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Takeaway: Quantitative and fundamental factors no longer support being short CHIX and EEM.

SUMMARY BULLETS:

  • While we are removing the iShares MSCI Emerging Markets ETF (EEM) from our Best Ideas list on the short side, this delta does not represent a change to our broader bearish thesis on EM capital and currency markets. Rather, the geographic allocation of the index no longer makes this our preferred vehicle to express the aforementioned bearish thesis going forward.
  • Specifically, the index’s #1 and #2 country weights are South Korea (15.8%) and China (15%), respectively. This setup makes the EEM ETF a rather precarious vehicle to be short from here given that we recently adopted a bullish bias on South Korean equities and have recently shifted to a neutral (formerly bearish) bias on Chinese equities.
  • In light of the latter shift, we no longer consider it appropriate at the current juncture to wager on a negative wholesale revaluation of the Chinese banking sector in light of the structural liquidity issues we have discussed at great length over the past few months – hence the removal of the Global X China Financials ETF (CHIX) from the short side of our Best Ideas list as well.
  • All told, while we remain bearish on emerging markets from a top-down perspective and will predominantly be engaged in hunting for SHORTS in this space, we think it has become decidedly less appropriate to passively short EM capital and currency markets at the asset class, regional and country levels.
  • As such, we’ve created proprietary divergence monitors to help aid us in rotating in an out of the best places to be on the SHORT side of emerging markets. Please email us if you’d like to see these monitors more regularly – we can obviously use these tools to help you appropriately allocate assets on the LONG side as well.
  • Lastly, in section III below, we describe the aforementioned divergence monitors in great detail and specifically highlight which asset classes, regions and countries appear most attractive on both the LONG and SHORT sides of the broadly investable universe of EM capital and currency markets at the current juncture.

***If you are not yet familiar with our firm-wide Best Ideas list, please shoot us an email and we’ll be happy to reach out to you to discuss whether or not shifting to a coverage model makes sense for you and/or your team.***

I. REMOVING CHIX & EEM FROM OUR BEST IDEAS LIST

Today, we are formally removing the CHIX ETF and the EEM ETF from our Best Ideas list; both were selected as shorts to #TimeStamp the performance of our #EmergingOutflows thesis and our bearish bias on the Chinese financial sector, respectively.

From its APR 23 addition to our firm-wide Best Ideas list through today’s closing price, the EEM ETF has declined a cumulative -2.4%, inclusive of a maximum drawdown of -12.8% during the ~2M period from APR 23 to JUN 24. With respect to our proprietary quantitative factoring, the EEM ETF closed above its intermediate-term TREND line for the first time in several months today.

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EEM

From its JUN 7 addition to our firm-wide Best Ideas list through today’s closing price, the CHIX ETF has appreciated a cumulative +7.1%, inclusive of a maximum drawdown of -13% during the ~2W period from JUN 7 to JUN 20. The CHIX ETF is now decisively bullish from an intermediate-term TREND perspective on our quantitative factoring.

NOTABLE CHANGES TO OUR BEST IDEAS LIST - CHIX

Obviously, we made the classic mistake of getting too greedy on the short side of both securities and it cost us in the performance category; hopefully you were able to better risk manage the aforementioned theses with respect to both security selection and market timing.

Pulling back the curtain a little broader, it’s clear that an investor(s) would’ve crushed it had they tactically allocated assets to EM equities right around the late-JUN lows, given that EM equity markets are up an average of +7.1% on a currency-adjusted basis since then. That, of course, would’ve more than likely required said fund to have been out of EM equities heading into those lows.

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EM USD Denominated Equity Market Returns  6 24 13 Bottom

Needless to say, not a lot of funds were actually out of EM equities heading into those lows. While there was certainly some forced selling amid outflows which happened to commence shortly after the time of our APR 16 #EmergingOutflows presentation, we’re guessing most funds were and still are quite long of EM equities. It’s worth noting that the $7.5B YTD cumulative outflow from EM stock and bond funds represents a minuscule 2.3% of the $322B of cumulative fund inflows into said funds since 2009 (EPFR Global data through the month of AUG).

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EM USD Denominated Equity Market Returns

II. THE “WHY” DOES NOT ALTER OUR POSITION OF BEING THE BEARS ON EMERGING MARKETS

While we are removing the iShares MSCI Emerging Markets ETF (EEM) from our Best Ideas list on the short side, this delta does not represent a change to our broader bearish thesis on EM capital and currency markets. Rather, the geographic allocation of the index no longer makes this our preferred vehicle to express the aforementioned bearish thesis going forward.

