Be Careful What You Wish For: Rising Yuan Could Hurt Retail ETFs

by on June 29, 2010 | ETFs Mentioned:

One of the biggest stories of the first half of the year (in the financial world at least) broke early last week, when Beijing announced that it would allow the Chinese currency increased flexibility against the U.S. dollar. The renminbi wasted little time, quickly reaching an exchange rate of 6.79 per greenback, setting a new high against the dollar in the modern era. This move by Beijing comes after months of pleading from a host of Western nations who felt that the currency was undervalued by as much as 35%. The international community argued that an artificially cheap yuan gives Chinese exports a significant competitive advantage, killing jobs in the U.S. and other markets in the process.

The move also represents a shrewd political play by China, since the shift came just days before the G-20 meeting in Toronto where the Chinese currency was likely to be a major issue. The change is likely to deflect some criticism of the Chinese government in the short-term, but many expect the calls for the yuan to appreciate further to grow louder in the coming months.

While the initial shift is relatively small, it represents the first step towards a free floating Chinese currency. In the long run, this is likely to be good news for most in China who will see buying power surge. The rising yuan will also affect American firms, as they may be able to sell more goods to China and eventually compete with Chinese manufacturing on a more level playing field.

But there are some potential drawbacks of a stronger yuan for U.S. firms as well. Companies that rely on China for significant portions of their raw materials just saw prices jump, and further increases in the future seem very likely. In terms of particular industries, this shift is likely to have a huge impact on retail ETFs, which obtain manufactured goods from China. Since retail can be a very low-margin business, firms will have no choice but to demand that their suppliers eat the increased costs or pass those costs on to consumers. Should firms pass those costs onto consumers, it could temper demand for many products, which would ultimately cut into retailer profits.

It’s still early in the game, but look for retail ETFs to be in focus in coming months as more details on China’s currency plans emerge. Below, we profile two ETFs that offer exposure to this sector of the U.S. economy:

Merrill Lynch Retail HOLDRS (RTH)

The top holding of this fund is Wal-Mart (19%), a company that makes extensive use of Chinese manufacturing and is likely to be among the most heavily impacted by yuan exchange rate changes. The fund holds 18 securities in total and also offers high weightings in Target (9%) and Walgreen’s, two more companies with high levels of exposure to China [see more holdings of RTH here]. Over the past 52 weeks RTH is up about 15%, but year to date the fund is down almost 5%. In terms of fees, RTH, like the rest of the HOLDR family, does not have an expense ratio but rather charges a flat fee per block of 100 shares held [read Five Facts About HOLDRs Every ETF Investor Must Know].

PowerShares Dynamic Retail Fund (PMR)

PMR offers more diversified exposure to the retail industry by tracking the Dynamic Retail Intellidex Index, an “intelligent” benchmark that evaluates companies based on a variety of characteristics including fundamental growth, stock valuation, investment timeliness and risk factors [see more information on PMR's fact sheet]. PMR holds 31 companies and allocates just only about 45% of assets to the top ten holdings. Some of its top holdings include Limited Brands (5.5%), Gap, Inc. (5%), and Nordstrom (4.9%). PMR has posted a gain of about 17% over the past 52 weeks and has posted a solid 2% gain thus far in 2010 [also see Are Toilet Paper Sales Signaling A Strong Recovery?].

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Disclosure: No positions at time of writing.