comes from China and emerging Asia. As such, Apple is well placed to comment on the effects that the EM FX bloodbath is having on sales. According to Tim Cook, ongoing strength in the USD reduced revenues by up to 15 percent in the last quarter, a non-trivial sum given the scale of Apple's revenue. Samsung also blamed currency fluctuations for $331m hit to earnings in the fourth-quarter highlighting just how much damage current volatility in EM FX markets are having on corporate earnings. With all signs pointing to continued devaluation of the Yuan, EM currencies will remain under pressure for the rest of 2016 and will prove to be a major obstacle for the EM ETFs to overcome.
No Compelling reason for gaining EM exposure
In short, our main thesis for a consumer led slowdown in 2016 remains intact, an event we believe will be hardest felt in the EM world. The latest guidance from the world's largest tech heavyweights have only highlighted why the sector should be avoided for the time being. From a trading angle we would be waiting for capitulation post first-quarter results before becoming interested and remain sidelined for now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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