- EM has come under pressure again, helped by yet another flare-up in US-China trade tensions and a less dovish than expected Fed
- MSCI EM has since given up nearly three quarters of this year’s gains
- MSCI EM FX has fared even worse, giving up nearly all this year’s gains
- Our 1-rated grouping (outperformers) for Q3 2019 consists of China, Korea, UAE, Hungary, and Poland
- Our 5-rated grouping (underperformers) for Q3 2019 consists of South Africa, Egypt, Brazil, Pakistan, and Argentina
- Since our last model update on March 7, our proprietary EM equity portfolio is -6.5%, outperforming MSCI EM (-7.0%)
EM EQUITY OUTLOOK
EM has come under pressure again, helped by yet another flare-up in US-China trade tensions and a less dovish than expected Fed. Markets were unhappy that Fed Chair Powell wouldn’t commit to more rate cuts. The global liquidity outlook remains supportive for risk assets such as EM, but the positive impact has been fleeting as markets continue to fret about the growing downside risks to global trade and growth.
MSCI EM rallied over 16% from the January 4 low to the April 17 peak. MSCI EM has since given up nearly three quarters of those gains. The break below the May low near 982 sets up a test of the January low near 945.50 and then the October low near 930.
MSCI EM FX has fared even worse, giving up all this year’s gains. The break below the January low near 1610 sets up a test the September low near 1575.
MSCI EM is up 3% YTD and compares to 14.6% for MSCI DM. It’s worth noting that the correlation between EM and DM stocks is currently around 0.68, up from around 50% in June and July. Whilst slightly below the May peak near .70 and the April peak near .75, the correlation remains relatively strong and is well above the low around 0.45 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, Latin America is the best equity performer in 2019 (10.4% YTD), followed by EMEA (5.2%) and Asia (1.5%).
Our next quarterly update for Q4 2019 will come out in October.
Our 1-rated grouping (outperformers) for Q3 2019 consists of China, Korea, UAE, Hungary, and Poland. These are the same five countries at the top as last quarter. We note that of the top 10 countries, 5 are in EMEA, 4 are in Asia, and 1 is in Latin America.
Our 5-rated grouping (underperformers) for Q3 2019 consists of South Africa, Egypt, Brazil, Pakistan, and Argentina. Turkey improved from 5 to 4, pushing Pakistan 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.
Other notable movements in the rankings include both Taiwan and Chile improving from 3 to 2, which pushed Thailand and Peru down from 2 to 3.
Since our last model update on March 7, our proprietary EM equity portfolio is -6.5%, outperforming MSCI EM (-7.0%). Overweighting Korea and China hurt us, as they underperformed during this period and had relatively large weights in our model portfolio. Underweighting Brazil and South Africa also hurt, as they outperformed albeit with relatively large weights.
What positions helped our model performance during this period? Our overweight positions for Russia, Malaysia, and Thailand helped, as they outperformed with relatively large weights. Underweighting Pakistan also helped our return, as it underperformed during this period albeit with a relatively small weight.
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. The current MSCI weights reflect recently changes announced that will increase weights for China A-shares and Saudi Arabia effective August 28.