IDEA of the month: Increasing the Emerging Markets weight
This month we buy the ETF “Emerging Markets Liquid Eurobond Euro Index” with 10% weight. Our main argument is the attractive coupon of 7.5%. We clearly admit that this is a high risk investment. However, the stable economic outlook and ongoing low risk aversion should support EM bond markets in the next months. The two major regional blocks in the…….
index are Latin America with 43.7% weight and Emerging Europe with 42.8%. Main risk for buying the “Emerging Markets Liquid Eurobond Euro Index” is a softening of the economic recovery which could raise questions about the solvency in one of the major countries in the index.
Interest rates and yields have remained relatively low and central banks clearly indicate a smooth start of possible exit strategies. Thus, the environment for risky asset classes should remain favourable. Additionally, the Q3 reporting has triggered an acceleration of earnings upgrades and M&A activity seems to become stronger as well. Overall, all these factors confirm the position of our scorecards, which clearly point to an ongoing overweight of equities (see table on the right). The strong score for equities is reflected in an equity weight of 40% in the ETF portfolio (20% MSCI USA and 20% MSCI Emerging markets).
Our equity Region Scorecard shows that Europe is the most favoured region. Latin America enjoys the least support due to its expensive valuation and weak macro fundamentals.
According to our scorecard for European sectors, Technology, Insurance and Banks look the most attractive, while Basic Resourced and Food & Beverage are the least favoured.
Scorecards Fixed income, commodities and Forex
In the Fixed income segment, our scorecard supports the longer maturity bond classes (Eurozone 10-15 years, Eurozone 15 years+) and the Europe Sov. Inflation Linked bonds. UK Sov Inflation linked bond looks the least attractive. According to our Commodity Scorecard, Heating Oil, Crude Oil and Copper are the most attractive while the Precious metal group covering Silver and Gold along with platinum find the least favour. Our FX Scorecard is positively tilted towards the British Pound and is negative on the Australian Dollar, while staying neutral on the Euro and the US Dollar.
European ETFs enjoyed inflows of Euro 1.4 bn (1.0% of the total AUM) in October and Euro 6.2 bn (4.5% of total AUM) on a 3-month basis. Overall, the inflow has slowed over the last three months, but the inflow into equity ETFs has remained relatively stable since July 2009. In contrast to equities, Commodity ETCs have seen a significant slowdown of inflows over the last three months. They have enjoyed 9.8% inflows over the last three months, but net outflows of 1% in the last month. Money market ETFs continue to see outflows (6.6% over the last month). This is intuitive in the light of the low interest rate levels.
Credit ETFs have also seen outflows, but the base is relatively small. Total AUM of all the European ETFs collectively amounts to Euro139bn. Equity focused ETFs contribute to 66.6% of the total Assets under management followed by Debt focused ETFs contributing to 14.9% and commodity ETCs with 10.3%.
IDEA of the month: Buy ETF “Emerging Markets Liquid Eurobond Euro Index”
This month we buy the ETF “Emerging Markets Liquid Eurobond Euro Index” with 10% weight. One month ago we have bought the “MSCI Emerging Markets TRN” ETF and with this step we further increase our exposure to Emerging markets. Our main argument in favour of the “Emerging Markets Liquid Eurobond Euro Index” is the attractive coupon of 7.5%. We clearly admit that this is a high risk investment and we will analyse the risk in more depth below. However, the stable economic outlook and ongoing low risk aversion should support EM bond markets in the next months. Thus, we find the coupon attractive also when taking into account the relative higher risk and lower rating for some of the issuers in the index.
Clearly, the ETF “Emerging Markets Liquid Eurobond Euro Index” has a quite different regional exposure than the “MSCI Emerging Markets TRN”. Whereas in the “MSCI Emerging Markets TRN” Asia-ex-Japan has clearly the highest weight with 55%, in the ETF “Emerging Markets Liquid Eurobond Euro Index” the weight of Asia-ex-Japan is rather low with 13.5%.
Major Asian emerging economies like China and India have no liquid Eurobond market (because they are not in strong need of external financing) and are therefore not included in the index.
The two major regional blocks in the “Emerging Markets Liquid Eurobond Euro Index” are Latin America with 43.7% weight and Emerging Europe with 42.8%. The countries (issuers’) weight is determined based on GDP, GDP per capita, outstanding Eurobond volume and liquidity. The countries with the highest weight in the index are Venezuela with 13.5%,
Mexico with 10.4%, Turkey with 10.1%, Brazil with 9.5%, Philippines with 7.8% and Russia with 7.3%.
Reasons in favour of many of the major emerging markets include attractive demographics, superior GDP growth, improving skill levels, large stimulus packages, higher fund inflows anda banking system that is largely unaffected by the financial turmoil. Clearly, the main issuers in the “Emerging Markets Liquid Eurobond Euro Index” are a special subset within the Emerging Market space and the arguments are only valid to a limited degree. Therefore we give below more details on the countries with the highest weights.
41% of the portfolio is rated BBB and 40% is rated BB. Any rating below BBB is classified as speculative or junk bond and this currently is the case for 54% of the index volume: 40% of the index is rated “BB”. 14% of the basket is rated “B” and this is one issuer, Venezuela. So the country with the biggest weight in the index is also the country with the lowest rating.
