EM EQUITY ALLOCATION MODEL FOR Q3 2015 – UPDATE

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KEY POINTS

  • Given the prospects of Fed tightening and continued commodity weakness, we remain cautious on EM equities as we move further into Q3 2015
  • Measures of foreign investment inflows to EM reversed in August
  • Since our last quarterly model update on July 2, our proprietary EM equity portfolio has fallen -19%, outperforming MSCI EM, which has fallen -22.1% during the same period
  • Our 5-rated grouping (underperformers) for Q3 2015 consists of India, Egypt, South Africa, Russia, and Brazil
  • Our 1-rated grouping (outperformers) for Q3 2015 consists of Korea, Hong Kong, China, UAE, and Taiwan

EM EQUITY OUTLOOK

Softness in US data helped EM assets gain some traction in early Q2, but the gains have evaporated as the prospect of Fed lift-off nears and commodity prices continue their swoon.  After rising 14% from the March 13 low to peak on April 27, MSCI EM has since given up all those gains and is now making new cycle lows at levels not seen since 2009.  A break below the 754 area is needed to set up a test of the March 2009 low near 471.

Since the biggest risk to EM (the Fed rate hike cycle) still lies ahead, we believe the asset class remains vulnerable to continued selling.  This is especially true given ongoing China concerns in two areas:  its equity markets and its economy.  Heightened volatility in Chinese equity markets has spilled over into wider EM, while softer Chinese macro data has pushed several commodity prices to new cycle lows.  Both factors will likely continue in the coming months, weighing on market sentiment.

We still believe it is very important for investors to continue focusing on the fundamentals and also on hedging out currency risk when feasible.  Given China’s role as a potentially destabilizing force, we are concerned that Asia will no longer play the role of top performing region going forward.  Instead, that spot may end up going to Eastern Europe until China concerns have cleared up.  For the most part, both these regions benefit from lower commodity prices.  Latin America should continue to underperform due to its dependence on commodity exports.  Regionally, Latin America is the worst performer so far this quarter (-24.3%), followed by Asia (-22.5%)and then EMEA (-16%).

Our 5-rated grouping (underperformers) for Q3 2015 consists of India, Egypt, South Africa, Russia, and Brazil.  Compared to Q2, Russia and India moved from 4 to 5, swapping places with Indonesia and Czech Republic, which improved from 5 to 4.

Our 1-rated grouping (outperformers) for Q3 2015 consists of Korea, Hong Kong, China, UAE, and Taiwan.  Compared to Q2, Taiwan and Singapore swapped their 1 and 2 ratings.

Other noteworthy moves include Turkey and Peru, both improving from 4 to 3.  Thailand and Colombia worsened, with both moving from 3 to 4.  Our next model update for Q4 2015 will come out at the beginning of October.

MODEL PERFORMANCE

Since our last quarterly model update on July 2, our proprietary EM equity portfolio has fallen -19%, outperforming MSCI EM (-22.1%).  Overweighting Korea, UAE, Israel, and the Philippines helped our portfolio, as they have outperformed during this period.  Our EM portfolio was also helped by underweighting Brazil and Colombia, as they have underperformed during this period.

What other positions hurt our model performance so far this quarter?  Our overweight position for China was a big negative factor, as it underperformed within EM during this period.  Underweight positions for India, Thailand, and the Czech Republic also took away from our model performance, as these markets outperformed within EM during this period.

As a point of reference, MSCI DM has fallen -9.2% during this same period.  After diverging in both 2013 and 2014, DM and EM equities (as measured by MSCI) have now moved in tandem so far in 2015.  However, EM is well underperforming DM year-to-date at -22.1% vs. -9.2%, respectively.

FOREIGN EQUITY INFLOWS IN 2015

According to the latest report by the IIF, portfolio investment in Emerging Markets fell by -$4.5 bln in August, the first monthly outflow since December 2014.  A net inflow to EM debt of $4.2 bln was offset by an -$8.7 bln outflow from EM equities.  Note that 12-month total EM inflows fell to $135.1 bln in August, the lowest since April 2014.  The drop in  12-month equity flows was particularly pronounced, falling to $32.2 bln and the lowest since March 2014.

The IIF noted that equity outflows led the exodus:  “The sell-off intensified in late August, triggering a Flows Alert on Monday, August 24.  That day alone, the seven countries in our daily flows sample experienced outflows of $2.7 bln, the same magnitude as September 17, 2008 during the week of the Lehman Brothers bankruptcy.”

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 2015.  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.