EEM: Emerging markets still off my shopping list (NYSEARCA:EEM)

Main thesis / Background

The purpose of this article is to assess the emerging markets stock market in general, with a specific look at the iShares MSCI Emerging Markets ETF (NYSEARCA:NYSERCA: EEM). This is a Broad and passive ETF, with a aim “to track the investment results of an index composed of large- and mid-cap emerging market stocks.”

I cover US markets, primarily developed markets outside the US, but I also consider emerging markets when the time comes. This includes using vehicles like EEM, although I have generally been put off by the sector (and this fund) for a while. In fact, my last review had a cautious view on EEM's future prospects, and in retrospect I realised I was right:

However, this was a long time ago and Things change, so I wanted to look back at EEM to see if I should change my rating in the future.

After looking into the matter, I see a couple of potential catalysts for emerging markets as a whole, but for me these are overshadowed by the risks facing this thematic idea. Furthermore, I still see value in US large-cap stocks, so the idea of ​​changing positioning to favour a fund like EEM seems out of place for the moment. As such, I maintain the “hold” rating and will explain why in more detail below.

Are interest rates a tailwind? Maybe not

One factor that is driving markets, both here and abroad, is the US central bank. The Federal Reserve has been patient in holding rates steady, but the moment the market has been waiting (impatiently) for may finally have arrived. That is the start of a US Fed rate-cutting cycle, with a growing likelihood of a 0.50 basis point cut in the coming weeks:

Of course, readers may wonder why this belongs in this article. After all, EEM owns emerging market stocks, so who cares about the US Federal Reserve?

The answer lies in the fact that many emerging market countries (and companies) are highly dependent on what happens in the United States. We often hear that growing Interest rates in the United States are, on balance, bad for emerging markets. This is because much of their debt is denominated in US dollars, so as the dollar rises, the cost of servicing that debt in local currency increases. This puts social spending and financial flexibility at risk in those emerging economies and can often be a major obstacle.

So one might think that declining Interest rates here would now be a tailwind. Makes sense, doesn't it? While it may seem that way on the surface, I have my concerns. One of them is the reason because Interest rates are set to fall in the US due to concerns about high government spending, falling inflation and a possible recession in 2025. The problem is that if the US enters a recession, emerging markets could be particularly affected.

This is especially true for nations (many of them emerging markets in regions such as Latin America, the Middle East and Asia) that rely on exporting goods such as raw materials. In fact, according to a study report According to the World Bank, about two-thirds of emerging market and developing economies “rely heavily on commodities for exports, tax revenues, and economic activity.”

Why is this important? Well, because in recent years it has been a hindrance for commodity-rich countries, as prices (on average) have been declining:

What I am trying to convey here is that there are concerns about global economic activity and future demand for many commodities. Perhaps items like gold and silver could serve as hedges against recession, but exporting nations want to supply the world with items like oil, copper, coffee beans and a myriad of other commodities that depend on economic development and growth. Seeing the prices of these resources fall presents uncertainty for investors and especially for companies and governments in emerging markets.

This ties in with potential rate cuts by the Federal Reserve. While lower rates in the US may be a boon for global and emerging market companies, the reasons behind Therefore, I do not believe in the idea that lower rates are good for funds like EEM and remain cautious about my future outlook.

China remains in the crosshairs

Another reason for my neutral outlook on EEM has to do with the fund’s overweight allocation to Chinese stocks. With almost a quarter of total assets invested in this single country, EEM investors will want to be bullish on China before buying this particular product:

Overall, I am concerned about China's economic recovery and geopolitical tensions are not going away. In fact, they may be getting worse, which calls into question my view of the future.

For example, the EU announced tariffs on Chinese electric vehicle imports earlier this month. Fortunately (for investors) the tariffs were not as high as previously considered, coming in at 9%, down from the proposed rate of nearly 21%, according to a press release. release of the European Commission.

So there is good news: calm has prevailed, but I don't think the trade battle is anywhere near over. In response to the EU's decision, Canada is also considering a similar measure. And of course, the US has also already Imposing high tariffs on Chinese election vehicles.

The net result of all this is that China has some diplomatic problems. When you add to that the current real estate crisis in that country that has investors baffled, I feel reluctant to back investment in this territory. To put this into perspective, consider that even the most optimistic scenarios still show Chinese residential real estate investment well below its previous levels:

To emphasize this point, this reality has left large developers (think Evergrande and Country Garden, for example) on the brink of the financial abyss. It has stagnated investment in this sector and clouded future investment returns. When I look at this current context and an increase in geopolitical tensions with key trading partners such as the US and the EU, I cannot be optimistic about a fund like EEM that has so much exposure to China.

Discouraging expense ratio

The next topic I will cover is brief, but important. It concerns EEM in isolation and has nothing to do with the investment case for emerging market equities. Rather, it concerns the expense that investors pay for this particular fund. As a relatively passive ETF, an expense ratio of 0.70% seems high to me at first glance:

Personally, this is quite high for most ETFs across the investment spectrum and makes me wonder why iShares has it so high.

But the good news is that investors have plenty of options available. Popular emerging markets from other major firms like Vanguard and Charles Schwab offer similar exposure for a fraction of the annual cost:

Of course, these funds are not identical, but they do have many of the same core investments (often very close in percentage terms) and the country exposure is also very similar. So it stands to reason that even if one was While we are currently bullish on emerging markets, EEM is probably not the smartest way to bet on that idea.

India and Brazil are not expensive, but not cheap either

Throughout this review, I have certainly been quite bearish. I don't see EEM as a buy option at this point and I stand by that view. But I don't think it's fair to consider it an outright “sell” option either. There are a couple of reasons for that.

First, EEM has been performing very poorly over the past few years and could be on the verge of turning around. While I personally don't think that will happen, the situation is changing and it is probably past time to sell or short this fund. The disconnect between EEM and the S&P 500, for example, tells me that the performance gap is certainly around the corner. Therefore, I don't think it's worth being too pessimistic on this aspect.

Second, there is much talk about the valuation gap between emerging markets and the developed world, and that is certainly true today. For those looking for “value” – which is probably many of us, given the bubbly appearance of the S&P 500 and Nasdaq 100 – a fund like EEM might have some merit:

This offers a large discount to the S&P 500 (which is the most common benchmark) and could appeal to some investors who might not otherwise have been interested.

But how much “cheap” is really cheap? As I mentioned before, China makes up a good portion of this ETF, but it is by no means the only other country represented. Other nations, such as Taiwan, India, South Korea, and Brazil, are in the mix and are worth giving a lot of thought.

But therein lies the rub. While these countries may appear cheap compared to their developed market peers, they are actually trading (on average) at higher valuations than their peers. own Historical average. That is a key factor to consider:

I put this forward as a word of caution. We should not just consider a country's relative valuation relative to the United States. We should also consider its own trading history in isolation to get a more complete picture of the likelihood of further gains. In the examples given above, I would wait for a better opportunity to present itself.

In summary

EEM has been a long-term loser and I don't see a much brighter future ahead. There are many risks for US investors when they expand overseas and a fund with a heavy exposure to China is not on my radar for now. When I add to the mix that countries like India and Taiwan trade at elevated valuations relative to their own history and that a fund like EEM is quite expensive to hold, I am discouraged from upgrading my view for now. Therefore, I maintain a “hold” outlook and urge my followers to be very selective with any potential positions at this time.