EUM: Emerging Markets Not Out of the Woods Yet

Beijing still finds itself in a fiscal policy pickle

   
EUM: Emerging Markets Not Out of the Woods Yet

Editor’s note: This column is the latest update in our Best Stocks for 2014 contest. Anthony Mirhaydari’s pick is the ProShares UltraShort MSCI Emerging Markets (EUM) exchange-traded fund.

BestStocks2014size185 EUM: Emerging Markets Not Out of the Woods YetWhen I selected the inverse ProShares UltraShort MSCI Emerging Markets (EUM) ETF as my pick for the 10 Best Stocks for 2014 contest, it was an out-of-consensus idea, to put it lightly. The market had just come off of a roaring performance in 2013. Hopes were high. Sentiment and investor positioning was off the chart.

But my skepticism about the health of emerging market economies was justified by the currency turmoil and market volatility seen in January. Countries like Argentina and Turkey played a role, either because of fiscal mismanagement or political drama.

A powerful rebound in emerging-market stocks since then has many thinking the problem is solved.

But it’s not. Here’s why.

At center stage is what is happening in China, a country that has gone on an epic credit and infrastructure binge since the financial crisis, and is overdue for a massive hangover.

Just to give you an idea of the scale in play here, since 2008, the Chinese banking system has expanded by an amount equal to the current size of the U.S. banking system. In less than a decade, the Chinese have issued more credit than it took more than 100 years for America to accomplish.

Think about that.

In the beginning, things were fine. Loans were issued to fund new factories, condos and apartments. Then loan officers, encouraged by local politicians, got overzealous. A housing bubble formed. Overcapacity hit industries like coal and steelmaking. And in 2012, Beijing was forced to pull back on the reins as inflation became a problem.

China started to slowly tighten monetary conditions last summer. Banks were asked to hold more deposits in reserve. Inter-bank lending rates spiked. And as credit dried up, companies suffering from diminished revenue and pinched profitability (as economic growth slowed and the fixed costs of overcapacity hit the bottom line) were desperate to keep rolling over the credit burdens.

As a result, we’ve seen the yields offered on new debt products steadily increase over the last two years. The trend of higher-cost credit and lower profitability is not a sustainable one.

The problem came to a head in January on fears over the possible default of the $500 million “Credit Equals Gold #1″ debt trust issued by a struggling coal company. A last minute bailout ahead of the lunar New Year holiday eased concerns.

040214HSBC EUM: Emerging Markets Not Out of the Woods YetThen, amid a marked slowdown in Chinese economic data, Chinese stocks have rallied on hopes Beijing will be forced to loosen its grip on policy — maybe even announcing new stimulus measures — to reinvigorate economic growth.

On Tuesday, the HSBC China Manufacturing PMI indicated factory activity in the Middle Kingdom is contracting at its sharpest pace, month-over-month, since 2011.

That’s unlikely because Beijing understands that easing up now would only encourage speculators to dive into risky, high-yield bond products with even more enthusiasm. It’s all about moral hazard, or the risk that investors start believing that their government will save them from catastrophic losses.

040214SSEC EUM: Emerging Markets Not Out of the Woods Yet

No wonder, then, that the underlying Shanghai Composite stock index has melted lower during the past few days; in contrast to the rally in the U.S.-based iShares China Large-Cap ETF (FXI) ETF. Historically, when that has happened, the FXI has realigned with Chinese stocks and moved lower.

In response, I am adding the ProShares UltraShort China (FXP) back into my Edge Letter Sample Portfolio after selling it for a 14% gain back in March.

This is a more aggressive play on the same theme that led me to recommend the EUM fund at the start of the year.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he has recommended FXP and puts against FXI to his clients.


Article printed from InvestorPlace Media, http://investorplace.com/2014/04/emerging-markets-eum-update/.

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