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McCall’s Call: Emerging Markets Breather

The emerging markets have been the place to invest in the past decade, as developed nations struggle to achieve minimal gains for investors. EEM, the most heavily traded emerging markets ETF, came close to tripling in the seven years ended last year, while SPY, the large-cap U.S. equity ETF, rose just 14 percent.

Matthew D. McCall

For those interested in hedge-fund replication strategies, a
number of ETFs are on the market to help calm investors’ nerves
and lower daily price swings. So, I want to focus on those,
including those that soften the blow of volatility by going both
long and short.

However, the tides have been changing, with the iShares MSCI Emerging Markets ETF (NYSEArca:EEM) down 4 percent through the first six weeks of 2011, and the SPDR S&P 500 ETF (NYSEArca:SPY) SPY gaining 6 percent.

The deeper question is whether this pullback marks the end of the decade-long bull run in emerging markets, or are we looking at a brief setback before prices start rising again?

My best guess is that the emerging market juggernaut is intact over the longer term, but that investors need to pick their spots in the near term. The broad array of single-country ETFs now on the market make this challenge easy to meet for investors looking to buy on the dip in rapidly expanding countries such as India.

Egypt Revolt

Protests in the streets of Cairo were unforeseen and rocked the world of emerging market stocks and ETFs. For over two weeks, Egypt was basically out of business as the protesters shut down major roadways and stopped going to work. With the resignation of its president, Hosni Mubarak, the Egyptian military is in control of the Middle East's most populous country, and life is starting to get back to normal.

The unrest opened many investors' eyes to the high political risk associated with emerging market countries, and not just Egypt.

Even though there's great growth potential in emerging market nations, the risks accompanying such investments don't really apply to developed countries such as the U.S. and Western Europe. The recent flows of investment dollars to well-established economies, in part, reflect this.

China Rate Hike

Even before Egypt provided a reality check for emerging market investors, the Chinese government recently hiked its benchmark interest rate by 25 basis points, the third such hike since last October. This move is in response to rising commodity prices, which has led to fears of inflation in the booming nation, which surpassed Japan last year as the world's second-biggest economy.

Increased demand around the globe for food; industrial materials such as copper or oil; and other important commodities like cotton have pushed prices of many commodities to multiyear highs, increasing inflationary pressures in emerging market countries.

China is not the first country to raise rates, and it may actually be considered late in its tightening efforts. Since the beginning of 2010, Brazil has raised interest rates from 8.75 to 11.25 percent; India's benchmark went from 4.8 to 6.5 percent; and Indonesia increased its rate by 25 basis points to 6.75 percent.

Pullback Ahead Or Buying Opportunity?

With the emerging markets-as measured by EEM-trading 7 percent off the multiyear high set in early November, the asset class is at a precarious point. The pullback, which got as deep as 10 percent earlier this month, could be the coveted "10 percent pullback" that all the talking heads were calling for. Or it could be the start of a prolonged downtrend for the asset class.

My inclination is that the emerging markets as a whole have found a short-term bottom and will hold above the lows set in early February. That also suggests, as I said above, that I believe the long-term uptrend is intact and that I would be a buyer on the recent weakness; especially for long-term investors.

Countries To Buy And Avoid

If you are the type of investor who would prefer choosing specific countries when investing, there are certain areas I suggest you might focus on and some you may prefer to avoid.

One country that has been hit hard in the last three months is India; the Bombay SENSEX Index fell nearly 20 percent. I think it'll be bouncing back before long; and the WisdomTree India Earnings ETF (NYSEArca:EPI) is my favorite.

Another country that has positive factors behind it is Peru. The iShares MSCI All Peru Capped ETF (NYSEArca:EPU) will give investors exposure to a high-growth South American country that has a heavy reliance on commodity prices.

The one region of the world that continues to trade with high levels of risk is the Middle East/Northern Africa. That said, there could be short-term trades on heavy volatility. However, for long-term investors, there are better options in the asset class. This will lead me to stay away from ETFs such as the WisdomTree Middle East Dividend ETF (NYSEArca:GULF) and Market Vectors Gulf States ETF (NYSEArca:MES).

Then there's the 800-pound gorilla-China. The most heavily traded Chinese ETF, the iShares FTSE China 25 ETF (NYSEArca:FXI), is down 12 percent from the November high. As the country fights to quell inflation with higher interest rates, it could hurt the share prices of the Chinese stocks in the short term. That said, I'd underweight China right now, and look to add to positions in a few months' time.

At the end of the day, it comes down to weighing the reward potential with the risk of investing in each country. And, for the foreseeable future, the emerging markets will offer better rewards than their developed peers. But with that comes above-average risk.

Matthew D. McCall is editor of The ETF Bulletin andpresident of Penn Financial Group LLC, a Ridgewood, N.J.-based wealth management firm specializing in investment strategies using ETFs.

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Copyright ® 2011 Index Publications LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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