EM EQUITY ALLOCATION MODEL FOR Q1 2016

Blog icons-EM Equity Allocation Model

  • Fed lift-off has commenced, and further tightening in 2016 should keep pressure on EM assets
  • We remain cautious on EM equities as we move into 2016, but differentiation amongst countries should increase as the renewed slide in commodities has mixed implications
  • Since our last quarterly model update on October 8, our proprietary EM equity portfolio has fallen -7.6%, outperforming MSCI EM, which has fallen -10.5% during the same period
  • Our 1-rated grouping (outperformers) for Q1 2016 consists of Korea, China, Poland, Singapore, and Israel
  • Our 5-rated grouping (underperformers) for Q1 2016 consists of India, Indonesia, Russia, Brazil, and South Africa

 EM EQUITY OUTLOOK

After the December lift-off, Fed tightening should continue in 2016. We think EM assets are likely to remain under pressure, as markets are still in disagreement about the pace and the scale of the Fed tightening cycle. The Fed Funds futures strip is still much more dovish than the Fed’s dot plot. Until the scope of Fed tightening becomes clearer, we think it will be hard for EM to get much traction.

Furthermore, soft commodity prices should keep pressure on many of the major EM exporters, including Brazil, Mexico, and Russia. And the renewed swoon in commodities will likely keep China concerns at the forefront, potentially weighing on wider EM sentiment. On the other hand, the prospects of more PBOC easing and perhaps more QE from the ECB and BOJ could help support global equities to some extent.

For now, we think investors should make use of any EM bounces to rebalance their portfolios. Whatever the pace and scope of Fed tightening is, we still believe it is very important for investors to continue focusing on the fundamentals and also on hedging out currency risk whenever feasible. Regionally, Latin America was the worst equity performer in 2015 (-31.6%), followed by EMEA (-22.2%) and then Asia (-11.5% YTD). We expect this trend to largely continue in 2016.

Our 1-rated grouping (outperformers) for Q1 2016 consists of Korea, China, Poland, Singapore, and Israel. Singapore improved from 2 to 1, while Hong Kong worsened from 1 to 2.

Our 5-rated grouping (underperformers) for Q1 2016 consists of India, Indonesia, Russia, Brazil, and South Africa. India worsened from 4 to 5, while Egypt improved from 5 to 4.

Other noteworthy moves include Qatar, which improved from 4 to 2. UAE also improved from 3 to 2, while Hungary improved from 4 to 3. On the other hand, Malaysia and Chile both worsened from 2 to 3, while the Philippines worsened from 3 to 4.

Our next model update for Q2 2016 will come out at the beginning of April. However, we will provide monthly performance updates throughout Q1.

 MODEL PERFORMANCE

Since our last quarterly model update on October 8, our proprietary EM equity portfolio has fallen -7.6%, outperforming MSCI EM (-10.5%). Overweighting Korea, Hong Kong, Israel, Singapore, and Malaysia helped our portfolio, as they have outperformed during this period. Our EM portfolio was also helped by underweighting Colombia, South Africa, Russia, and Brazil, as they have underperformed during this period.

What positions have hurt our model performance during this period? Our overweight position for Poland was a big negative factor, as it underperformed within EM during this period. Underweighting Indonesia and Hungary also took away from some of our performance, as they outperformed within EM.

As a point of reference, MSCI DM has fallen -2.5% during this same period. Note that after diverging in both 2013 and 2014, DM and EM equities (as measured by MSCI) moved in tandem in 2015. However, EM underperformed DM in 2015 at -16.6% vs. -2.7%, respectively. So far in 2016, EM is still underperforming DM but by a lesser extent, at -5.0% YTD and -3.7% YTD, respectively.

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 22 of the 23 countries (excluding Greece) in the MSCI EM Index as well as 3 (Israel, Hong Kong, and Singapore) from the MSCI DM Index.

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), FDI/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 1.5 X MSCI EM weight.
  • Countries that are rated 2 will have a BBH weight that is 1.25 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 the parameters as closely as possible.

CHANGE IN METHODOLOGY AND COVERAGE

The move by MSCI to upgrade Qatar and UAE to Emerging Market (EM) status has led us to reformulate our coverage and our model inputs. We eliminated Argentina and Pakistan from our model universe and included Qatar and UAE.  

We have also introduced “Political Risk” (as measured by EIU) as a model input, and eliminated “Economic Freedom.” We believe that the “Index of Economic Freedom” was already being picked up in the “Ease of Doing Business” input.

In the past, we have taken a simple average of each grouping (1 through 5) in order 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 our benchmark MSCI EM.

Over the long run, our old model showed a consistent ability to pick winners and losers, and we believe that will be the case for the new model as we move through 2016. We continue to think that investors will continue to differentiate within EM, favoring those countries with stronger fundamentals. This environment should make a fundamentally-based allocation model such as ours much more accurate in picking winner and losers.