As the second quarter mercifully draws to a close, many investors are left scratching their heads and wondering just where the world economy will go from here. Just a few short weeks ago, investors were upbeat and many thought that the groundwork had been laid for a second half surge. However, recent events have called this theory into question, as markets around the world limped to the second quarter finish line. Hit particularly hard have been European economies, which have been rocked by a sovereign debt crisis that threatens to send the region into a double dip recession.
Going forward, markets could turn either way, as conflicting data reports and diverging economic outlooks looks to tug asset values in both directions. Unemployment remains dangerously high, as job creation is virtually non-existent even though governments around the world have thrown hundreds of billions of dollars at the problem. But oil prices have remained in check, and inflation is yet to rear its head, allowing interest rates to remain near record lows for the foreseeable future. Against this backdrop, the outlook for the final six months of the year is far from certain [see Three ETF Ideas For The First Quarter].
One potential way to play this choppy, uncertain market is to take a look at long/short investment pairs that have the potential to generate positive returns regardless of the general direction of the markets. For investors uncertain of what the future holds, we outline three all-ETF long/short investment ideas for the second half of 2010 [for more actionable ETF ideas, sign up for our free ETF newsletter]:
Long CHIQ/ Short RTH
With a slightly more flexible yuan and increased consumer purchasing power resulting from a massive uptick in wages, Chinese consumers look ready to spend heading into the second half of 2010. While these developments are great news for China’s markets, they could hurt American consumers who will end up paying for Chinese labor and currency gains at retail stores later this year. Many wages in factories across China have risen by as much as 40%, and if the yuan is allowed to appreciate by even 10% this year, labor costs to producers could soar. These costs are likely to be passed on to American firms, which can either demand that the Chinese eat these costs by taking lower prices, drastically increase productivity, or by raise prices Stateside. Since retail is such a low margin business to begin with, look for this huge wage increase to compound with any currency appreciation to severely cut into American retail firms’ profits this year [also read Be Careful What You Wish For: Rising Yuan Could Hurt Retail ETFs].
From a global perspective, any decline in the U.S. could be offset by a surge in China, as Chinese consumers flush with sharply higher wages and a stronger currency begin to spend more on consumer goods. Considering these trends, an interesting investment for the rest of the year is to go long the China Consumer ETF (CHIQ) and short the Merrill Lynch Retail HOLDRS (RTH).
Long EWO/ Short EWP
Europe has been especially in focus over the past few months as investors have grown increasingly worried about government budgets. Two countries that have been in the spotlight lately are Hungary and Spain, which many investors feared were headed for default. But such a drastic outcome seems highly unlikely for Hungary given the country’s relatively sound budget situation as well as the ability of the country to print more of its currency, the forint, at will. Spain has neither of these advantages and additionally is faced with unemployment levels above 20%, among the highest in the developed world.
With such high levels of unemployment, it seems highly unlikely that the country will have the political capital required to slash government jobs. In Hungary, the government is poised to meet its deficit goal of 3.8% on the year–hardly a “crisis level” considering that it represents only a fraction of the U.S. budget deficit. Furthermore, the country has shown that it has willingness and ability to cut spending, something that many Western and Southern European nations, including Spain, seem to be incapable of doing.
Hungary’s budget crisis is overblown, but Spain’s is not. So a long/short play targeting the iShares MSCI Austria Index Fund (EWO) and a short investment in iShares MSCI Spain Index Fund (EWP) is an intriguing play. EWO certainly isn’t a pure play on Hungary’s economy, but in recent months it has moved in unison with neighboring markets, a trend we think is likely to continue [see Austria ETF Unfairly Hit By Hungarian Crisis].
Long DFJ/ Short EWJ
Large Japanese corporations have been in the news a lot lately, but not for the right reasons. A rash of issues at Chinese plants, as well as poor press from the big four Japanese car makers and electronics giant Sony, threaten to instill an image of low quality in consumers’ minds when they see the words “made in Japan.” Moreover, a stubbornly strong yen makes it difficult for exporters to send their products abroad, since these goods will be more expensive to those outside of Japan. A stronger yen is the goal of the new administration–that would boost buying power and enhance the attractiveness of exports–but that is easier said than done. These factors are crucial to consider when one looks at two of the most popular ETFs in the Japan Equities ETFdb Category, the iShares MSCI Japan Index Fund (EWJ) and WisdomTree Japan SmallCap Fund (DFJ). EWJ focuses on large multinational firms such as Toyota Motor (4.7%), Mitsubishi, and Honda (2.4%) that depend heavily on exports and are battling image problems at present.
Meanwhile, DFJ focuses on smaller dividend-paying companies that are more likely to sell their products locally and depend on growth in local consumption. This distinction is an important one when the euro zone appears to be headed towards a prolonged period of zero to low growth; although chaos in the euro zone won’t be beneficial to DFJ, it may not have quite the adverse impact on this fund that it would on its large cap counterpart. For these reasons, a long/short ETF play that goes long on small cap DFJ while shorting the large cap Japanese counterpart EWJ could be interesting for the rest of 2010 [also see the Guide To Small Cap International ETFs].
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Disclosure: No positions at time of writing.