EM Equity Allocation Model For Q2 2019 UPDATE

  • EM has come under pressure again, helped by another flare-up in US-China trade tensions
  • MSCI EM is down nearly 7% from the April peak and has given back nearly half of this year’s gains
  • MSCI EM FX has fared even worse, giving up nearly three quarters of this year’s gains
  • Our 1-rated grouping (outperformers) for Q2 2019 consists of Hungary, Poland, China, UAE, and Korea
  • Our 5-rated grouping (underperformers) for Q2 2019 consists of Brazil, Turkey, Argentina, Egypt, and South Africa
  • Since our last model update on March 7, our proprietary EM equity portfolio is -2.0%, outperforming MSCI EM (-2.9%) 

 

EM EQUITY OUTLOOK

EM has come under pressure again, helped by another flare-up in US-China trade tensions. The more dovish US and eurozone interest rate outlooks should have helped risk assets such as EM, but the positive impact has been fleeting as markets continue to fret about the growing downside risks to global activity.

MSCI EM rallied over 16% from the January 4 low to the April 17 peak. It has since turned lower, down nearly 7% from that peak and giving back nearly half of this year’s gains. The next major retracement objectives from this year’s rally come in near 1022.35 (50%) and 1004.20 (62%). The 200-day moving average comes in near 1024.

MSCI EM FX has fared even worse, giving up nearly three quarters of this year’s gains. It is on track to test the January low. Its 200-day moving average come in near 1618.50. We believe continued weakness in MSCI EM FX will eventually drag MSCI EM down towards its January low as well.

MSCI EM is still up nearly 8% YTD and compares to 13.2% for MSCI DM. It’s worth noting that the correlation between EM and DM stocks is currently around 0.65. Whilst below the April peak near .75 and last September’s peak near .80, the correlation remains relatively strong and is well above the low around 0.43 from last June.

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, EMEA (9.4%) is now the best equity performer so far in 2019 (9.4% YTD), followed by Asia (8.1%) and Latin America (5.5%).

Our next quarterly update for Q3 2019 will come out in June.  

 

MODEL PERFORMANCE

Our 1-rated grouping (outperformers) for Q2 2019 consists of Hungary, Poland, China, UAE, and Korea. We note that of the top 10 countries, 5 are in EMEA, 4 are in Asia, and 1 is in Latin America. UAE improved from 2 to 1, pushing Russia down from 1 to 2. Czech Republic improved from 3 to 2, pushing Taiwan down from 2 to 3.

Our 5-rated grouping (underperformers) for Q2 2019 consists of Brazil, Turkey, Argentina, Egypt, and South Africa. Pakistan and Colombia both improved from 5 to 4. This pushed both Turkey and Argentina down from 4 to 5. We note that of the bottom 10 countries, 4 are in Latin America, 4 are in EMEA, and 2 are in Asia.

Since our last model update on March 7, our proprietary EM equity portfolio is -2.0%, outperforming MSCI EM (-2.9%). Overweighting Korea and China hurt us, as they underperformed during this period and had relatively large weights in our model portfolio. Overweighting Poland and Malaysia also hurt, as they underperformed albeit with relatively smaller weights.

What positions helped our model performance during this period? Our overweight positions for Russia and Thailand helped, as they outperformed with relatively large weights. Underweighting Brazil, Turkey, and Indonesia also helped our return, as they underperformed 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.

 

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.

The move by MSCI to add Argentina and Saudi Arabia to Emerging Market (EM) index has led us to reformulate our model coverage. Last year, we eliminated Hong Kong and Singapore (both were rated 1 last quarter) from our model universe to make room for these two new additions.