The emerging markets have been outperforming, but some prominent Wall Street banks are issuing a word of caution if the risk-on sentiment suddenly sours. Investors who are wary of any potential risks can look to bearish or inverse exchange traded funds to hedge their developing market bets.
After the quick rebound to start off the new year, Societe Generale SA, Bank of America Corp. and Wells Fargo & Co. are warning that there might not be much value left in developing nations, pointing toward potential pitfalls ahead, Bloomberg reports.
Riskier assets like the emerging markets benefited from the dovish turn out of the Federal Reserve, but global growth is still a major headache as the U.S.-China trade talks falter.
“EM’s structural weaknesses will reemerge from the dark sooner rather than later,” Bank of America strategists including London-based David Hauner wrote in a note to clients. “We strongly advise looking for well-priced hedges.”
Societe Generale’s Jason Daw also warned that investors should hedge against a recession in the world’s largest economy as the bank predicts the U.S. could slip into a recession in the first half of 2020.
“Timing the U.S. recession or judging the magnitude of the U.S./global slowdown is not easy,” Daw wrote in a report to clients. “But when it starts, having some recession hedge ideas in the back pocket can prove useful.”
Investors who were wary of pullbacks in the emerging markets can capitalize on the decline with inverse or bearish ETF plays. For instance, the ProShares Short MSCI Emerging Markets (NYSEArca: EUM) takes the inverse or -100% daily performance of the MSCI Emerging Markets Index, the benchmark to EEM. The ProShares UltraShort MSCI Emerging Markets (NYSEArca: EEV) follows the -2x or -200% daily performance of the Emerging Market Index. Additionally, the Direxion Daily Emerging Markets Bear 3x Shares (NYSEArca: EDZ) tracks the -3x or -300% performance of the benchmark.
Additionally, Wells Fargo argued that Brazil, an area where investors have become excessively optimistic following the elections of a reform-minded leader, could also be the first to decline in a sell-off. The Brazilian real is among the best-performing currencies this year as traders anticipate President Jair Bolsonaro will pass unpopular social security reform, privatize state-owned companies and revive growth.
“Now would be a good time to hedge EMFX risk, especially for some of the currencies that are still fragile,” Brendan McKenna, a currency strategist at Wells Fargo, told Bloomberg. “Brazil is a good example. I have a longer-term bearish view on the real, and would say now would be a good time to put a hedge on as the real has strengthened a fair amount.”
Investors can also hedge against a pullback in Brazilian equities through something like the ProShares UltraShort MSCI Brazil Capped ETF (NYSEArca: BZQ), which attempts to deliver two times inverse of the daily performance of the MSCI Brazil 25/50 Index,
For more information on the developing economies, visit our emerging markets category.