Geopolitical Risks in Emerging Market Equity ETFs

Last week included several dramatic examples of unexpected geopolitical developments in emerging markets: Two nuclear powers in South Asia, India, and Pakistan, clashed and appeared to be on the brink of full-scale war; and the US-North Korea summit in Hanoi ended badly, with Trump walking out.

Market Commentary - Cumberland Advisors - Geopolitical Risks in Emerging Market Equity ETFs

Also, unsettling markets were some negative signs about the state of US-China trade negotiations which, later in the week, were offset by some positive signs. With country-specific emerging-market equity ETFs, the risk of such geopolitical shocks is always present. It is interesting to look at how the respective national equity markets reacted to last week’s developments.

The India-Pakistan clash intensified last Tuesday, February 27, when Indian warplanes dropped bombs on a suspected terrorist camp inside Pakistan in response to a deadly terrorist attack on Indian soldiers earlier. Pakistan shot down at least one Indian plane and captured the pilot. Artillery barrages across the border followed, and thousands of troops converged. Pakistan Prime Minister Imran Khan then announced on Thursday that his country would release the captured Indian pilot, “In our desire of peace … and as a first step to open negotiations.” This move appeared to calm matters for the moment, but the situation remains tense. India’s stock market dropped sharply at first but later recovered as the situation eased. The iShares MSCI India ETF, INDA, finished the week up 0.4%. Clearly, should fighting resume, the market would tumble.

The long-standing India-Pakistan dispute over Kashmir is one of the most dangerous geopolitical risks. This clash is a reminder to investors that this risk should not be ignored. Indian stocks have been trending downward for fundamental economic reasons. Economic growth slowed to 6.6% in the fourth quarter of last year from 7% in the third quarter, which in turn was slower than the second quarter’s 8% growth rate. The ETF INDA is down 5% for the last twelve months ending March 1st and is down 2.3% year-to-date. Other emerging markets were also down last year. However, unlike Indian equities, most other emerging markets have rallied so far this year. The iShares MSCI Emerging Markets ETF, EEM, is up 8.8% year-to-date. Our International and Global ETF Portfolios are overweight in emerging markets, but we are not holding any India-specific positions.

The unpredictable North Korean regime and its nuclear capabilities constitute another dangerous geopolitical risk overhanging markets, particularly that of South Korea. The failure of the Hanoi summit appears to have resulted from inadequate preparations at a lower level and failure to recognize that the very complex and difficult issue of denuclearization could not be settled prematurely by a “deal” between two heads of state. There now is the risk that, following this humiliation for Kim, he will respond by moving to add to North Korea’s nuclear capabilities. Hopefully, seasoned diplomats on both sides will seek to restore the negotiations.

As was the case for India, South Korea’s stock market dropped in response to the bad news, with the iShares MSI South Korea Capped ETF, EWY, losing 2.2% over the week. But unlike the case for Indian stocks, the South Korean market has participated in the emerging-market rally so far this year. Despite last week’s losses, EWY is up 7.12% year-to-date as of March 1st. We are maintaining our South Korea positions in our International and Global Portfolios, while monitoring further developments closely.

The South Korean economy is strong, with close ties to the US economy. It is quite advanced and is considered by many to no longer be an emerging-market economy. The Korean equity market is large, accounting for 14% of the iShares MSCI Emerging Markets ETF, EEM, and is exceeded only by Hong Kong’s 23% share. China’s share in EEM is only 8%, but that does not yet include most of the Mainland China stocks. South Korea’s equity market is heavily weighted (40%) with technology stocks. Samsung Electronics alone accounts for 23% of the holdings. Long-term investors in South Korea’s equity market using EWY have done well: The annualized total return over the past 10 years is 12.37%.

Last week was also a volatile one for Chinese stocks, which lurched down and back up with each press comment and tweet hinting at the state of US-China trade talks or the severity of the moderation in the growth of China’s economy. In the end, the broad-based iShares MSCI China ETF, MCHI, was little changed for the week, with an increase of 0.5%.

There was a definite plus for Chinese stocks announced before the market opened on March 1st. The index publisher MSCI announced that it will quadruple the weight of Mainland China shares in its benchmarks. The benchmarks are the basis of many ETFs and funds. It is estimated that this quadrupling will lead to new passive inflows into Mainland China’s stock markets of some $US 80 billion. Chinese equities are also participating in the emerging-market recovery. MCHI is up over 16% year-to-date.

