With all the chatter recently about the pullback in emerging market stocks, I decided to take a closer look.
I dutifully checked on the largest emerging markets ETFs -- iShares MSCI Emerging Markets ETF (EEM) and Vanguard's FTSE Emerging Markets ETF (VWO) . These two ETFs combine for over $85 billion in assets under management.
Thus far in 2018, EEM has fallen 10.55% and VWO has declined 10.69% versus a 15.82% gain for the Nasdaq Composite, so that comparison would imply that institutional money continues to flow toward big-cap tech stocks at the expense of those in developing economies.
But is that a fair comparison?
Looking down the page on iShares' website, a glance at the top-10 holdings of EEM paints a picture of a security that is not much of a benchmark for the world's emerging economies. Seven of EEM's top 10 holdings are based in China, and the one that is located in a country with an emerging economy, South Africa's Naspers (NPSNY) , only has the size to be included because of its significant investment in China's Tencent Holdings (TCEHY) , the largest of EEM's holdings.
So, what the financial media is describing as an "emerging markets meltdown" is really a pullback in Chinese stocks. China is not in the throes of an economic meltdown; far from it actually. Also, China's economy has long since outgrown the definition of emerging, even if MSCI and others place it in that box.
Actual emerging market meltdowns are characterized by currency weakness, capital outflows, and massive action (or overreaction) by central banks and foreign lenders. That is exactly what is happening in Turkey and Argentina these days, but that has almost zero bearing on the valuation of EEM.
A very helpful metric is Morgan Stanley's external coverage ratio (as shown in this article), a measure of a country's total reserves divided by its external funding needs (the sum of current account, short-term debt and next 12-months long-term debt amortizations). On that ratio, a higher score is better, and China's 3.1 ratio puts it near the top of the league.
The ratios of Turkey, Ukraine, Argentina and Jordan -- which lie between 0.4 and 0.6 -- are indeed scary, and suggest that remedial action must be undertaken. Argentina has won funding guarantees from the IMF and Turkey has gained external financing from Qatar and other countries.
So, the issue is that the most widely followed emerging markets benchmarks may be hiding the reality they are meant to convey. When the emerging markets benchmark really is a measure of the country with the world's second largest GDP, it concerns me that real economic problems are being hidden.
If you are playing EEM, you are playing China's market. I believe that further intensification of trade tensions between the PRC and the United States will continue to pressure those stocks.
As I mentioned in my recent Real Money column on Tencent, the demographics in China are wonderful for consumer products companies. A decidedly bearish turn in short-term market sentiment has convinced me, however, that names such as Tencent, Alibaba Group (BABA) , Baidu (BIDU) and iQiyi (IQ) have more downside, so I'm standing on the sidelines for now.
So, if you really want to play emerging markets, you have to look at the fixed-income side, and of course there is an ETF for that. iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) tracks developing country bonds, and China is only the fourth largest national exposure for the fund.
EMB's top-10 holdings read like a drag racing Christmas tree's starting light, arrayed with a lot of flashing yellows and reds. EMB's number-one holding is sovereign debt issued by the Philippines, followed by sovereigns from Colombia, Russia, Turkey and Argentina. That is where the global economic flashpoints are, not in mainland China.
So, if you really want emerging markets exposure, have a look at EMB, but I have to warn you to be very, very, very careful. Stocks like Tencent and Baidu are going to move based on sentiment, but sovereign bonds are much more closely pegged to individual countries' national account balances and the value of their home currencies.
If you think the era of "King Dollar" is going to end quickly EMB would be a great way to play that, but I would warn you that that is very much a contrarian opinion.
I am convinced that 10 years from now Tencent shares will be trading at levels that are magnitudes greater than their price today, but I need to buy them as cheaply as possible to produce relative return for my clients.
Will the Philippines be a stronger credit 10 years from now? I have no idea, and I am certainly not going to risk my clients' money on such a bet.