By: Joseph Hogue of Street Authority
The days of dartboard investing in emerging markets are over.
Over the two years ended April 2008, a basket of these markets, as represented by the iShares MSCI Emerging Markets (NYSE: EEM), surged an impressive 60%. You could have invested in any number of these economies and seen solid returns.
This group of markets eventually swooned and rebounded, but it's increasingly clear that the days of heady returns are gone. In the two years to 2015, the fund lost 11% and individual country funds are posting huge disparities in returns.
As an emerging markets analyst and an expatriate living in South America, I see the shifting economic environment first hand and it's not just down here. The Russian market is crumbling and stocks of African countries have not done any better.
Yet you can't paint these markets with a broad brush. Some markets, notably China and India, have done very well over the last year. The iShares China Large-Cap fund (NYSE: FXI) has risen 14% and the WisdomTree India Earnings ETF (NYSE: EPI) has zoomed 38% higher in that period.
In fact, the disparity in emerging markets has reached the point that Jim O'Neill, the former Goldman Sachs Group economist responsible for coining the BRIC acronym, recently told Bloomberg that Brazil and Russia are in danger of being dropped from investors' radar.
The Russian economy is expected to contract 1.8% this year, while Brazil might eke out 1% growth, according to economists surveyed by Bloomberg. That compares with 7% growth in China and 5.5% growth expected in India.
The key factor behind increasingly disparate returns is the various national trade balances. Tumbling prices for energy and metals have cut export growth for Russia and Brazil, while reducing import costs for Chinese and Indian businesses. O'Neill cut his estimate for BRIC group economic growth to 6%, from a prior forecast of 6.6%, for the decade, but said Brazil and Russia should partially recover.
Are Brazil and Russia at risk of becoming emerging market pariahs? Can China and India continue to outperform and post strong returns?
Does A BRIC Break-Up Spell Profits?
I have never been a part of the China hard-landing chorus and have held shares of the large-cap fund over the last several years. The country has amassed nearly $4 trillion in foreign exchange reserves and has enough monetary might to become a true geopolitical powerhouse.
India has had a less certain outlook, but investors do seem to be onboard with the administration of newly-elected Prime Minister Narendra Modi. The new PM has promised sweeping reform to cut red tape, simplify taxation and improve the overall business climate.
Against this optimism, it still makes for a difficult case in calling either country a buy at this point. Shares of the iShares China fund trade for 14.4 times trailing earnings, while the WisdomTree India fund trades for 13.6 times earnings. While there may not be a hard-landing on bond defaults, China's economic growth is clearly slowing and the government has yet to transition to a demand-based model. Investors have cheered Modi's enthusiasm and promises, but few of those promises have yet to become reality.
While I'd avoid the stronger countries, you still might be able to take advantage of the vast disparity in global economic health.
Russia and Brazil's stock markets have trended to the same miserable direction over the last year, but their problems are unique and could set up for a pair-trade.
Even amidst the weakness in oil prices, Russia's government reserves of $170 billion would cover more than three years of budget deficits with oil at $45 per barrel. International currency reserves include two sovereign wealth funds and total $386 billion.
With that kind of a capital backstop and a valuation discount of more than 75% on the SP 500, it is hard not to look at long-term possibilities for the Russian market. The country signed two major gas deals with China last year that could account for as much as 17% of China's gas consumption by 2020.
While Brazil has a relatively large stash of $374 billion in foreign currency reserves, foreigners hold $415 billion in portfolio investments that could be liquidated quickly if the economy weakens further. Price controls have lowered electricity by 30% and transportation by 20% in Brazil, meaning inflation will head higher when the government seeks to loosen regulation.
We have already seen that the Brazilian central bank is steadfast in its fight against price pressures with a 0.5% rate increase last week. Inflation trends may not allow the monetary authority to support the weaker economy.
Back in September, bond-rating firm Moody's noted that Brazilian debt represented 60% of the economy, well above the 39% median for countries which retain similar credit grades. Standard Poor's lowered the country to one level above junk last year and it could just be a matter of time before agencies start lowering the country to junk status.
Valuations between the two markets are also quite stark: The Market Vectors Russia ETF (NYSE: RSX) trades for just 4.7 times 2014 earnings, against a multiple of 20 times earnings for the iShares MSCI Brazil Capped (NYSE: EWZ).
Any rebound in energy prices could bring a big rebound in the Russian market, while Brazil's problems look more systematic and long lasting. Brazil still must meet its promises on infrastructure for the 2016 Summer Olympics and this could reignite protests if social spending is cut to balance the budget.
The nature of weakness in the two markets, along with relative valuation, makes a strong case for a pair-trade. Investors buying the Russian fund can hedge further global emerging market weakness by shorting the Brazilian fund. Continued strength in the dollar and lower oil prices will drive both funds lower, with gains on the Brazilian shorted fund helping to offset losses in Russian shares. If oil prices rebound or settlement appears likely in the year-long Ukraine conflict, then Russian shares could jump while any gain on the Brazilian shares would likely be more moderate on continued economic uncertainty.
Risks To Consider: The Brazil and Russian funds are not perfect substitutes and react to different market factors. While the Brazilian market should face losses on further weakness in commodity prices, hedging some downward risk on Russian stocks, other factors could push it higher. Even if the pairs trade does not play out over the short-term, valuations should make it profitable over a longer-horizon.
Action To Take -- Take advantage of the fall of the BRICs with a pair-trade in the two weaker markets of Brazil and Russia. Russia's problems are largely tied to oil prices and could prove to be short-term in nature if energy prices rebound. Brazil's problems are much more structural and could persist over the long-term.
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