It is no secret that 2015 has been another glum year for emerging markets equities and exchange traded funds. The Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO) and the iShares MSCI Emerging Markets ETF (NYSEArca: EEM), the two largest emerging markets ETFs by assets, are off an average of 8% year-to-date.
That is positioning EEM and VWO to finish lower on an annual basis for a third consecutive year and the fourth time in the past five years. Recently, emerging markets ETFs of nearly all stripes were pressured by China’s decision to devalue the yuan.
China’s currency devaluation is aimed at propping up exporters in the world’s second-largest economy amid slack economic data. Beijing revealed that exports declined 8.3% in July, the largest drop in four months and worse than the expected 1% dip. Exports to the Eurozone plunged 12.3% in July and shipments to the U.S. fell 1.3%. [Violent Turn for the Yuan]
“The yuan devaluation may signal that China’s efforts to rebalance its economy toward greater growth may be proving more challenging than anticipated. According to some estimates, the trade-weighted yuan has increased by over 11% in the past year, and exports have been falling sharply — down 9.2% in July. A weaker yuan may help turn growth around by boosting China’s exports, but a roughly 2% currency devaluation is only a small step toward that goal,” said Invesco in a recent research note.
However, the options market in EEM is signaling something interesting could be afoot.
“Implied correlation, which attempts to measure this phenomenon, jumped to 80% on Wednesday. A high implied correlation means that EEM’s volatility is spiking much more than the volatility of the underlying country ETFs. The five other times this year EEM had a high implied correlation were followed by an average increase of 8% over the next month, according to UBS,” reports the Wall Street Journal.
The Journal notes that the last time such a scenario was in place, EEM surged 14% in less than two months. Interestingly, China’s currency devaluation has made it expensive to bet against EEM and the MSCI Emerging Markets Index.
The subsequent spike in volatility caused by China’s newly loose monetary policy is elevating the cost of protective bearish hedges on marquee emerging markets indexes.
“The Chicago Board Options Exchange Emerging Markets ETF Volatility Index, which tracks hedging costs on the iShares MSCI Emerging Markets fund, jumped to the highest level in 18 months versus a similar gauge for the Standard & Poor’s 500 Index,” report Callie Bost and Aleksandra Gjorgievska for Bloomberg.
iShares MSCI Emerging Markets ETF
Tom Lydon’s clients own shares of EEM.