Emerging Markets Rally Toolkit: Currencies, Equities & Bonds

Whether investors are trading on greater stability in commodity prices or a less “hawkish” Federal Reserve (Fed), or they’re simply reallocating en masse to less expensive assets, emerging markets (EM) are soaring. But with virtually all EM assets rallying, which one makes sense for the current environment? Below, we examine the risk and return profile of three ways to position for a continued resurgence across the broader emerging markets.   Emerging Market Currencies While the last five years have seen a broad, sustained rally in the value of the U.S. dollar, 2016 has seen a fairly dramatic reversal in this trend, particularly in EM. After being beaten down to (in some instances) unprecedented levels, emerging market currencies have rallied sharply over the past two months. In our view, for investors to remain bullish on EM, they must be comfortable assuming foreign currency risk. As one alternative, the WisdomTree Emerging Currency Strategy Fund (CEW) offers a straightforward way to express this view. With assets peaking at more than $700 million in August 2011, CEW currently provides exposure to 15 emerging market currencies. Given that the strategy gains exposure to EM currencies through currency forward contracts, the total returns of the Fund are determined by three components: the interest earned on the collateral (U.S. Treasury bills) of the forwards, changes in spot prices of EM currencies and the interest rate differential between EM countries and the U.S. As of April 15, CEW’s embedded income yield was 4.22%.¹ Put another way, EM currencies would need to depreciate by just over 4% in the next 12 months in order to break even on this investment. For this reason, CEW has tended to be less volatile than EM stocks or bonds. Since inception, CEW has had an average annual volatility of 8.7%.²   High-Dividend Emerging Market Equities Over market cycles, dividends have the ability to boost returns and dampen volatility normally associated with equity investing. In our view, one of the most underappreciated elements of emerging market equities is that more than 93% of all publicly traded EM companies pay dividends.³ The WisdomTree Emerging Markets High Dividend Fund (DEM) takes dividend-focused investing a step further by allocating to the highest-yielding 30% of the WisdomTree Emerging Markets Dividend Index. After peaking at more than $5.8 billion in May 2013, WisdomTree’s high dividend approach declined with broader markets because of its over-weight to the Financials, Energy and Materials sectors. Today, with the outlook for these industries potentially stabilizing, a price/earnings ratio (P/E) of 9.8x, a majority of companies trading below book value and a trailing 12-month dividend yield of 5.2%, we believe investors should consider taking a value-focused approach to emerging markets.⁴ Since inception, DEM has had an average annual volatility of 21.8%.⁵   Emerging Market Local Debt Similar to CEW, the WisdomTree Emerging Markets Local Debt Fund (ELD) derives its total returns from three components: changes in value of EM currencies against the U.S. dollar, income via coupon payments from bonds and changes in bond prices due to shifts in EM interest rates. A key difference between the strategies is that CEW is investing in three-month currency forwards versus ELD’s investments in longer-maturity bonds. As a result, higher income potential has generally helped dampen volatility compared to CEW. Assets peaked at more than $2.1 billion in May 2013, and negative performance since then can largely be attributed to a strengthening U.S. dollar and negative sentiment over a majority of emerging market countries. With yields ranging from 1.7% in South Korea to 13.4% in Brazil, ELD currently boasts an embedded income yield of 6.3% (and duration of 4.89 years) by investing across 17 countries. Since inception, ELD has had an average annual volatility of 11.2%.   Click for standardized performance of DEM, CEW and ELD. With a variety of options for exposure to emerging markets, how should an investor allocate in the current environment? In our view, DEM represents the deepest value strategy across WisdomTree’s emerging markets suite. While dividends have historically dampened volatility compared to the MSCI Emerging Markets Index, performance will ultimately depend on continued improvement in sentiment resulting from stabilization in China and commodity prices. For investors comfortable assuming currency risk, EM local debt offers perhaps less value but higher income potential than stocks. As a result, volatility in EM fixed income will likely be lower than that of emerging market equities, but returns will likely be lower during a strong risk-on environment. Finally, while CEW will likely offer the lowest amount of volatility, the drivers of return are more straightforward: EM currencies must continue to rally against the U.S. dollar. With these factors in mind, we believe investors should strongly reconsider their current exposure to emerging market assets.         ¹Source: WisdomTree. ²Compared to MSCI Emerging Markets Index volatility of 19.0%, as of 3/31/16. ³Source: MSCI, as of 3/31/16. ⁴Source: WisdomTree, as of 3/31/16. ⁵Compared to MSCI Emerging Markets Index volatility of 24.8%, as of 3/31/16.