EM ETFs Had A 7-Year Best 1H: Will The Surge Last?

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Includes: DEM, EEM, EIDO, EZA, PXH, RSXJ, THD, UUP
by: Zacks Funds

After a string of issues, including the turmoil in China, global growth slowdown, the gradual waning of cheap dollar inflows and currency concerns dragging the emerging markets (EM) down, a positive shift in sentiment has been seen lately.

The popular emerging market ETF, the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM), shed 5.5% in 2013, 0.05% in 2014 and 15.1% in 2015. However, after reeling under pressure for the last three years, EM stocks managed to return 8.6% in the first half of 2016, beating the developed markets by 5.5% and underscoring the best first-half performance in seven years. EEM was up over 10% in 1H16.

Behind the Surge

First of all, moderation in U.S. growth has lowered the chances of a faster rate hike this year, which is why the Fed is acting dovish after a liftoff in December and is likely to remain accommodative in the near term as well. This in turn has curbed the gains of the greenback, which was the king of currencies last year.

So far this year (as of July 18, 2016), the PowerShares DB USD Bull ETF (NYSEARCA:UUP) is down over 2.6%. In the wake of a weaker dollar, impressive gains were noticed in commodity prices as most commodities are linked to the U.S. dollar.

A favorable demand-supply balance also gave cues that the commodity market rout has almost bottomed. And as emerging markets are rich in commodities, a boom in commodities acted as a major tailwind to their economies. A staggering performance was delivered in the first half by Latin America and Russia. While Russia benefited from an oil price rally, Latin America won on stronger commodities and hopes of a political change for the better.

Second, a subdued greenback did a lot in shoring up the EM currencies with the latter logging their largest first-half advances since 2011. This in turn reduced the countries' current account deficit. And from late last year, this aggregate deficit turned out a surplus, as per an article published in the Financial Times. Also, a cheaper valuation following a steep sell-off in 2015 perhaps opened the door to EM investing.

Can Emerging Markets Sustain the Rally?

Though it is too early to take a call at this stage, the initial hints are positive. We would also like to note that big research houses including Citigroup, Credit Suisse and BlackRock believe they can gain in 2H. Analysts even projected 17% expansion in EM equities over the next 12 months. Plenty of upbeat factors can drive this often-volatile segment going forward.

Brexit a Boon to EM?

EM looks less perturbed by Brexit. Trade relations between the U.K. and the broad-based emerging market are meager, thus posing no-to-little threat to emerging market investing.

Plus, the Fed has indicated that it will keep a tab on how Brexit impacts the global economy before hurrying up on policy tightening. This ensures a few more days of cheap money inflows to EMs.

Hunt for Yields: With bond yields at record-low levels across the developed world, investors' craving for steady and strong current income is warranted. Now EM securities are known for their solid yields. Also, emerging market local currency bonds provide investors greater protection to capital gains than EM equities.

Agreed, the space is risky enough, but as per Bloomberg, emerging market bonds topped the risk-adjusted returns table in 1H16. USD IG EM corporate index headed the list with 2.96% riskless return and 8.26% total return.

Stabilization in China: Of late, Chinese worries, which often turn the global market crazy, have subsided. China's relentless efforts to shore up its waning economy should act as a driver in the broad-based EM rally.

Better Growth Picture: Despite broad-based growth issues, especially after Brexit, Morgan Stanley expects emerging markets to pick up steam going into 2017. The bank expects developed markets to log only 1.2% growth next year, whereas emerging markets to grow from 4% this year to 4.7% in 2017.

Year-to-Date Winners

So far this year (as of July 18, 2016), Russia ETFs are ruling, with the VanEck Vectors Russia Small-Cap ETF (NYSEARCA:RSXJ) gaining over 45%. Among the other outperformers, the iShares MSCI Thailand Capped ETF (NYSEARCA:THD) (up about 23.5%), PowerShares FTSE RAFI Emerging Markets Portfolio ETF (NYSEARCA:PXH) (up about 24.5%), Schwab Fundamental Emerging Markets Large Company ETF (NYSEARCA:DEM) (up 24.3%), iShares MSCI South Africa ETF (NYSEARCA:EZA) (up 19.5%), iShares MSCI Indonesia ETF (NYSEARCA:EIDO) (up 21.2%) and WisdomTree Emerging Markets Equity Income ETF (DEM) (up 19.3%) worth a mention.

Risks to the Rally

If the Fed turns hawkish sooner than expected, the commodity market (along with key oil) rally gets over soon and China comes up with new economic issues, the dream rally that the EM ETFs have seen may fail to last long.

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