Emerging markets have had a disappointing few years. These are less developed countries that have lower incomes per capita than the 24 economies that comprise the Organization of Economic Co-operation and Development (OECD).
Over the last five years, the iShares MSCI Emerging Markets ETF (NYSE: EEM) is down 7.6% per annum compared to the iShares MSCI World ETF (TSX: XWD) which is up 10.3% annually over the same period. However, the Canadian dollar version of EEM, which trades on the Toronto Exchange under the symbol XEM, is only off 2% per year. The weakness in the loonie mitigated the loss by 5.5 percentage points per year.
Developed markets shares have done better but their strength is almost entirely due to the U.S. The iShares MSCI World ETF (TSX: XWD) is up 10.3% per annum over the last five years but the ETF for non-U.S. developed markets is ahead by a much lower 4% annually. Still, those returns are a lot better than the unimpressive results from emerging markets.
Those countries had been seen as attractive due to their faster GDP growth, younger populations, and lower debt levels. Surprisingly, however, their debt markets have outperformed their stock markets. U.S. dollar denominated debt issued by emerging economies as tracked by the iShares Emerging Market Bond ETF (NYSE: EMB) has produced a positive return of 0.6% per annum over the last five years. This not only beats the return from shares but also is much better than the 0.3% annual return from the iShares S&P/TSX Composite ETF (TSX: XIC), when adding the 5.5% per year benefit of the strength in the U.S. dollar into the equation.
Why have the emerging markets done so badly, especially in the last year, when EEM fell 23% (to May 10) and XEM lost 18.3%? To a large extent, the poor performance can be attributed to three major factors: the fall in energy and commodity prices, the slowdown in China, and slower growth in sales of computers and smartphones, most of which are manufactured in Taiwan and South Korea. With financials comprising 27%, information technology 20.5%, and energy and materials 14.7% of the ETF, almost two-thirds of stocks in the portfolio have exposure to sectors that have been experiencing substantial problems.
The first two factors are linked, in that China's slowdown has contributed to the fall in commodity prices. As the major purchaser of industrial commodities such as iron ore, coal, nickel, and copper, as well as one of the major importers of oil, a slower Chinese economy inevitably has affected the commodity exporters. These include Brazil, Russia, and South Africa, all major components of the emerging markets index. Only domestically oriented India has held up, helped by the fact that it is a commodity importer.
Let's look more closely at our recommended emerging markets stock ETFs and see why they were so weak over the last year.
iShares MSCI Emerging Markets ETF (NYSE: EEM)
Originally recommended on April 8/12 (#21212) at US$42.11. Closed Friday at US$32.27.
iShares MSCI Emerging Markets ETF (TSX: XEM)
Originally recommended on April 8/12 (#21212) at $24. Closed Friday at $23.45.
The largest positions in EEM (XEM holds shares in EEM) are Korean and Taiwanese technology companies. They include Samsung Electronics, TSMC, and Hon Hai. All have been negatively affected by the slowdown in sales of smartphones (both Samsung's and Apple's) and computers.
Chinese banks China Construction Bank, ICBC, and Bank of China have been hit by worries over bad loans from the slowdown in Chinese GDP to 6.5% last year. Brazilian banks Itau Unibanco and Banco Bradesco were also badly affected as Brazil slumped into recession due the collapse in commodity prices.
Energy companies have been savaged by the halving of the oil price as well as the sharp decline in commodity-based currencies such as the Brazilian real and Russian ruble. These include Chinese firms CNOOC, Sinopec, and PetroChina. Also down are Brazil's Petrobras, India's Reliance, and Russia's Gazprom.
Only defensive sectors such as consumer stocks like South African media play Naspers, Brazilian and Mexican beverage companies Ambev and Femsa, and Indian software providers Infosys and Tata Consultancy have held up relatively well. Chinese e-commerce companies Tencent, Alibaba, and Baidu have also been standouts.
Two of the reasons I suggested buying emerging markets four years ago were their reasonable valuation and their under-performance against the developed markets after the initial recovery from the financial crisis. The recommendation has not worked out to date, although the depreciation of the Canadian dollar has softened the loss.
The structure of this ETF is not ideal. Its biggest sector is financials, most of them Chinese and Brazilian, with potential bad debt exposures due to their economic slowdowns. It also has large exposure to Korean and Taiwanese technology companies, which are much more dependent upon demand in the developed markets and new product cycles than on the emerging middle class in developing economies. That said, this ETF remains the largest and most liquid vehicle for exposure to fast growing countries with much improved financials and attractive demographics.
Action now: On an historic price/earnings ratio of 11.4, price/book ratio of 1.4, and a dividend yield of 2.3%, this ETF remains a Buy for those able to handle the volatility associated with the investment. For those wanting a less volatile route to benefit from improving emerging market fundamentals, the emerging market bond ETF is worth considering (see below).
iShares JPMorgan USD Emerging Market Bond ETF (NYSE: EMB)
Originally recommended on April 8/12 (#21212) at $112.90. Closed Friday at $111.85.
This ETF invests in U.S. dollar debt issued by governments or government-backed entities in emerging markets. It suffers from the downside of all bond ETFs, which is that the countries that borrow the most have the largest weightings, not always a desirable situation.
Having noted that structural weakness, the largest issuer in the ETF is Mexico (6.9% of assets). There are three of the so-called Fragile Five countries in the top 10: Indonesia (5.3%), Turkey (5.1%), and Brazil (4.3%). The remainder include Russia (5.4%), the Philippines (5.1%), China (4.1%), Colombia (3.9%), Hungary (3.8%), and Poland (3.7%).
With Argentina, the ETF's twelfth largest position at 3.5%, returning to international bond markets after its deal with creditors, the ETF's exposure to less attractive issuers like Ukraine and Venezuela has been reduced.
With over two-thirds of emerging markets rated investment grade, up from less than one-third 15 years ago, and with all issues denominated in U.S. dollars, the ETF represents an attractive alternative to low or negative yielding developed market debt
