Emerging Markets: The iShares MSCI Poland Capped ETF

| About: iShares MSCI (EPOL)
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While Emerging Markets generally outperform developed markets, Poland is an exception as its single factor ETFs are underperforming.

Poland has a high GDP growth, but it has been profoundly affected by deflation which is expected to reverse in 2017.

Based on the economic and fundamental analyses, investing in the single factor ETF is a good long-term investment.

For the last year, Emerging Markets exhibited excellent performance, better than the performance of developed markets. For example, the Vanguard FTSE Emerging Markets (VWO) outperformed the SPDR S&P 500 ETF Trust (SPY) by 10.05%.

Source: Bloomberg Terminal

Since Poland joined the European Union in 2004, its GDP growth rate was higher than the rest of the European Union countries. Poland was the only European country that was able to avoid the global financial crisis due to the smaller size of its economy and its flexible exchange rate regime.

The IMF expects that growth will continue with Poland's GDP expected to grow by 3.7% in 2017 and to continue to outperform other European economies in 2018.

Nevertheless, the credit ratings have a different opinion about the Polish economy. After reviewing Poland's economy on July 1, 2016, the S&P affirmed its BBB+ rating with a negative outlook. Of the three rating agencies, the S&P provided the lowest rating. On May 14, 2016, Moody's gave Poland an A2 rating with a negative outlook, while Fitch gave Poland an A- credit rating with stable outlook on January 15, 2016.

Is it a good idea to consider investing in a single factor ETF in Poland based on the excellent performance of Emerging Markets, its GDP growth rate, and its investment grade credit ratings?

The iShares MSCI Poland Capped ETF (NYSEARCA:EPOL) is the largest single factor ETF with investments of $184,168,898. Since inception until 2014, the iShares MSCI Poland Capped ETF's performance was in line with the SPDR S&P 500 ETF Trust; however, the fund significantly underperformed after 2014.

Source: Bloomberg Terminal

I will take the SPDR S&P 500 ETF Trust as a benchmark for comparing the investment opportunities in emerging markets and developed markets that are available for the American investor. Developed markets are less risky, but are expected to have a lower return.

Asset Allocation and Security Selection

There are differences between asset allocation and security selection that affect total returns.

Source: Bloomberg Terminal

  • First, the most heavily weighted Financial sector slightly outperformed the benchmark, while the second most heavily weighted Energy sector underperformed.
  • Second, the third most heavily weighted Materials sector and the lightly weighted Information Technology and Real Estate sectors significantly outperformed the benchmark.
  • Finally, the Utilities, Industrials, and Telecommunication Services performed poorly relative to the benchmark.

Why is there a significant difference in performance taking despite high GDP growth rate?

Poland experienced economic deflation in 2014 when consumer prices started to decline. Deflation is the primary factor considered by the Federal Reserve in making a decision to increase interest rates.

Japan's monetary policy of quantitative easing and low-interest rates showed how dangerous deflation could be and how the Central Bank can get into the deflationary trap. A deflationary trap is an example of the inability of monetary policy to stimulate inflation through quantitative easing and interest rate cutting.

What are the reasons behind deflation in the Poland?

There are four indirect reasons for the falling consumer prices.

  • First, negative output gap combined with moderate wage growth did not have enough inflationary power.
  • The second reason is the low food prices and the Russian embargo of European Union agriculture products, and the third reason is the weakness of imports from other European Union countries.
  • Weak Energy price inflation that started with a sharp decrease in crude oil price in June 2014.
  • Weak imported inflation from the rest of the European Union countries.
  • Finally, quantitative easing, which boosted bank reserves did not increase lending and the velocity of money. These ultimately deepened Poland's deflation.

In response to the deflation, the Central Bank of Poland cut interest rates by 50 bps in 2015, a record low. The interest rate did not improve the deflationary environment in Poland, and after the recent meeting of Central Bank of Poland, the country's interest rates remained unchanged.

What is the difference in the fundamentals between the two ETFs?

Source: Bloomberg Terminal

Source: Bloomberg Terminal

Overall, investors pay $42.36 per $1 of earnings on the single factor ETF relative to the $20.36 per $1 of earnings of the benchmark.

Even though that single factor ETF is overvalued compared to the benchmark, there are at least three points to consider.

  • First, the Dividend Yield of the single factor ETF is higher compared to the benchmark. This represents a double-edged sword for the investor: On one hand, it provides higher returns; on the other, it indicates a lack of growth potential.
  • Second, the Financial sector, which weighs almost half of the ETF's portfolio, are reasonably priced based on the P/E ratios with lower leverage (D/E ratios), higher Return on Equity (ROE) and Return on Capital.
  • Finally, the Energy sector is undervalued relative to the benchmark based on the P/E ratio. The ROE and ROC are also higher than the benchmark.

The Financial and Energy sectors contribute 62.04% of the ETF's portfolio. Falling prices had a strong effect on the lending power of banks and their ability to make a profit. Despite the deflationary environment and lower commodity prices, those two industries have higher ROC and ROE. This means that the two sectors have a significant potential for growth in the natural inflationary environment.

The analyst projects that by 2017, Poland will experience inflation at a rate of 1.5%, which is lower than the 2.5% target of the Central Bank. This improvement is based on the forecasted increase in commodity prices over the next two years.

Source: Bloomberg Terminal

Source: Agricultural Prices projections, Bloomberg Terminal

Source: Energy Prices projections, Bloomberg Terminal

A deflationary environment puts downward pressure on the exchange rate. Since 2014, the zloty depreciated by 20% from 3.068 zloty per dollar to 3.82 as of September 26, 2016. The iShares MSCI Poland Capped ETF's share price is negatively correlated with the exchange rate and the price decreased from $32 in 2014 to $18.30 as of September 26, 2016.

Source: Bloomberg Terminal

The zloty is expected to appreciate to 3.20 per dollar between 2018 to 2020.

Source: Bloomberg Terminal

The Bottom Line

  • Poland is one of the fastest growing economies in the European Union, and this trend is expected to continue in 2018.
  • Poland, however, is experiencing deflation that puts significant downward pressure on the Financial, Utilities and Consumer Staples sectors.
  • The prices for agricultural products and commodities are expected to increase and thereby support the Energy sector and the pressures of inflation.
  • Poland is forecast to have an inflationary environment in 2017 with forecasted inflation of 1.5%, which is still lower than the Central Bank's target of 2.5%.
  • The iShares MSCI Poland Capped ETF's share price is negatively correlated with the exchange rate. Because of the depreciation of Poland's currency, investors receive less value in terms of US dollars.
  • The share price is expected to increase because of the expected appreciation of the zloty.
  • Given a high GDP growth rate, an expected 1.5% inflation rate and the appreciation of the national currency, buying shares of the iShares MSCI Poland Capped ETF is a good long-term investment.

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.