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Are Good Times Over for Emerging Market ETFs?

Sweta Killa
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After a banner year, the emerging markets thrived in the first quarter of 2018 too, courtesy of cheap monetary policies, a strong global economy, rising commodity prices, and a weak dollar. The trend seems to be reversing now as the greenback has gained strong momentum, triggering a selling spree in the emerging market currencies.

Notably, the Bloomberg Dollar Spot Index has risen 3.1% in a one-month period while the ICE U.S. Dollar Index, which measures the basket against six currencies, hit its highest level since late December (read: Dollar ETFs Bounce Back: Can the Rally Continue?)

The slump in currencies could push inflation higher and force their central banks to raise interest rates, thus ending the emerging markets’ three-year long interest rate cut cycle. This is especially true as Argentina has been the worst hit by a strengthening dollar, which forced the country's central bank to increase interest rates three times in just eight days to halt the peso’s dramatic slide against the U.S. dollar. The interest rates jumped to 40% from 27.25% before the rapid-fire rate hikes.

Turkey also bore the brunt with rate hikes ahead of the presidential elections in June. In addition, bets of a rate hike are increasing in Indonesia after a series of interventions by the central bank failed to stem the slide in the currency to a two-year low. All these rate hikes have led to increased uncertainty on monetary policies of the emerging nations.

Further, China's slowing economic growth and potential credit problems could lift the greenback higher, indicating more pain for the emerging market currencies and their stocks (read: Should You Buy EM ETFs Despite Trade War & Other Concerns?).

Moreover, inflationary pressures in the United States are fueling the speculation for the Fed’s aggressive rate hikes and in turn resulting in an increase in bond yields. This has raised worries over emerging markets, which were the worst hit by the taper tantrum of 2013 that resulted in a huge capital flight. This is because the prospect of faster rate hikes would pull out more capital from these markets, stirring up trouble for most emerging nations.

According to the Lipper data, U.S.-based emerging market equity ETFs saw outflows of $611 million last week, their first weekly loss in 2018. Per Institute of International Finance estimates, investors have pulled out roughly $8.4 billion from emerging-markets assets since mid-April.

Emerging Market ETFs Depressed

Given the huge outflows and pessimism over emerging market growth, the appeal for these ETFs has dampened. As a result, most of the emerging market ETFs saw terrible trading over the past one month, pushing many of these into the red from a year-to-date look. From a specific country look, iShares MSCI Turkey ETF TUR and VanEck Vectors Vietnam ETF VNM have stolen the show losing double-digits over the past one month, followed by losses of 9.3% for iShares MSCI Indonesia ETF EIDO and 7% for Columbia India Small Cap Fund SCIN. All these four ETFs are in deep red from a year-to-date look except VNM, which is up 0.4%.

Coming to the broad emerging market funds, First Trust Emerging Markets Small Cap AlphaDEX Fund FEMS, WisdomTree Emerging Markets Consumer Growth Fund EMCG and ALPS Emerging Sector Dividend Dogs ETF EDOG shed 6.6%, 5.7% and 5.1%, respectively, in a month.

What Lies Ahead?

Despite the huge slide, emerging markets still look attractive thanks to improving economic growth in a number of the developing countries, a pickup in manufacturing activity, rise in commodity prices, better current accounts, building foreign reserves, better-than-expected earnings, and growth policies. In particular, most of the nations including, Brazil, India and South Africa lowered their current account deficit while Thailand has turned its shortfall into a surplus of more than 10% of gross domestic product.

Though U.S. rates hikes make emerging assets unattractive, these reflect a strengthening domestic economy that could lead to higher demand and benefit emerging market exporters (see: all the Broad Emerging Market ETFs here).

Further, most of the funds mentioned above have a Zacks ETF Rank #2 (Buy) or 3 (Hold), suggesting room for upside.

Given the solid long-term outlook but somewhat bearish near-term sentiments, investors may want to consider staying on the sidelines for the time being. However, risk-tolerant, long-term investors may want to consider this recent slump a buying opportunity, should they have the patience for extreme volatility.

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