What are emerging markets?

Emerging markets are characterized as those economies with high GDP growth rates, normally high populations and enormous potential. They are high risk but high reward markets. The main one’s we think about are the BRICs (Brazil, Russia, India and China) but other members include Mexico, Turkey, Indonesia and South Korea. These countries have so much potential but the risks often outweigh the benefits and scare many investors away. Hedging EM holdings with inverse emerging markets ETFs can mitigate some risk of these positions in a portfolio.

What’s the concern with emerging markets?

Emerging Markets have experienced severe turmoil over the past couple years. The equity markets and currencies of many EM countries have been slashed. Many of these economies are commodity-based and the collapse in the price of oil has wreaked havoc on the markets of Russia, Brazil and other Latin American countries.

Equities

Through the proliferation of ETFs, even retirees now have access to these exotic corners of the markets. The popular Emerging Markets ETFs, including BlackRock’s EEM, and Vanguard’s VWO have around $80 billion in combined assets. Many of the emerging markets have liquidity issues (China still hasn’t reopened all of its stocks post-crash and selling is severely restricted if legal at all) so if there is a rush to the exits asset prices could fall precipitously.

China

The collapse in the Chinese Shanghai stock market sent ripples through the global financial markets and show the extent that debt (margin) can play in inflating asset prices. When the debt unwinds or is called, the results are one-third of its equity market cap gone in about a month.  Many think the ‘wealth management’ products and the level of local, municipal debt in China is the next bubble to burst. Devaluation of the yuan has followed-time will tell if the slowdown in China spreads throughout the region. We’ve seen the currencies of Indonesia and Malaysia falter again, in a mini-repeat of the Asian Currency Crisis of the late 1990’s.

Debt

Emerging market corporations have jumped aboard the global debt issuing bandwagon. According to Barclays Research, via Bloomberg, As an asset class, emerging market corporate debt issuance has grown sevenfold. Let’s take another BRIC member as an example, Brazil. The amount of Brazilian corporate debt (denominated in foreign currencies such as the US dollar or Euro) has risen seven-fold over the last decade, according to Barclay’s. The problem is, the Brazilian currency (the real) has gotten hammered as the price of oil and government corruption have continued to erode investor confidence in the country. This makes repaying that debt very difficult. The desperation was seen in the state-owned oil company Petrobras, which recently issued a one hundred year bond (talk about duration risk).

You may say, “yeah, but who is crazy enough to buy emerging market debt”? The answer is investors who are starved for yield-an unfortunate consequence of the Fed’s zero interest rate policy. This includes many banks (mostly European), many life insurance companies, pension funds and many mutual funds.

Currencies

But the trouble is not just with China and Brazil. JP Morgan’s EMCI (emerging markets currency index) is down 15% since the start of 2015. This makes repayment of their dollar-denominated debt that much harder to repay. Combine this with collapsing commodity prices including oil, copper and lumber and a real problem exists that could be a yoke around growth for these countries for years to come. Lower growth rates means lower valuations for their markets and they could continue to sell off.

Hedging EM exposure with inverse emerging markets ETFs

The most popular emerging markets inverse ETF is the ‘Short MSCI Emerging Markets’ fund, EUM. This may provide broad hedging exposure to 1- an emerging market bear market 2- a commodities crash 3- a strong U.S. dollar. Here are a few emerging market bear ETFs:

Inverse EM ETFs:

  • EUM
  • CHAD
  • FXP
  • YXI
  • YANG
  • EDZ
  • EEV
  • RUSS
  • EFU