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EM ETFs Had a Seven-Year Best 1H: Will the Surge Last?

Zacks Equity Research

After a string of issues including the turmoil in China, global growth slowdown, the gradual waning of cheap dollar inflows and currency concerns dragging the emerging markets (EM) down, a positive shift in sentiment has been seen lately (read: 3 Emerging Market ETFs with Q4 Gains).

The popular emerging market ETF iShares MSCI Emerging Markets ETF (EEM) shed 5.5% in 2013, 0.05% in 2014 and 15.1% in 2015. However, after reeling under pressure for the last three years, EM stocks managed to return 8.6% in the first half of 2016, beating the developed markets by 5.5% and underscoring the best first-half performancein seven years. EEM was up over 10% in 1H16.

Behind the Surge

First of all, moderation in U.S. growth has lowered chances of a faster rate hike this year which is why the Fed is acting dovish after a liftoff in December and is likely to remain accommodative in the near term as well. This in turn has curbed the gains of the greenback which was the king of currencies last year (read: Best and Worst Performing Currency ETFs of 2015).

So far this year (as of July 18, 2016),PowerShares DB US Dollar Bullish ETF UUP is down over 2.6%. In the wake of a weaker dollar,impressive gains were noticed in commodity prices as most commodities are linked to the U.S. dollar.

A favorable demand-supply balance also gave cues that the commodity market rout has almost bottomed. And as emerging markets are rich in commodities, a boom in commodities acted as a major tailwind to their economies. A staggering performance was delivered in the first half by Latin America and Russia. While Russia benefitted from an oil price rally, Latin America won on stronger commodities and hopes of a political change for the better.

Second, a subdued greenback did a lot in shoring up the EM currencies with the latter logging their largest first-half advances since 2011. This in turn reduced the countries’ current account deficit. And from late last year, this aggregate deficit turned out a surplus, as per an article published in Financial Times. Also, a cheaper valuation following a steep sell-off in 2015 perhaps opened the door to EM investing.

Can Emerging Markets Sustain the Rally?

Though it is too early to take a call at this stage, the initial hints are positive. We would also like to note that big research houses including Citigroup,Credit Suisse and Blackrock believe it can gain in 2H. Analysts even projected 17% expansion in EM equities over the next 12 months. Plenty of upbeat factors can drive this often-volatile segment going forward.

Brexit a Boon to EM? EM looks less perturbed by Brexit. Trade relations between the U.K. and the broad-based emerging market are meager, thus posing no-to-little threat to emerging market investing (read: Bremain or Brexit: No Worries for EM ETF Investing).

Plus, the Fed has indicated that it will keep a tab on how Brexit impacts the global economy before hurrying up on policy tightening. This ensures a few more days of cheap money inflows to EMs.

Hunt for Yields: With bond yields at record low levelsacross the developed world,investors’ craving for steady and strong current income is warranted. Now EM securities are now known for their solid yields. Also, emerging market local currency bonds provide investors greater protection to capital gains than EM equities (read: Play These Emerging Market Bond ETFs to Lessen Brexit Woes).

Agreed, the space is risky enough, but as per Bloomberg, emerging-market bonds topped the risk-adjusted returns table in 1H16. USD IG EM corporate index headed the list with 2.96% riskless return and 8.26% total return.

Stabilization in China: Of late, Chinese worries which often turn the global market crazy have subsided. China’s relentless efforts to shore up its waning economy should act as a driver in the broad-based EM rally.

Better Growth Picture: Despite broad-based growth issues, especially after Brexit, Morgan Stanley expects emerging markets to pick up steam going into 2017. The bank expects developed markets to log only 1.2% growth next year, whereas emerging markets to grow from 4% this year to 4.7% in 2017.

Year-to-Date Winners

So far this year (as of July 18, 2016), Russia ETFs are ruling with VanEck Vectors Russia Small-Cap ETF RSXJ gaining over 45%. Among the other outperformers, iShares MSCI Thailand Capped ETF THD (up about 23.5%), PowerShares FTSE RAFI Emerging Markets Portfolio ETF PXH (up about 24.5%), Schwab Fundamental Emerging Markets Large Company Index ETF FNDE (Up 24.3%), iShares MSCI South Africa ETF EZA) (Up 19.5%),iShares MSCI Indonesia ETF EIDO (up 21.2%)and WisdomTree Emerging Markets High Dividend Fund (DEM) (up 19.3%) worth a mention.

Risks to the Rally

If the Fed turns hawkish sooner than expected, the commodity market (along with key oil) rally gets over soon and China comes up with new economic issues, the dream rally that the EM ETFs have seen may fail to last long (read: 5 ETFs for Those Who Believe the Oil Rally is Over).

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PWRSH-DB US$ BU (UUP): ETF Research Reports
 
SCHWAB-F EM LCI (FNDE): ETF Research Reports
 
VANECK-RUS SC (RSXJ): ETF Research Reports
 
ISHRS-MSCI THAI (THD): ETF Research Reports
 
PWRSH-F/R EMP (PXH): ETF Research Reports
 
ISHARS-MS INDON (EIDO): ETF Research Reports
 
ISHARS-S AFRICA (EZA): ETF Research Reports
 
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