Specifically, the index’s #1 and #2 country weights are South Korea (15.8%) and China (15%), respectively. This setup makes the EEM ETF a rather precarious vehicle to be short from here given that we recently adopted a bullish bias on South Korean equities and have recently shifted to a neutral (formerly bearish) bias on Chinese equities.

In light of the latter shift, we no longer consider it appropriate at the current juncture to wager on a negative wholesale revaluation of the Chinese banking sector in light of the structural liquidity issues we have discussed at great length over the past few months – hence the removal of the Global X China Financials ETF (CHIX) from the short side of our Best Ideas list as well.

III. SO THEN, HOW DO ONE PLAY SAID THESIS FROM HERE?

To help clients get a better grasp of all the moving parts across EM capital and currency markets, we have created two dashboards to systematically monitor performance divergences with the intent on flagging developing, existing, and dissipating trends in the marketplace. One of the dashboards is programmed to highlight divergences in excess of [1] standard deviation relative to their respective sample mean and the other is programmed to highlight divergences based upon the max/min values within the respective sample.

Each dashboard is symmetrically grouped into three distinct buckets (i.e. samples): Asset Classes, Regions and Countries. Realizing that we could and should do better than implementing an all-or-nothing strategy in emerging markets, this multi-tiered setup will allow us to spot the development and dissipation of said trends at the level most appropriate for any given investor.

Lastly, we thought it would be best to use actual ETFs, rather than the benchmark indices themselves to track said divergences because: A) the universe of liquid ETFs most likely accurately reflects the universe of broadly investable emerging market securities and asset classes; B) the ETFs are all both un-hedged and priced in US dollars, which means they automatically adjust for deltas in the currency markets; and C) ETFs have an underlying fund flow element to them that influences price trends – which is precisely what we’re trying to capture with our #EmergingOutflows thesis.

It’s also worth noting that whenever there was a collection of ETFs that represented a particular asset class, region and/or country, we selected the specific ETF in our sample based on a combo score of size (AUM) and liquidity (average daily trading volume).

MAX/MIN Divergence Monitor:

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EM Divergence Monitor  MAX MIN

 

STDEV Divergence Monitor:

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EM Divergence Monitor

Below we analyze and interpret the signals being generated by the developing, existing and dissipating trends that are currently being highlighted by our divergence monitors:

At the asset class level: We think it pays to rotate out of being short EM equities here in favor of being short EM debt – both dollar-denominated and local currency paper. EM FX is not flashing anything meaningful in terms of developing price signals, but the mere fact that it hasn’t outperformed recently after having been such a long-term laggard (-10.8% on a 3Y duration) suggest a continuation of the slow bleed.

As always, it’s worth noting that the risk management setups per our quantitative factoring models support the aforementioned conclusions:

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EMB

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EMLC

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - CEW

At the regional level: The one meaningful signal we see starting to develop is the outperformance of Latin American equities; this is likely a dead-cat bounce in the context of severe underperformance and absolute declines over longer durations, but to the extent recent outperformance starts to trend, short-covering and [perceived] value-buying could perpetuate higher-lows on an intermediate-term basis.

At the country level: Indonesia still looks like death… as does Turkey… Peru’s dead-cat bounce appears fleeting… both China and Russia have recently developed a trend of outperformance… Thailand looks like it wants to resume its secular outperformance… Mexico does not… Brazil could begin to look more interesting on the long side from fund flow front-running perspective if it can turn its WoW outperformance into something more lasting (i.e. MoM).

As an aside, we have done and continue to do a ton of work on which countries look good and which countries do not. Email us if you’re interested in discussing any country from an intermediate-term TREND GIP (i.e. GROWTH/INFLATION/POLICY) perspective – or from the perspective of our proprietary, four-pillared EM Crisis Risk Model, which is naturally better suited for managing long-term TAIL risk.

NOTABLE CHANGES TO OUR BEST IDEAS LIST - EXPLANATION TABLE

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - PILLAR I

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - PILLAR II

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - PILLAR III

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - PILLAR IV

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - AGGREGATED RISK

 

NOTABLE CHANGES TO OUR BEST IDEAS LIST - SUMMARY TABLE

All told, while we remain bearish on emerging markets from a top-down perspective and will predominantly be engaged in hunting for shorts in this space, we think it has become decidedly less appropriate to passively short EM capital and currency markets at the asset class, regional and country levels.

As such, we’ve created proprietary divergence monitors to help aid us in rotating in an out of the best places to be on the SHORT side of emerging markets. Please email us if you’d like to see these monitors more regularly – we can obviously use these tools to help you appropriately allocate assets on the LONG side as well.

Darius Dale

Senior Analyst