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Malaysia ETF: Trouble on the Horizon?

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Emerging markets have clearly been out of favor with investors for the past few months. Slow growth in some of the key emerging economies and slow but steady growth in the U.S. economy led to a sell-off in these markets. They were further hurt by the Fed’s taper talk.

Malaysia seemed to one of the brighter spots in the emerging markets investing this year as iShares MSCI Malaysia ETF (EWM - Free Report) had an almost flat return year-to-date versus 12% loss for the broader iShares MSCI Emerging Markets ETF (EEM - Free Report) .  (Read: The Best ETFs in the market’s top sector)

The ETF was hit earlier this year by the political uncertainty in the country but it surged after the election results. Even though election did not result in majority win for the ruling party and there were widespread protests after the election on allegations of electoral fraud, investors clearly cheered the victory and sent the Malaysian stocks higher.

Like many other emerging countries, Malaysia had also seen a surge in portfolio inflows in the last few years, thanks to sluggish growth and ultra-low interest rates in most of the developed countries. (Read: 3 Sector ETFs to Profit from Rising Rates).

Increasing concerns about the reversal of these flows due to a strengthening US dollar and rising rates in the US are currently acting as significant headwinds for these countries. And, a robust domestic demand in many of these economies is not able to offset weakness in the external environment.

Fitch downgrades the outlook

Earlier this week, Fitch Ratings downgraded its outlook on Malaysia. According to the rating agency, “Malaysia's public finances are its key rating weakness. Federal government debt rose to 53.3% of GDP at end-2012, up from 51.6% at end-2011 and 39.8% at end-2008”.

Per Fitch, the country faces two key budgetary vulnerabilities—its reliance on petroleum-derived revenues (33.7% of federal revenues in 2012) and the high and rising weight of subsidies in expenditure.

Malaysian Economy in Focus

While the country has gradually reduced its dependence on exports in the last few years, exports still account for more than 50% of the GDP, leaving the country vulnerable to the challenging external environment. Also, with an already high household debt to GDP ratio (~80%) and the recent measures taken by the central bank to restrict the household debt, further expansion in domestic demand may not be easy.

Last week, the World Bank cut its forecast for Malaysia's economy to 5.1% in 2013, down from 5.6% last year and said that the country is at risk of recording its first current-account deficit since 1997. (Read: 3 Unknown ETFs that continue to crush SPY)

The Malaysian ringgit is down 6.3% against the US dollar in 2013, which however, doesn’t look too bad if we compare it to the some other currencies in the region; the dollar has surged 13% against the yen and 10% against the Indian rupee this year.

The central bank left its key rate unchanged at 3% during its latest policy meeting. Inflation has remained low during the first half and even though the central bank expects it to pick up modestly during the second half, it may keep the policy rates unchanged.

It remains to be seen whether the new administration will accelerate reforms and remain on track to achieve its ambitious plan to join the ranks of high income countries by 2020. Hopefully the outlook downgrade will act as a wakeup call for the administration.

iShares MSCI Malaysia ETF (EWM - Free Report)

EWM which made its debut in 2006 now has $961 million in AUM which are invested in 43 securities.

The fund charges 53 basis points in fees annually. As of now, it is concentrated in financials which account for almost 31% of the asset base, with industrials (13%) and telecom (12%) rounding out the top three.

EWM is currently a Zacks Rank#3 (Hold) ETF.

Despite some weakness after the downgrade, the product has outperformed the funds tracking Malaysia’s regional peers like Thailand (THD - Free Report) , Philippines (EPHE - Free Report) and Indonesia (IDX - Free Report) and as well as broader emerging markets ETF (EEM - Free Report) in the past three months.

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