We are recommending a long position in EM equities, implemented via the EEM ETF with a target of 55 (+15%).
Our overall view of the global cycle and asset environment for the remainder of the year remains constructive. Since November, we have argued to avoid EM equity exposures given tightening and inflation pressures. But we think the balance of risks is shifting as we have highlighted in recent publications, and markets have yet to acknowledge this still nascent development. The tightening headwind has seen many large EM markets underperform substantially in recent months, and we think the forward profile looks much better than a few months ago.
We expect EM tightening to continue. But several large EM economies have already seen a significant slowing in activity. For example Brazil and India have seen industrial production slowing from close to 20% yoy to the low single digits. Perhaps most importantly, as our China economics team recently outlined, we believe that Chinese policy tightening and slowing activity have come through somewhat faster than expected. So we expect lower growth in 1Q, but expect economic momentum to reaccelerate for the rest of the year as policy authorities ease the pressure on the brake pedal, and equity markets typically benefit in this type of macro environment. Our Asia Pacific Portfolio Strategy team has upgraded Chinese equities to overweight today.
In addition, agricultural prices, a significant part of the EM inflation problem, have plateaued in recent weeks, and while there is still plenty of risk of higher prices, normal weather would see the impact of this factor in the headline inflation measures start to fade gradually over the summer. Broadly speaking, we believe there is a good chance that the most intense phase of tightening in EMs is behind us. While we do not yet see policy easing anywhere, the pace of incremental tightening is set to slow and we want to position ourselves for this shift earlier rather than later.
The most obvious risk to this trade is that we are too early. Inflation could run ahead of our current forecasts and the actual fact of ongoing rate tightening – even if anticipated by the market and at a slower pace than before – could continue to be a market headwind. And we expect tightening to continue in EM markets and in some places to intensify. But on our central outlook we expect inflation to moderate and growth to settle at healthy levels.
There are other risks as well, including higher oil prices, continuing headline risks out of the MENA region and a broader soft patch in global markets as leading indicators moderate and some of the G4 central banks begin to inch back from their exceptional easing stance. But given the poor performance of EM equities hitherto, they are arguably somewhat better protected. The dollar denominated EEM ETF has underperformed developed market equities very sharply since November 2010 despite its historically positive beta to these markets, and the local currency indices have actually sold off significantly in absolute terms too. So the risks seem more asymmetric here, with limited further downside, but the possibility of significant returns as fundamentals and sentiment on EM equities turn.
While the pattern of tightening and the balance of other risks varies across the main markets, we think the diversification offered by a broad group of EMs is probably helpful.
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Investors should consider the investment objectives, risks, and charges and expenses of an ETF carefully before investing. Each ETF prospectus contains such information about the ETF, and it is recommended that investors review carefully such prospectus before investing. A copy of the prospectus for all ETFs mentioned in this material can be obtained by investors from their Goldman Sachs sales representative, or from the offices of Goldman, Sachs & Co., 200 West Street, New York, NY, Attn: Prospectus Dept. (1-212-902-1394). Prospectuses are also available from ETF distributors.
Goldman Sachs is an authorized participant in each ETF mentioned in this material and participates in the creation and redemption of shares of each ETF mentioned in this material. Goldman Sachs, as an authorized participant or otherwise, acquires securities from the issuers of the ETFs mentioned in this material for the purposes of resale. As of March 30, 2011, Goldman Sachs has the following positions: EEM-long. Professionals who authored this material have no financial interest in any ETF mentioned in this material. One or more affiliates of Goldman Sachs is a specialist, market maker or designated liquidity provider for the following ETFs: EEM.