Schwab Fundamental Emerging Markets Large Company Index ETF (NYSEARCA:FNDE) invests in large-cap stocks in the emerging markets. The fund is tilted towards value stocks but still lost about 22.6% of its value since reaching the peak in late-2021. While emerging markets PMI data has shown signs of stabilization and that the global inventory correction is likely to come to an end this year, Fed fund rate is going to stay elevated or even higher beyond 2023. Since FNDE’s share price has an inverse correlation with the rate in the U.S., we do not see much catalyst for FNDE to move higher. Also, given its so-so record of performance in the past, we think investors may want to stay away from this name in 2023.
Owning FNDE was not pleasant in the past 10 years
While investors owning the S&P 500 Index (SP500) have enjoyed a total return of over 180% in the past decade, investors owning FNDE only delivered a total return of about 35%. If not considering the dividend, the capital gain was merely 3.23% in the past 10 years.
Not only did FNDE trailed the S&P 500 in the long run, it also underperformed the S&P 500 in this bear market. Since reaching the peak in mid-2021, the fund has declined by 22.6%. On the other hand, the S&P 500 only declined by about 16.4%. If not due to the recent stock market rally that began in late 2022, FNDE would have declined by as much as 30%.
Looking forward to the rest of 2023 and in the longer term, we have a few thoughts for investors to consider:
1) Emerging markets may continue to see fund outflows due to elevated rate in the U.S.
Although many FNDE’s portfolio of large-cap stocks generally do have strong balance sheets to sail through high-rate environments, their share price can often be impacted negatively due to rate changes in the United States. Below is a chart that shows the fund price of FNDE and the 10-year treasury rate in the past 5 years. As can be seen from the chart, FNDE’s fund price has an inverse correlation to the treasury rate. As the rate rises, FNDE tends to fall. On the other hand, as rates decline, FNDE’s fund price tend to move higher. As treasury rates rise, it becomes more attractive for foreign money to flow out of the emerging markets into the U.S. to invest in treasuries as they are considered risk-free assets. Since emerging markets are perceived to involve more risks, as treasury rate moves higher, more money will flow out of these riskier markets to seek lower-risk assets such as risk-free U.S. treasuries. Valuations of equities in the emerging markets will continue to be depressed in this environment.
Since the Federal Reserve is still combating the inflation and has indicated that they will not declare a victory too soon due to a persistent job market and strong consumer data, we expect that they will keep the Fed fund rate elevated beyond 2023 or perhaps even longer. This rate may go up even higher this year. Right now, the market is predicting that the Federal Reserve will raise the rates by 50 basis points in the upcoming March meeting. Therefore, investors should not expect that a rate drop will be the catalyst to move FNDE’s fund price higher this year. Any rate drop will be a story beyond 2023. If the rate continues to move higher, we might even see FNDE’s price resume its decline that we have seen throughout much of 2022.
2) Emerging market PMI data appears to be stabilizing
Since PMI is often a good forward indicator, we suggest investors to also pay attention to emerging markets PMI data. As can be seen from the chart below, emerging markets PMI appears to be stabilizing after some turmoil in the first half of 2022. This stabilization is likely due to China’s reopening of the economy in late 2022. In addition, we think global inventory correction which started in the first half of 2022 will likely come to an end in 2023. As inventories drop, manufacturing orders will increase. This will result in higher PMI. Therefore, we do think EM PMI has the potential to move higher.
3) FNDE’s high exposure to China not favorable in the long-term
FNDE has a high exposure to China as Chinese equities consist of 35.4% of its total portfolio. While China’s economy may rebound in the near-term thanks to its reopening policy, the country is facing both near-term and long-term structural issues.
First, the country has a very high level of debt. In fact, China’s debt represents almost 3 times the country’s GDP. This is the highest level it has ever recorded in the 27 years since China began recording the number. This high debt level means it will be very challenging to stimulate the economy.
Second, the communist party tend to introduce policies and regulations based on their own interest and not the interest of the people. Some policies may cause headwinds to the overall economy.
Third, the country is facing a structural population decline due to the one-child policy it introduced several decades ago. In fact, China’s population has declined by about 850 thousand people. This decline will likely not stop anytime soon and should accelerate as time progresses.
Should you buy FNDE now?
Based on a few points we have presented above, we know that Fed fund rates likely will stay elevated in the rest of 2023 and this will continue to depress on valuations of stocks in the emerging markets despite PMI showing signs of stabilization. Given this macroeconomic uncertainty and that long-term growth potential of stocks in Schwab Fundamental Emerging Markets Large Company Index ETF’s portfolio appears to be low, the risk and reward profile does not appear to be favorable. Therefore, we think investors should stay on the sidelines.
The year 2023 is going to be a year of uncertainty. While we expect inventory correction to be over very soon and that emerging markets PMI data should gradually rebound, stock market prices are also depicted by the Federal Reserve’s monetary policy. Since Fed fund rate will likely stay elevated or even higher for the rest of 2023, we think valuations of emerging market stocks will likely be depressed. Given this uncertainty, and the fact that Schwab Fundamental Emerging Markets Large Company Index ETF has not performed well in the past, we do not see it risk and reward profile attractive. Therefore, we think investors should stay on the sidelines.