foxex: Emerging Markets Give Up Recent Gains

Chart Advisor | Focus on the Price

By John Jagerson, CFA, CMT

Wednesday, February 06, 2019

1. Chinese stocks still uncertain

2. A rising dollar will drag on returns

3. Watch earnings from life insurance companies for more insight

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Major Moves

Although bullish confirmation is still valid, the major indexes stalled today as investors worried about trade and another possible government shutdown. I remain confident that one of the key factors that will send the market higher (or lower,) is whether trade conditions between the US and China improve (or deteriorate,) compared to where they are now. As I have mentioned in previous Chart Advisor issues, unfortunately, the Chinese markets are closed for the week which means we're not getting any official data and it's unlikely we will receive any updates on trade negotiations. However, we are able to see whether investor sentiment in the U.S. relative to China is changing.

Most of the ETF's in the market that track Chinese stocks have Chinese or Hong Kongese-listed stocks in their portfolio. If the ETF trades on US exchanges, investors can push the price of the ETF's shares higher or lower even if the price of the underlying shares held by the fund are technically unchanged. The most recent market price of an ETF's holdings is called its Net Asset Value (NAV) which can deviate from the ETF's per-share price.

If investors are feeling very confident about China, the price of the ETF's shares can rise above the fund's NAV per share. For example, the iShares China Large-Cap ETF (FXI) has a net asset value based on last Friday's market price of $42.69. However, Tuesday's close price of the ETF's shares was $43.41, which indicated that investors were expecting the underlying stocks in the fund to rise in value once the holiday in China is over. Today, however, that excess valuation evaporated as emerging market stocks dropped in value at a far faster pace than US equities on Wednesday.

As you can see in the following chart, FXI has had a fairly wide trading range over the last two days as investors try to price in the potential for changes in the US/China trade relationship. You will also notice that the ETF's chart makes it look like Chinese stocks are still struggling against resistance, which is not quite true if we look at Chinese stock indexes directly that are priced in yuan. However, in either case, the rally is still relatively new and a breakout is uncertain until we get more positive news about trade negotiations.

Read more:

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What are Exchange Traded Funds (ETFs)?

What Does Net Asset Value (NAV) Mean?

Risk Indicators - The USD

Part of the reason that ETF's holding shares of Chinese companies (and other emerging markets) look a little worse than the actual indexes for those stocks is due to a stronger dollar. If the dollar rises in value relative to the yuan, or other emerging market currencies, it deflates the potential gains from those foreign investments and can increase the potential losses.

For example, imagine that a group of foreign stocks held by an ETF has paid a dividend of 100 yuan but the value of the dollar has risen by 5%. When the dividend is translated from yuan into dollars it will have lost 5% in that process. From March through October 2018 the dollar gained over 10% against the yuan which reduced demand for Chinese investments. In the short term, a falling dollar would be supportive for international trade because it tends to be anti-inflationary in emerging markets and it makes US goods more competitive. That should improve the US trade deficit.

A falling dollar is also a sign of confidence that investors are not seeking shelter from volatility. However, over the last 5-days, the dollar has been rising. As you can see in the following chart, the emerging head and shoulders pattern in the dollar—that I mentioned in one of last week's Chart Advisor issues—has started to fade and is looking less likely to complete in the short term. In my view, it is unlikely that we'll see US stocks back to their prior highs without an accompanying decline in the dollar.

Understanding the Futures Market

Technicals Still Bullish Despite Resistance

Bottom line: Looking for guidance

There are still a lot of earnings to be reported this week, including a few life insurance companies like Prudential (PRU) and MetLife (MET) who report late Wednesday afternoon, which should help us understand the outlook for corporate performance a little better. Life insurance companies are very sensitive to changes in interest rates and expected return from the market. If forward guidance provided by management at the insurance companies is positive, it's likely to give the markets another boost to the upside.

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