According to CMA Vision, Venezuela spreads currently indicate a 51% cumulative Probability of Default (CPD) (quantifies the probability of a country being unable to honour its debt obligations over a 5-year period). While Venezuela is clearly a high risk country with 14% weight in the index, the remaining countries are clearly more solid. Looking at the countries with the highest weights in the index besides Venezuela, for Mexico a cumulative Probability of Default of 11.2% is priced in, for Turkey 13.5%, for Brazil 9.2%, for the Philippines 12% and for Russia 14.5%, according to CMA Vision calculations.
In addition, the strengthening of emerging market countries is discussed in more detail in the report Globalisation after the credit crisis, 9 September 2009. The report discusses the structural power shift from the developed/Western world towards the emerging world and emerging market companies in detail.
The Emerging Markets Liquid Eurobond Euro Index offers a higher return, but also has higher volatility than the Global Sovereign Index. Since 1 January 2001 the Emerging Markets Liquid Eurobond Euro Index has posted a performance of 121% compared to the Global Investment Grade Sovereign with 55%. From August 2008 to October 2008, the Emerging Markets Liquid Eurobond Euro Index has lost 30% because of the strong aversion of risk at that time. From November 2008 to November 2009 the index has fully recovered. So we buy the Index because of the attractive coupon (especially relative to yields for Iboxx Eurozone bonds) and because of our view that risk aversion should not increase strongly over the next months.
“db xtrackers MSCI Emerging Markets TRN” ETF 20% weight
We continue to own the ETF “db x-trackers MSCI Emerging markets TRN” with 20% weight. Regionally, Asia ex-Japan constitutes more than 50% of the total weight of the index. At the country level, China, Brazil, Korea, Taiwan; India, South Africa and Russia have the largest weight in the index. Reasons in favour of many of the major emerging markets include attractive demographics, superior GDP growth, improving skill levels, huge FX reserves and active SWF funds, large stimulus packages, higher fund inflows and a banking system that is largely unaffected by the financial turmoil. The points above are discussed in more detail in the report Globalisation after the credit crisis, 9 September 2009. The report discusses the relation between demographics and asset prices. The more favourable demographics in many emerging markets compared to developed countries suggests also a more favourable development of asset prices in the longer term. The report also discusses the structural power shift from the developed/Western world towards the emerging world and emerging market companies in detail. Therefore emerging market companies could well benefit from continuing globalisation over the next years more than they did in the past 10 years. The global integration has led to industrialisation in the emerging markets and de-industrialisation in the developed countries. From this trend the large global players in the developed countries have benefited in the last decade. But the emerging market companies may well seek to compete more aggressively with the developed countries in the next decade and benefit from rising skills sets in emerging markets as well as the strong growth rates in their home countries. Main risks for buying the “MSCI Emerging Markets TRN” ETF are a general decline of equity markets and an increased risk aversion of investors. Also major political tensions in major emerging markets like China, Brazil or Taiwan would be a negative.
“db xtrackers MSCI USA TRN” ETF 20% weight
We had bought the ETF “db x-trackers MSCI USA TRN” for three reasons: 1) Our economists expect an ongoing strong recovery of the US economy. 2) Our US equity strategist expects a continuing performance of US equities. Our US-Strategist has an S&P 500 target of 1260 for end-2010, an upside of 14% from current level of 1106. 3) A recovery of the US-Dollar would be supportive for the performance. Our FX strategist expects a recovery of the US-Dollar to a level of 1.40 USD/Euro on a 12-month view. Also most US economic data has continued to come in strongly over the last weeks. Unit labour costs in the US have recently seen the strongest decline since 1948, by 3.6%. US companies have seen an excellent Q3 reporting season. In addition, US Sales and production generally move synchronously. But since the start of the crisis production fell far in excess of sales which have been stable for some time. This gap could bring the potential of a strong bounce back of US industrial production. Also the US housing sector seems to have bottomed. October existing home sales rose a better than expected 10.1% to 6.10 million units after rising 8.8% in the previous month, the highest reading since February 2007. Main risks for buying the ETF “MSCI USA TRN” are a weakening of the US-Dollar, negative news flow from the US economy, major earnings downgrades for US companies and declining US equity markets.
“db x-trackers Currency valuation” ETF 20% weight
In currency markets the majority of the participants are “liquidity seekers”. “Profit seekers” are a minority in currency markets and can generate returns on the expense of the “liquidity seekers”. Profit-seekers can generate returns by buying “under-valued” currencies and shorting “over-valued” currencies. A widely used measure to determine “under-valued” and “over-valued” valuation for currencies is the concept of “Purchasing Power Parity” where “fair” exchange rates are calculated by comparing the prices of a basket of goods in different countries. The ETF “db x-trackers Currency valuation” buys each quarter the three currencies with the “lowest” valuation out of the universe of the G10 currencies and sells the three currencies with the “highest” valuation using the PPP concept. In addition, the correlation to equities and bonds is very low and therefore the currency valuation index helps to diversify our ETF portfolio. The index is currently long in the US Dollar, New Zealand Dollar, and the British Pound whereas the index is short in the Swiss Franc, Swedish Krona and the Norwegian Krona. Risks to the investment include that currencies movements become less rational again. Especially increased uncertainty about the economic development could trigger a flight back into expensive currencies like the Swiss Franc .
We bought the “Emerging Markets Liquid Eurobond Euro Index” ETF with 10% weight and sold the “db x-trackers DJ Stoxx Global Dividend 100 ETF”. The trading portfolio below reflects the changes discussed above. The portfolio targets absolute return and has the EONIA index as benchmark.
Source: Trading Ideas ETF: Ideas and Flows – Deutsche Bank AG