Investors who wish to limit exposure to the country-specific risks inherent in emerging-market stocks can invest in highly diversified ETFs that include stocks from a number of national markets. Two good examples are the ETFs EEM, mentioned above, and the Vanguard FTSE Emerging Markets Index Fund, VWO. Investors in individual-country ETFs need to monitor developments closely and seek to separate the noise in the daily news flow from developments that signal meaningful and lasting changes in the prospects for a market. Often events that capture the headlines for several days or more have little lasting market impact. At Cumberland Advisors we sort key signals from the noise by bringing together fundamental economic and financial analysis, technical market analysis, and geopolitical expertise.

William Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
Email | Bio


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Sources: Financial Times, Wall Street Journal, CNBC.com, ETF.com


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Considering China

China stocks surged Monday following Trump’s announcement that he will be delaying US tariffs on China. Prospects for a trade agreement between China and the US are now looking very good. It is evident that both sides need a positive resolution and are willing to compromise. Last year, China’s stock markets experienced their worst year since 2008, with the Shanghai composite dropping 24.6% and the Shenzhen composite tumbling over 33%. These markets appeared to bottom at year end and staged a strong recovery as trade tensions began to ease. This recovery is likely to continue if indeed a trade deal is reached.

The other main cause of last year’s plunge in China’s stock market was increasing signs of a slowdown in China’s economy, paired with uncertainty about the severity of the downshift. It has now become clearer that the slowdown is real but moderate, in contrast to the more dire predictions of some commentators. GDP growth is easing from 6.6% last year to 6.2% this year. In 2020, the economy is projected to expand at a similar and still very robust pace, thanks in part to the anticipated ample policy stimulus and easing of trade tensions.

As Morgan Stanley has noted, China is steadily advancing towards high-income status and a current account deficit that implies the necessity of substantially higher capital inflows. That prospect should encourage further opening up of the economy. Another technical factor that will cause passive investment inflows is MSCI’s plans to increase China A-shares weights in its EM index this year and more in future years. Similarly, FTSE Russell plans to increase the weight of China A-shares in its FTSE Emerging Index.

Changes in the structure of the Chinese economy provide some promising opportunities for investors. The economic slowdown has been mainly in the manufacturing sector, which used to be considered the most important part of the Chinese economy. According to Caixin Purchasing Managers Index data reported by Markit, while manufacturing companies’ output declined modestly in January, service-sector activity continued to expand “solidly,” with the result that the Caixin China Composite PMI for January signaled higher activity for the thirty-fifth month in a row.

It is important to note that China’s services sector became a more important contributor to GDP than its industrial sector in 2013. It has steadily outgrown the industrial sector ever since. The fact that China has already changed into a services/domestic consumption-based economy is not widely recognized.

The Chinese consumer is breaking records. Total Chinese retail sales, which surpassed US retail sales for the first time in 2017, rose a further 9% in 2018 to about US$6.3 trillion. According to 2017 figures cited by KraneShares, Chinese web sales, at US$1.14 trillion, accounted for 19.6% of total Chinese retail sales, whereas US retail web sales, at US$453.5 billion, accounted for just 8.9% of US retail sales. And there is still substantial room for China’s internet population, which is currently less than 60 % of the total population, to grow.

Investors now have 46 US-listed ETFs for Chinese stocks, excluding those ETFs using leverage. Many of these still have limited assets under management (AUM), which implies limited liquidity. There are just 10 that have AUM of at least US$100 million: FXI, MCHI, KWEB, GXC, ASHR, CQQQ, KBA, PGJ, CHIQ, and CXSE.

The largest China ETF, the iShares Large-Cap, FXI, invests in 50 large-cap China stocks traded in Hong Kong, with a heavy concentration of financials, particularly state-run banks. It is up 15.20% year-to-date February 25. The second and fourth largest Chinese ETFs invest in the “total market” (not including A-shares) with a tilt towards financial and technical firms. The iShares MSCI China ETF, MCHI, has gained 17.92% year-to-date. Similarly, the SPDR S&P China ETF, GXC, is up 17.56%.

