My initial EM strategy was to go long a MSCI Emerging Markets index ETF. The index is heavily weighted towards the MSCI China Index and China´s closest trading partners such as Korea (South), Taiwan and Brazil (graph #1 depicts EM countries by percentage of exports to China).
Although both the MSCI China Index and China´s closest trading partners equity markets look cheap on a fundamental basis these markets may experience negative shocks from China´s economic transition into a modern consumer based economy. Furthermore China´s closest trading partners currencies will most likely depreciate significantly alongside China´s planned currency devaluation scheme. Such currency depreciation may be positive for the trading partners in the short-term as it may increase exports (graph #2 depicts EM countries by short-term GDP growth sensitivity to a 10 % devaluation of the Chinese currency). However in the mid- to long-term I suspect countries dependent on exports to China will go through a painful transition.
Overall EM is cheap on both a local currency basis and USD basis, however I want to decrease my overall exposure to a potential Chinese black swan. Goldman Sachs stated in a 2016 - 2020 forecast that "Chinese stocks could see a downdraft similar to Japan's 1990s post-bubble tumble. That could leave mainland equities with a 7-8 percent a year decline over the period". I will sell my MSCI EM index ETF and be more selective in my EM exposure going forward.
I have gathered data covering the twelve most important EM countries excluding China and made an investable index based on three criteria: Valuation (graph #3), percentage of exports to China (graph #1) and 2016E real economic growth (graph #4). The valuation measure is based on annual expected real return from 10Y Shiller P/E reversion in local currency and the current dividend yield. The three criteria have equal weight and each country receives a score between 1 - 12 where 12 is the best score for each of the three criteria.
The four countries that received the best total scores were Poland, Turkey, India, and Russia according to the investable index (graph #5). I will not invest in India as India´s current valuation is stretched. I will invest in ETF´s reflecting the equity markets of Russia, Poland and Turkey, where I will overweight Russia as I am a strong believer in an improved oil price in the mid- to long-term: Oeistein Helle: Stein´s law makes me 99 % certain that the oil price will bounce back in the mid- to long-term
Graph #1: Percentage of total exports to China
Graph #2: Short-term GDP growth sensitivity to a 10 % devaluation of the Chinese currency
Graph #3: 10Y expected local currency real return derived from Shiller P/E and dividend yield
Graph #4: 2016E real GDP growth
Graph #5: Final EM investable index
Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving any compensation for it. I am planning on going long MSCI Poland/ Turkey/ India/ Russia ETF´s.
