Overseas Gains with a Currency Kicker

03/15/2012 11:39 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

Invest in rallying Japanese stocks and emerging-market bonds without paying the price for the strengthening dollar, writes MoneyShow.com senior editor Igor Greenwald.

The year’s off to a great start for almost every stock index around the world. Of the 46 developed and emerging markets tracked by MSCI Barra, only Spain and Portugal are (marginally) in the red for 2012, whereas 25 stock markets have rallied at least 10%.

The list of double-digit winners includes such long shots as Greece, Italy, and Japan—the latter up 18%, the second-best developed-market gain behind Germany’s 20%. It also includes China, which is up 15% year-to-date but is still down 9% over the last year.

After a nice pop into the Chinese new year, March hasn’t been so kind to Shanghai. The economic backdrop remains weak, with home prices accelerating their decline and hiring weakening, even as wages continue to rise.

Adrian Mowat, JPMorgan’s chief Asian strategist, told a conference in Singapore yesterday that China’s slumping, according to Bloomberg News.

“If you look at the Chinese data, you should stop debating about a hard landing,” he said. “China is in a hard landing. Car sales are down, cement production is down, steel production is down, construction stocks are down. It’s not a debate anymore...it’s a fact.”

In fact, the Shanghai market action of late has resembled the last-hurrah rally in New York in the fall of 2007, when investors were still counting on monetary relief to forestall a slump after years of economic mismanagement.

Except that China has been somewhat less forthcoming on that score than the Bernanke Federal Reserve in 2007, relaxing lending curbs somewhat, but not enough to move the economic needle. When Chinese premier Wen Jiabao lowered the government’s symbolic growth target by a half-point to 7.5% last week, he was signaling official acquiescence to a slowdown.

And just in case that message hadn’t sunk in, Wen said at a press conference Tuesday that home prices “are still far from a reasonable level,” dashing hopes for a relaxation of market curbs. The Shanghai Composite sank 2.6% following the remarks, and extended its losses today.

The Chinese downturn is spreading ripples far and wide. In the US, the sectors showing the most steam—housing, financials, techs, and biotechs—are among the least exposed to a Chinese slowdown. In contrast, metals miners and makers of heavy machinery have lagged of late. The market is showing a clear preference for industries leveraged to a US recovery over those dependent on capital spending by China.

Some of the best-performing foreign-market ETFs and funds are also indirect plays on the Chinese slowdown. In Brazil, diminished Chinese demand for iron ore and other raw materials is one of the causes of a growth hiccup that’s prompted aggressive rate cuts by the central bank.

The genuine easing of borrowing costs has in turn propelled Brazil’s small cap shares and the iShares MSCI Brazil Small Cap Fund (EWZS), which is up 26% year to date.

The same rate cuts also add to the value of Brazil’s dollar-denominated bonds. The JP Morgan US Dollar Emerging Markets Bond Fund (EMB) is up 5% in two months, in addition to its annual yield of nearly 5%, and could be in the early stages of a breakout.

If China does make a successful switchover from an investment-driven economy to one led by domestic demand, Japanese suppliers of consumer goods would be among the primary beneficiaries. They are already cashing in on the recent drop in the yen, which is making their products more competitive.

One way to play that recovery without incurring offsetting currency losses is via the WisdomTree Japan Hedged Equity Fund (DXJ), which hedges out its yen exposure. The DXJ has broken out to the upside with a 16% gain over the last two months, versus not quite 10% for the unhedged iShares MSCI Japan Index Fund (EWJ).

As in Brazil, Japanese equities are benefiting from easing by Japan’s central bank, in its case via asset purchases. The trend is clear: invest in countries where authorities are more accommodating than they currently are in Beijing, and don’t forget to hedge your currency exposure.

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