How long have you heard that the global economic uncertainty and currency levels were bad for emerging markets? And how long have you heard that the United States and developed markets were the best game of all markets? According to the Merrill Lynch RIC Report for May, the time to make a change is now. The firm now believes that the time has come to move back into emerging markets from developed markets, moving emerging markets to an Overweight allocation from a prior Underweight allocation.

The Merrill Lynch’s report indicates that the firm now is scaling back its allocation to developed markets. More specifically, it is cutting allocations to Japan and the United Kingdom.

The firm’s case for more emerging market exposure is based partly on the recent weakness in the U.S. dollar. Additional drivers are a firming up in commodity prices and signs that Chinese monetary policy is gaining some traction.

24/7 Wall St. decided to examine some of the key exchange traded funds (ETFs) for emerging and developed markets. Note that moving to an Overweight allocation would not be a considered an “all in” press, nor should it be considered a call to exit all developed markets in order to go all in at once in emerging markets.

Tuesday’s focus is on emerging markets as a whole, China, Brazil and the so-called state-owned enterprises (SOEs).

The iShares MSCI Emerging Markets (NYSEMKT: EEM) is of course the most active emerging market ETF of them all (more than 60 million shares traded per day). Investors should consider that it has a massive exposure to China due to the weightings. Its last seen price was up 1.5% at $32.90, versus a 52-week trading range of $27.61 to $43.16.

The iShares MSCI Brazil Capped (NYSEMKT: EWZ) ETF was up almost 3% to $28.29 Tuesday morning. This closed down almost 2% on Monday at $27.48, but it had drifted briefly under $26.00 on the news. The main Brazil ETF has a 52-week range of $17.30 to $37.35.

Petroleo Brasileiro S.A. (NYSE: PBR), or Petrobras, was last seen up 4% at $7.11. This is the troubled SEO that is Brazil’s oil and gas giant, and its $6.83 close on Monday was far lower than the $7.33 close on Friday due to the Rousseff vote news. Petrobras has a 52-week range of $2.71 to $10.46, but it used to be a stock well over $30, long before oil’s crash and long before Brazil’s corruption news went into high gear.

The iShares China Large-Cap (NYSEMKT: FXI) ETF was last seen up 1.4% at $32.06. This ETF tracks the FTSE China 50 Index, which is made up of large-cap Chinese equities that trade on the Hong Kong Stock Exchange. The ETF is very active and has a 52-week range of $28.10 to $52.08.

There is also the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSEMKT: ASHR), which is less active, but it tracks mainland China better than most ETFs. It tracks the CSI 300 Index, with at least 80% of its assets in securities of issuers to reflect the performance of the China A-Share market, made up of the 300 largest and most liquid stocks in the China A-Share market, many of which are or were SOEs. This ETF was last seen trading up 1.6% at $23.08,and its 52-week range is $20.90 to $55.19.

Additional detail from the May 2016 RIC report has been included below.
The RIC has been underweight in emerging markets since last summer. The concerns had been about rising debt levels and debt costs, a strong dollar, lower commodity prices and a potential for further currency devaluations, all of which are bad for emerging markets. The team said:

Now that the dollar is showing signs of peaking, commodity prices are firming, and Chinese monetary policy seems to be gaining traction, we are reversing that view. We are upgrading emerging markets to a narrow overweight in our equity allocation. A risk to our call is that the dollar renews its gains against emerging market currencies, which is the current view of our foreign exchange strategists. That would reduce the potential gains for dollar based investors.

Merrill Lynch strategist Ajay Kapur noted a few more issues, as follows:

• Valuations are low relative to historical averages, but admitting that they have been attractive for a while and on their own were not a reason enough to increase exposure.
• Emerging market currencies have become highly competitive and are also at historically attractive levels, helping profit margins by making their exports more desirable.
• Falling capital expenditures in Asia and Latin America also help equity markets, as operating profit margins in emerging markets should rise versus those in the United States and Japan, where capex is likely to rise.
  Higher margins should lead to improved valuations, and analysts of many emerging market stocks are likely to be positively surprised.
• Margins could improve further from the lagged impact of commodity price weakness into better trade terms, which is a leading indicator of Asia’s operating margins.
• Merrill Lynch’s fundamental analysts in emerging markets are now more bullish than consensus on earnings growth for the first time in five years. Investors should expect more upgrades to emerging market earnings estimates.

On China, lower Chinese rates create favorable monetary conditions and are correlated well with emerging market stock prices. The firm does acknowledge that China still faces challenges of bad debt, as well as excess capacity and a potential for capital flight. Still, China’s easy monetary policy can allow a transition to a slower economy that is services driven and one where stock prices will benefit.

Outside of China, Merrill Lynch also sees an opportunity SOEs are expected to implement reforms. These entities account for around 50% of emerging market capitalizations. Kapur said:

Against a backdrop of more expensive and less available capital from developed markets, deteriorating fiscal positions and public backlash against corruptive actions, SOEs are likely to implement reforms that boost efficiency and returns. In Brazil, SOEs account for about 20% of market cap but exert a strong influence on employment, lending and social policy …

Regarding Brazil, driving forces for SOEs should be considered a new regulatory framework approved by the Brazilian senate, a new political equilibrium and improved cash flow given the end of a capex cycle.

Brazilian stocks and funds were weak on Monday after news broke that Brazil’s lower house declared the impeachment vote of Dilma Rousseff to be revisited due to procedural error.

Thank you for reading! Have some feedback for us?
Contact the 24/7 Wall St. editorial team.