Investors have had an on again, off again relationship with emerging market (EM) stocks and exchange-traded funds. That makes sense considering emerging markets led the way out of the 2009 market low then faded as the dollar strengthened. More recently, fears of a double-dip U.S. recession sent investors back to emerging markets, and then the weak dollar and the rise of inflation in China brought these investors back home.
The Blackrock iShares strategy team chimed in on the subject, noting that investors are increasingly looking to decouple their EM investing from such broad funds as the iShares Emerging Markets ETF (NYSE: EEM).
Blackrock pointed out that EM stocks and funds will continue to struggle because: 1) they are overvalued relative to investments in developed markets; 2) inflation continues to be a problem in EMs; and 3) investor risk appetite has been falling.
Given all of this, you would expect investors to sell EM stocks and move on. Yet this dismisses the great long-term growth fundamentals of countries like Chile. Instead, investors are getting picky.
The Blackrock strategists noticed early signs of “unbundling” — increasing flows in single country ETFs as investors implement more specific EM investment strategies especially over the short- to medium-term horizon.
Consider this: Inflows into the iShares Brazil (NYSE: EWZ) in January matched the $1.3 billion raised in all of the fourth quarter. The iShares South Korea Index Fund (NYSE: EWY), the iShares Canada (NYSE: EWC), and iShares Taiwan (NYSE: EWT) have also shown strong flows. The iShares Chile (NYSE: ECH), shown above, has also been a strong performer.
Investors are clearly becoming more selective about their emerging market exposure, an approach that should be embraced as they look to capitalize on the promising long-term growth prospects in select economies.
For now, I recommend investors avoid EM stocks altogether or look at short positions in weaker regions or those countries more sensitive to rising price pressures, like Brazil. My favorite way to play this is the ProShares UltraShort Brazil (NYSE: BZQ), which returns twice the inverse daily return of the iShares MSCI Brazil Index (NYSE: EWZ).
One of Brazil’s central bank officials warned this week that inflation is likely to pass its annual target in coming months. If so, interest rates will be raised if needed. Consumer price inflation is already running at a 6.4% annual rate while the country’s policy interest rate stands at a whopping 12%.
According to the iShares strategists, Brazilian equity performance and Brazilian inflation rates are closely linked. Equity valuations are sensitive to what prices are doing. Right now, for Brazilian stocks to move back to historical fair value would require the inflation rate to fall to 4.5%. That’s not likely. And as a result, stock prices will be under pressure to fall in order to restore historical norms. That, as a result, will benefit the BZQ fund.
Overall, once risk appetites return and the dollar looks to start falling again, the key to success will be to focus not on EM stocks in general but on the individual country-specific ETFs which hold the most promise.
Disclosure: Anthony has recommended the UltraShort Brazil (NYSE: BZQ) to his newsletter subscribers.
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