EM Equity Allocation Model for Q3 2018

  • EM has stabilized but remains vulnerable to further losses
  • MSCI EM is set to retest the August low near 1040 and then the June 2017 low near 1000
  • The move by MSCI to upgrade Argentina and add Saudi Arabia to Emerging Market (EM) status has led us to reformulate our model coverage
  • Our 1-rated grouping (outperformers) for Q3 2018 now consists of Korea, Hungary, China, Peru, and Czech Republic
  • Our 5-rated grouping (underperformers) for Q3 2018 now consists of Indonesia, Mexico, Egypt, Brazil, and South Africa
  • Since our last quarterly model update on April 12, our proprietary EM equity portfolio has fallen -5.8%, outperforming MSCI EM (-9.2%)

EM EQUITY OUTLOOK

EM has stabilized but remains vulnerable to further losses. The higher US interest rate outlook remains a major factor, with the 2-year yield making new highs near 2.63% and the 10-year yield approaching 3%. Ongoing trade tensions is the other major negative driver for EM. Recent sideways price action only offers a respite from the bear trend that’s been seen for much of this year.

MSCI EM rallied for much of 2017, with the last leg up from early December until late January. It peaked at 1279 on January 29. Since then, it has retraced that entire leg and is trading at levels not seen since August. Indeed, MSCI EM tested the August low near 1040 at the end of June before we saw this modest bounce. Given our negative EM outlook, we think that low will eventually be broken, which would set up a test of the June 2017 low near 1000. Looking further out, the break below the 1076 area sets up a test of the April 2017 low near 951.

MSCI EM is down -16.5% from the January peak and is -7.5% YTD. This compares to +1.5% YTD for MSCI DM. It’s worth noting that the correlation between EM and DM stocks is currently 0.66 and rising. This compares to the March peak near .70 and it is now well above the low around 0.42 at the start of the year.

We still believe it is very important for investors to continue focusing on country fundamentals. Hedging out currency risk has become more important now for US investors in this strong dollar environment. Furthermore, we continue to look for potential divergences within EM. Regionally, Asia is the best equity performer so far in 2018 (-6.5% YTD) along with Latin America (-6.5%), and then followed by EMEA (-11.8%).

The move by MSCI to upgrade Argentina and add Saudi Arabia to Emerging Market (EM) status has led us to reformulate our model coverage. We have eliminated Hong Kong and Singapore (both were rated 1 last quarter) from our model universe to make room for these two new additions (both come in at 4).

Our 1-rated grouping (outperformers) for Q3 2018 now consists of Korea, Hungary, China, Peru, and Czech Republic. We note that of the top 10 countries, 5 are in Asia, 4 are in EMEA, and 1 is in Latin America. Peru improved from 4 to 1, while Hungary improved from 2 to 1, as these two filled the vacuum at the top after we dropped Singapore and Hong Kong from our model. Poland, Russia, and Malaysia all improved from 3 to 2.

Our 5-rated grouping (underperformers) for Q3 2018 now consists of Indonesia, Mexico, Egypt, Brazil, and South Africa. Both Qatar and Turkey worsened from 2 to 3, while Pakistan improved from 4 to 3. Lastly, Indonesia worsened from 4 to 5, trading places with Colombia. We note that of the bottom 10 countries, 5 are in Latin America, 3 are in EMEA, and 2 are in Asia.

Our next quarterly update for Q4 2018 will come out in October.   

MODEL PERFORMANCE

Since our last quarterly model update on April 12, our proprietary EM equity portfolio has fallen -5.8%, outperforming MSCI EM (-9.2%). Overweighting China, Taiwan, and Korea helped, as they outperformed during this period and have relatively large weights in our model portfolio. Underweighting Brazil also helped, as it underperformed with a relatively large weight.

What positions hurt our model performance during this period? Our overweight positions for Hungary and Turkey hurt as they underperformed, albeit with relatively smaller weights. Underweighting South Africa, Mexico, and India also hurt our return, as they outperformed during this period with relatively large weights. 

MODEL DESCRIPTION

Our equity allocation model is meant to assist global equity investors in assessing relative sovereign risk and optimal asset allocation across countries in the EM universe. The countries covered include 25 of the 26 countries (excluding Greece) in a simulated MSCI EM Index that includes Argentina and Saudi Arabia.

A country’s score reflects its relative attractiveness for equity investors – the likelihood that its equity market will outperform the rest of our EM universe over the next three months. A country’s score is determined as a weighted composite of 15 economic and political indicators that are each ranked against the other 24 countries in our model EM universe. Categories are industrial production growth, real interest rates, export growth, expected P/E ratio, real bank lending, current account, real money growth, GDP growth, investment/GDP, per capita GDP, inflation, retail sales, political risk (EIU), NIIP/GDP, and ease of doing business (World Bank).

A country that is typically ranked first in many of the categories will end up with a low composite score (the lower the better). Exchange rate fluctuations can have significant effects on the dollar return to foreign investors, and so we have chosen several variables that tend to highlight exchange rate risk (such as current account balance and FDI). Others were chosen as leading indicators of economic growth.

From a portfolio construction standpoint, we are benchmarking to MSCI Emerging Markets. As a result, our BBH model portfolio weights will be Underweight/Overweight compared to the MSCI weights.

  • Countries that are rated 1 will have a BBH weight that is 1.2 X MSCI EM weight.
  • Countries that are rated 2 will have a BBH weight that is 1.1 X MSCI EM weight.
  • Countries that are rated 3 will have a BBH weight that is equal to MSCI EM weight.
  • Countries that are rated 4 will have a BBH weight that is 0.75 X MSCI EM weight.
  • Countries that are rated 5 will have a BBH weight that is 0.5 X MSCI EM weight.

In order to have the BBH model portfolio weights add up to 100%, there may be some exceptions to the rules outlined above. However, we will always try to keep to these parameters as closely as possible.

CHANGE IN METHODOLOGY AND COVERAGE

In the past, we have taken a simple average of each grouping (1 through 5) to determine model performance. That allowed small markets such as Egypt or Peru to really skew the results. We are now taking a weighted approach, with country returns weighted by the BBH model weightings. Then, we compare our model performance against the benchmark MSCI EM.