With markets reeling around the world we feel it is time to revisit our cautious stance on emerging markets which we have had in place since the middle of August 2015. The timing of our initial call was spot on - with the benchmark emerging market ETFs like (NYSEARCA:EEM) and (NYSEARCA:VWO) plunging 8% and 12.5% respectively for the remainder of 2015. While the EM world managed to recover off the late August lows - the ETFs have been relatively dead money ever since and performance will continue to be under pressure as they fall victim to a one-two punch combination of a rate tightening cycle in the US, and an ongoing currency devaluation from the PBoC in China. Add plunging commodity prices into the mix and the result is a highly noxious cocktail for emerging markets over the next six months.
As a result we retain our call to remain sidelined from the EM world for at least the first half of 2016.
Tech and China weightings likely to drag on performance
Central to our thesis for persistent weakness in the EM world in 2016 is our call for a consumer led slowdown in developed markets in the first half of the year. We expect evidence of this slow down to start appearing in the results of 4Q consumer discretionary names especially those exposed to consumer technology. Most of the major players in the Emerging Market ETF space such as and are both heavily exposed to this consumer tech sector. South Korean large cap tech firms along with Apple's myriad of suppliers dominating the top holdings and both ETFs are also overexposed to China. With technology valuations worldwide at elevated levels, EM ETFs are also exposed to any sentiment shift in the developed market tech sector - a risk not worth taking on in our view.
Renminbi Devaluation looks set to accelerate posing contagion risks for EM FX
Despite some respite for Chinese markets toward the tail end of 2015, this week's epic plunge in Chinese stocks has refocused investor concerns on the potential for further Renminbi devaluation throughout the coming year. Offshore Yuan rates have been falling sharply in recent days and any sustained weakness is likely to spread to emerging FX. Currencies such as the Won, Rupiah, Ringgit, Rand, and Real are all under threat in our view which would severely curtail returns for investors with the US dollar as their base currency, although Yuan weakness will be the biggest driver of fund underperformance. Commodity players are also at severe risk and will likely lead to balance of payment issues for resource rich countries like Brazil, South Africa and Indonesia. Plunging currencies will also reignite the usual concerns regarding FX reserves as governments try and attempt to stem the effects of capital flight.
Deteriorating credit conditions should lead to downgrade in ratings
With the start of a rate tightening cycle underway, one of the last places investors will want to position themselves is in Emerging Market debt- corporate or sovereign. The dearth of liquidity in world wide fixed income markets since the Fed pulled the trigger in late December poses even greater challenges for the EM world where shallow liquidity could lead to outsize moves to the downside over the next 6 to 12 months. While we have yet to see the wave of downgrades from the major credit agencies, most EM currencies are already trading as such - and we believe the next wave of currency weakness will lead to downgrades all round with some markets in danger of losing investment grade status. The overall jump in risk premium for the sector will be unwelcome news for corporates who face significant spikes in their financing costs over the next year.
In summary, our previous call to remain sidelined from Emerging Markets remains intact going into the first half of 2016 as we see no compelling reason for dollar based investors to expose themselves to a sector with such unfavorable risk reward metrics. Gains in stocks are likely to be offset by deteriorating FX positions and liquidity fears in these markets are likely to be a growing story for the first six months of 2016. Stay sidelined.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.