EM Equity Allocation Model For Q3 2020

• Since our last model update on November 14, our proprietary EM equity portfolio is up 7.7% and outperforming MSCI EM, which rose 4.9%
• Our 1-rated grouping (outperformers) for Q3 2020 consists of Korea, Hungary, China, Qatar, and Turkey
• Our 5-rated grouping (underperformers) for Q3 2020 consists of Pakistan, Argentina, India, Mexico, and South Africa
• EM has rallied sharply in recent weeks, helped by growing optimism that we’ve seen the worst of the pandemic
• MSCI EM FX has lagged, retracing only half of this year’s drop before running out of steam

MODEL PERFORMANCE

Since our last model update on November 14, our proprietary EM equity portfolio is up 7.7% and outperforming MSCI EM, which rose 4.9%. Simply put, overweighting China, Korea, and Taiwan was the main factor, as all three greatly outperformed MSCI EM with relatively large weights in our model portfolio. Underweighting Mexico, Brazil, and South Africa also helped as they underperformed with relatively large weights.

What positions hurt our model performance during this period? Our underweight position for Argentina hurt, as it outperformed albeit with a relatively small weight. Overweighting Russia also hurt our return, as it underperformed during this period with a relatively large weight.

NEW RATINGS

Our 1-rated grouping (outperformers) for Q3 2020 consists of Korea, Hungary, China, Qatar, and Turkey. Qatar and Turkey moved up from 4 to 1, helping to push both UAE and Poland down from 1 to 2. We note that of the top 10 countries, 6 are in EMEA and 4 are in Asia. There are none in Latin America.

Turkey is worth a special mention. While we are very negative on the lira because of the overall negative fundamental backdrop, much of our model is liquidity driven. As a result, Turkey comes in first in our rankings in the categories of negative real rates as well as strong money and loan growth in real terms. Turkey’s P/E ratio is very low and is in the top five for this category. While we considered overriding our model, we decided to maintain Turkey at its current high position.

Our 5-rated grouping (underperformers) for Q3 2020 consists of Pakistan, Argentina, India, Mexico, and South Africa. Brazil improved from 5 to 4, helping to push India down from 3 to 5. We note that of the bottom 10 countries, 4 are in Latin America, 3 are in EMEA, and 3 are in Asia.

There were a couple of notable movements in the rankings. Thailand improved from 3 to 2, which pushed Peru down from 2 to 3. Colombia and Saudi Arabia both improved from 4 to 3, which helped pushed Indonesia down from 3 to 4. Chile and Czech Republic both fell from 2 to 4.

PRICE ACTION SUMMARY

EM has rallied sharply in recent weeks, helped by growing optimism that we’ve seen the worst of the pandemic. MSCI EM has nearly retraced the entire sell-off from February. Break of that high near 1113 would set up a test of the 2020 high near 1151 from January 20. After that, the next big target is the January 2018 high near 1279. In between are the February and March 2018 high near 1229, the April 2018 high near 1187, and the May 2018 high near 1171.

MSCI EM FX has lagged, retracing only half of this year’s drop before running out of steam. The 50% retracement objective near 1610 coincides with the 200-day moving average. A break of the 62% level near 1625 is needed to set up a test of the January high near 1673.

MSCI EM is -2.2% YTD and compares to 1.5% YTD for MSCI DM. It’s very rare for EM to underperform DM in a bull market, and we suspect this will ebb as the rest of EM follows China out of this downturn. It’s worth noting that the correlation between EM and DM stocks is currently around 0.51, down from nearly .85 back in March.

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 the current volatile environment, and sharply lower interest rates in EM have made hedging much cheaper. Furthermore, we continue to look for potential divergences within EM. Regionally, Asia is the best equity performer in 2020 (5.8% YTD), followed by EMEA (-20.2%) and then Latin America (-31.8%).

Our next quarterly update for Q4 2020 will come out in October.

 

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. The current MSCI weights reflect changes announced last year that increased weights for China A-shares and Saudi Arabia.