The third largest China ETF takes a more direct aim at the Chinese consumer and internet web sales. KraneShares CSI China Internet ETF, KWEB, has gained 26.19% year-to-date. This ETF tracks only overseas-listed Chinese shares of internet-sector companies, primarily US-listed N-shares. Also of possible interest is the Investco China Technology ETF, CQQQ, which holds a broad range of technology companies, including US-listed shares. CQQQ has also outperformed this year, gaining 24.31% year-to-date.

Investors considering adding China-specific ETFs should take account of the China exposure they may already have in more aggregate ETFs. For example, the iShares MSCI Emerging Markets ETF, EEM, includes China stocks with a weight of 10.6% and Hong Kong stocks with a weight of 23.15%. Also, China ETFs have historically been subject to wide swings, and the relatively high volatility is likely to continue.

 

William Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
Email | Bio


Sources: Morgan Stanley Research, KraneShares, Caixin, HIS Markit, CNBC, ETF.com, IMF


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European Growth Concerns Deepen

The latest economic indicators reveal that the economic slowdown in Europe persists. President Draghi of the European Central Bank (ECB) has underlined the continued weakness, expectations for softer near-term growth, and downside risks. The International Monetary Fund (IMF) has lowered its economic projections for the euro area. Political uncertainties in Europe add to the headwinds affecting investor sentiment.

 Cumberland Advisors Market Commentary by Bill Witherell, Ph.D.

The HIS Markit Flash Euro Area Composite Purchasing Managers’ Index (PMI) , which combines manufacturing and service sector data, fell to 50.7 for January, following a reading of 51.7 in December. The January mark was significantly weaker than the consensus expectation of 51.4. The moderation in the euro area’s economic growth, which began a year ago, is continuing in the first quarter of 2019.

The Flash Composite PMI for France fell unexpectedly to 47.9 because a sharp drop in the services component more than offset a pick-up in the manufacturing component. Conversely, the Flash Composite PMI for Germany recovered slightly to 52.1, following a 66-month low of 51.6 in December. A further decline in the manufacturing component was offset by a stronger performance in the services sector. Adding in the other euro area economies, we observe overall declines in both manufacturing and services PMIs for the region. Manufacturing new orders as well as services incoming new business fell in January.

The IMF, in the quarterly update of its World Economic Outlook, lowered its projection of economic growth in the euro area to 1.6% in 2019. Last fall, their projection was for 1.9% growth. They continue to expect 1.7% growth in 2020. Subdued external demand due to a projected global growth slowdown is one reason for this weaker outlook for the euro area, particularly for Germany. The IMF cites some country-specific factors affecting the near-term outlook: revised auto emission standards in Germany, weak domestic demand and higher borrowing costs in Italy, and demonstrations and strikes in France.

The ECB Governing Council at its January meeting also warned that near-term growth prospects have softened. While markets will have to wait until the Bank’s March meeting for new economic projections, the risk assessment guidance has “moved to the downside.” Mario Draghi, ECB president, said, “We were unanimous about acknowledging the weaker momentum and changing the balance of risk for growth.” The Governing Council cited the continuing uncertainties of Brexit and trade disputes as important downside risks for the region. While the ECB did not announce any change in policy, market expectations for a rate increase later in the year have weakened. On the other hand, a new round of long-term refinancing operations (TLTROs) is looking more likely.

Euro area equity markets have joined in the global equity market recovery in January but are down significantly over the past 12 months. The iShares MSCI Eurozone ETF, EZU, is up 6.0% year-to-date January 25 but is still down 20.5% over the last 12 months. Similarly, the iShares MSCI Germany ETF, EWG, is up 6.3% year-to-date but down 23.7% over the past 12 months. The iShares MSCI France ETF, EWQ, is up 4.1% year-to-date and down 17.2% over the past 12 months. In these and the other euro area markets, the moderation in the euro area’s economic growth appears to be largely priced in. Also, several of the negative factors are likely to prove transitory, including the new emission standards in Germany and the demonstrations in France. While the uncertainties relating to Brexit remain high, the tail risk of a hard or no-deal break of the UK from Europe appears to have been substantially reduced. Positive developments with respect to Brexit and/or an easing of trade disputes with the US would certainly be welcomed by investors. We remain cautious with respect to the euro area in our International and Global portfolios, monitoring developments closely.

William Witherell, Ph.D.
Chief Global Economist
Email | Bio


Sources: Financial Times, Markit Economics, International Monetary Fund, Goldman Sachs Research, BBH Global Currency Strategy


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.