Emerging Markets! Just Not Yet …

Think emerging markets are a good place to park your money for the long run? You’re definitely on the right track.

But if you rush into bets on emerging markets now, you may be disappointed.

Why? Because you’re late to the party.

Just take a look at this chart of the iShares MSCI Emerging Markets ETF (EEM). You’ll see that investors have been going bonkers for emerging markets over the past year and a half.

In fact, EEM has gained a whopping 38.9% since the beginning of 2016. Compare that to a rise of just 19.5% for the S&P 500.

That’s for good reason. Emerging markets are cheaper, and growing much faster than the U.S.

So, it’s understandable that Credit Suisse would come out this week and say, “it is not too late … to engage in emerging-market equities.”

However, that doesn’t make them a “Buy” today.

For now, I think the rally is overdone. On top of that, I expect a 13% correction from current levels. Here’s why …

The price pattern for EEM suggests the rally is at a stopping point, at least for now. And that it’s due for a pause that refreshes for more gains.

At the same time, there are several fundamental factors lining up that make emerging markets increasingly vulnerable. The big one is the potential for rising interest rates.

Look, the Fed has already begun raising interest rates, albeit in baby steps … so far. But the next phase is to start unwinding its balance sheet.

Markets seem to think the Fed can take its sweet time with interest-rate hikes and asset liquidation. That’s because inflation is not a threat.

But the Fed must also be concerned about being too easy with its monetary policy. Specifically, whether it’s encouraging asset-price inflation that’s not justified by the underlying economic conditions.

That’s exactly what we’ve seen in equity markets here at home … and especially in emerging markets.

The likelihood of another rate hike before year-end is falling, but don’t bet on it. Why? Because the U.S. dollar has fallen nearly 10% this year. And this gives the Fed extra leeway.

So if there were ever a time to tighten monetary policy, now might be it.

Yet, markets aren’t expecting it. This would trigger a surprise rally in the dollar … and a nasty surprise for emerging markets, as those typically react badly to a stronger dollar.

The Financial Times reports that …

“Total EM debt has risen from 145% of GDP at the end of 2012 to 184% as of the end of 2016 … Foreign ownership of EM debt, excluding China, has risen from 21% to 25% over the same time period.”

That is a big concern still.

A hawkish Fed … rising U.S. interest rates … and a stronger U.S. dollar will force a rapid rethink. One that pulls capital away from emerging markets, in the near term. But not for too long.

That’s because emerging markets offer much better longer-term potential than the U.S. and most other developed markets, for that matter.

The Cyclically-Adjusted Price to Earnings ratio (CAPE), currently 29.85, suggests there is not a whole lot of upside potential for U.S. equities in the coming decade. CAPE for emerging markets “is 16.1, well-below the historical average of 24.2 and cheaper than developed world equities,” according to a strategist at JPMorgan.

Plus, emerging markets are not as vulnerable to deep, sustained capital outflows as they were several years ago. That’s because their cross-border borrowing is not nearly as high as it was in 2007 before the financial crisis hit.

Indeed, because of the shifting make-up of capital flows since the global financial crisis, emerging markets are not likely to respond as badly to Fed policy going forward as they would have in the past.

Bottom line: Emerging markets account for 40% of global GDP. Valuations are relatively low. They seem to have become more resilient to Fed policy. And capital flows seem to be rebuilding, rather than topping out.

Emerging markets seem like a good long-term investment if we avoid a global credit event. As I suggested last week, that’s not something I am willing to “write off,” if you’ll pardon the pun!

But nearer term, I think EM is overbought and vulnerable to shifting U.S. dollar and U.S. interest-rate sentiment. In fact, outflows from emerging-market ETFs began last week, and this may only be the beginning …

For investors, this means a longer-term buying opportunity at more-attractive prices lies just ahead.

But first, more aggressive traders might consider first betting on the decline I expect.

An easy way to profit from it, while avoiding the need to sell short any stocks or ETFs, is to target an inverse ETF like the ProShares MSCI Short Emerging Markets ETF (EUM), which is designed to rise in value as emerging markets decline.

Do right,
JR Crooks