EEMS - EEMS: Accessing Emerging Market Small Caps

2023-12-07 23:00:08 ET

Summary

• Emerging market small-cap stocks have performed well in recent years and after the 2009 financial crisis.
• iShares MSCI Emerging Markets Small-Cap ETF is a good investment option with reasonable fees and unique industry exposure.
• EEMS provides strong exposure to IT and consumer stocks and has a lower weighting in financials compared to other emerging market ETFs.

Opportunity Overview

Select emerging markets could be worth examining in 2024 as investors search for alternative investments. In particular, emerging market small-cap stocks have had a pretty good track record in the past couple of years, and they also performed well in 2009, following the GFC.

The iShares MSCI Emerging Markets Small-Cap ETF (EEMS) is an interesting vehicle to consider as it has a reasonable management fee and offers unique industry exposure. The valuation for this ETF is also relatively attractive. The major downside is that it has very concentrated exposure to many larger emerging markets and offers less exposure to smaller emerging markets that could outperform the index this decade. However, economic improvements in multiple countries, such as South Korea and Taiwan, could drive favorable performance moving into 2024.

Emerging Market Small Caps

Emerging markets have not been a bright spot in 2022 and 2023, as they underperformed the S&P 500 in these years. However, small-cap stocks have outperformed so far in 2023.

Small-cap stocks in emerging markets also had very stellar performance following the 2008 financial crisis.

The MSCI Emerging Markets Small Cap Index returned over 100% in 2009, and then later returned around 27% in 2010. In comparison, the MSCI ACWI IMI only returned 36% and 14% during these years.

ETF Overview

The iShares MSCI Emerging Markets Small-Cap ETF invests in over 1,400 different small-cap stocks in various emerging markets. It charges a 0.70% fee , which is in line with other ETFs such as the iShares MSCI Emerging Markets ETF (EEM).

This ETF has a relatively lower weighting in financials and provides strong exposure to IT and consumer stocks. This ETF is an appealing setup as many emerging market ETFs, including general ETFs and country-specific ETFs, have a 20% or higher weighting in financials.

The geographical breakdown closely mimics the MSCI Emerging Markets Small Cap Index. This ETF offers strong exposure to Asia, and the top 4 constituents account for well over half of the ETF's assets.

While the broader equity markets in regions like India could be considered overvalued, this ETF provides a vehicle to access some of these more dominant markets at more acceptable valuation levels.

This ETF trades at around 12.5x earnings and 1.5x book, which is a slight discount to the MSCI Emerging Markets Index. In comparison, India trades at 23x earnings and 3.5x book and the MSCI Emerging Markets Index trades at 13.5x earnings and 1.5x book. This ETF provides exposure to emerging markets at an acceptable valuation, especially considering that over 25% of its assets are invested in India.

Inflation has Improved, for now

Inflation has begun to gradually improve in both developed and emerging markets. Developed Central Banks may begin to consider cutting rates if inflation remains stable in the coming months. Notably, it is crucial to consider that runaway inflation has been less of an issue in some of these larger emerging markets.

Source: Trading Economics Data

The gyrations in inflation this year, and likely next year, will likely result in a massive divergence in emerging equity performance, which will be driven by the country's export structures and reliance on commodity imports.

Moreover, equity markets that have struggled with inflation have still delivered stellar or acceptable YTD returns on a USD basis. The Global X MSCI Argentina ETF (ARGT) has outperformed the S&P 500 by nearly 30 percentage points this year.

The pullback in inflation may also provide short-term relief for certain net commodity-importing countries. This middle ground level could provide support for many smaller emerging markets, like Egypt and Pakistan.

This ETF provides acceptable exposure to many larger markets that may benefit from a reduction in inflation. If you are counting on an uptick in inflation in 2024, it may be best to hedge your exposure by adding smaller emerging markets, such as Peru and Colombia, that export commodities and have underperformed in recent years.

Global Electronics Outlook

One important factor to monitor is the global appetite for demand for electronics, as this ETF provides investors with strong exposure to South Korea and Taiwan.

There are many concerns about slower economic growth in China, Europe and the United States. However, demand for global electronics could likely outpace general growth in the economy. The beginning of 2023 was relatively challenging for economies like South Korea and Taiwan. However, recent export data shows that there have been some improvements in these economies' exports. Recent data from October this year shows that South Korea's electronic exports are beginning to pick up again, following months of declines.

A recent report from Future Market Insights noted that electronics demand is expected to grow at a CAGR of over 5% through 2023 . Semiconductor demand should be relatively strong moving into 2024, as well. The Semiconductor Industry Association projected that semiconductor sales would grow by 13.1% in 2024. Economies like South Korea and Taiwan will be strong beneficiaries of this trend if this demand ensues.

Taiwan GDP Annual Growth

Taiwan's exports also recently rose for the first time in 13 months this September, which was largely driven by increased demand for semiconductors. This growth allowed the economy to avoid a recession in recent quarters.

Moving forward, equities should continue to rebound if these trends remain in place in 2024, as 2022 and the beginning of 2023 was a challenging period for the stock markets of these countries.

These improvements have allowed the MSCI South Korea ETF (EWY) and the iShares MSCI Taiwan ETF (EWT) to outperform the iShares MSCI Emerging Markets ETF this year.

Other Risks to Note

One of the main economic risks to monitor moving forward may be the rising sovereign debt levels in various emerging markets, especially since rates have been rising and certain currencies in these markets have had weak performance.

JP Morgan forecasts that emerging market growth will reach 3.7% next year , exceeding the growth in many developing countries. If developed countries are able to cut rates next year, this could bode well for some countries with USD-denominated debt. However, global debt, including emerging market debt, has risen to record highs, and many emerging markets have already defaulted in previous years.

The IIF projects that global debt will reach $310 trillion by the end of this year, which is a 25% increase over the past five years.

Small Caps vs. Large Caps

So far, small-cap stocks have trounced larger emerging market stocks this year, yet they still remain very attractively valued.

On a long-term basis, the emerging market small caps have also outperformed MSCI Emerging Markets. This appears to be a relatively new trend, driven by strong outperformed beginning in 2022.

I think this ETF could be a safer bet than the iShares MSCI Emerging Markets ETF because of its lower valuation and historical outperformance during poor market cycles.

My main concern is its strong exposure to China and India and lower exposure to other Latin American markets that could benefit from a commodities bull market.

Emerging markets have many potential headwinds that could support equity sentiment moving into 2024. However, it is crucial to monitor risks like inflation, rising populism, sovereign debt quality, and other economic risks.

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