EM EQUITY ALLOCATION MODEL FOR Q3 2015 – UPDATE

Blog icons-EM Equity Allocation Model

KEY POINTS

  • Given the likelihood of Fed tightening and more commodity weakness ahead, we remain cautious on EM Equities as we move further into Q3 2015
  • Measures of foreign investment inflows to EM slowed in July
  • Since our last quarterly model update on July 2, our proprietary EM equity portfolio has fallen -11%, outperforming MSCI EM, which has fallen -12.8% 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 likelihood of Fed lift-off in September has risen 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 and approaching the 2012/2013 low near 877/878.  Charts are pointing to a test of the 2011 low near 824.

Since the biggest risk to EM (the Fed rate hike cycle) still lies ahead, we believe the asset class remains vulnerable to renewed selling.  This is especially true given ongoing China concerns in two areas:  the equity markets and the 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 will likely continue to do so

We still believe it is very important for investors to continue focusing on the fundamentals and also on hedging out currency risk when feasible.  We still favor Asia as a region, while Latin America and (to a lesser extent) EMEA should continue to underperform.

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 -11.0%, well outperforming MSCI EM (-12.8%).  Overweighting Hong Kong, UAE, Israel, and the Philippines helped our portfolio, as they have outperformed during this period.  Our EM portfolio was also helped by underweighting Brazil, Russia, South Africa, and Colombia, as they have underperformed during this period.

What positions hurt our model performance so far this quarter?  Our overweight position for China was also a negative factor, as it underperformed within EM during this period.  Underweight positions for Egypt, India, and Czech Republic also took away from our model performance, as these markets outperformed within EM during this period.  Regionally, Latin America and Asia were the worst performers during this period (-13.1%), followed by EMEA (-9.2%).

As a point of reference, MSCI DM has fallen -0.2% during this same period.  After diverging in both 2013 and 2014, DM and EM equities (as measured by MSCI) had moved in tandem in H1 2015.  However, the two have once again diverged with EM underperforming DM year-to-date, at -7.2% vs. +1.8%, respectively.

FOREIGN EQUITY INFLOWS IN 2015

According to the latest report by the IIF, portfolio investment in Emerging Markets fell to $6.7 bln in July, down from a relatively strong June number of $11.3 bln. Net inflows to both EM debt and equity markets declined, especially to the latter.  Equity inflows fell to just $1.6 bln, the low for the year, while those for debt fell to $5.1 bln.  The institute also noted that inflows to Latin America were most resilient, while flows to EM Asia slowed and EM Europe experienced a sixth month of outflows.  Note that 12-month total EM inflows fell to $154.5 bln in July, the lowest since May 2014.

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.