Emerging Markets Q4 2015 Equity Allocation Model – UPDATE

Blog icons-EM Equity Allocation Model

  • Recent US data puts Fed lift-off squarely back in play; EM assets are likely to remain under pressure
  • We remain cautious on EM equities as we move into 2016, but differentiation amongst countries should increase as the renewed slide in commodities has mixed implications
  • Since our last quarterly model update on October 8, our proprietary EM equity portfolio has fallen -3.1%, outperforming MSCI EM, which has fallen -4.8% during the same period
  • Our 1-rated grouping (outperformers) for Q4 2015 consists of Korea, China, Poland, Hong Kong, and Israel
  • Our 5-rated grouping (underperformers) for Q4 2015 consists of Egypt, Indonesia, South Africa, Russia, and Brazil

EM EQUITY OUTLOOK

Recent US data puts Fed lift-off squarely back in play. We think EM assets are likely to remain under pressure, even though this event is almost fully priced in. Why? Because the pace and the scale of the Fed tightening cycle remain unknown. Until this becomes clearer, we think it will be hard for EM to get much traction.

Furthermore, sliding commodity prices will keep pressure on many of the major EM exporters, including Brazil, Mexico, and Russia. And the renewed swoon in commodities will likely bring China concerns back to the forefront, potentially weighing on wider EM sentiment. On the other hand, the prospects of more PBOC easing and perhaps more QE from the ECB and BOJ could help support global equities to some extent.

For now, we think investors should make use of any EM bounces to rebalance their portfolios. Whatever the pace and scope of Fed tightening is, we still believe it is very important for investors to continue focusing on the fundamentals and also on hedging out currency risk whenever feasible. Regionally, Latin America is the worst equity performer (-29.3% YTD), followed by EMEA (-20.4% YTD) and then Asia (-11.1% YTD).

Our 1-rated grouping (outperformers) for Q4 2015 consists of Korea, China, Poland, Hong Kong, and Israel. Compared to Q3, Poland and Israel improved from 2 while Taiwan worsened to 2 and UAE worsened to 3. It’s worth noting that two EMEA countries have moved into the top 5.

Our 5-rated grouping (underperformers) for Q4 2015 consists of Egypt, Indonesia, South Africa, Russia, and Brazil. Compared to Q3, Indonesia moved from 4 to 5, swapping places with India, which improved from 5 to 4.

 

Other noteworthy moves include Chile and the Czech Republic, both improving to 2 from 3 and 4, respectively. Thailand improved from 4 to 3. On the other hand, the Philippines worsened from 2 to 3, while both Qatar and Hungary worsened from 3 to 4. Our next model update for Q1 2016 will come out at the beginning of January.

 

MODEL PERFORMANCE

Since our last quarterly model update on October 8, our proprietary EM equity portfolio has fallen -3.1%, outperforming MSCI EM (-4.8%). Overweighting Korea, China, Hong Kong, Taiwan, and Israel helped our portfolio, as they have outperformed during this period. Our EM portfolio was also helped by underweighting Qatar, Colombia, Egypt, South Africa, and Russia as they have underperformed during this period.

What positions have hurt our model performance during this period? Our overweight position for Poland was a big negative factor, as it underperformed within EM during this period. Overweight positions for Chile and the Czech Republic also took away from our model performance, as these markets underperformed within EM during this period. Underweighting Indonesia and Hungary also took away from some of our performance, as they outperformed within EM.

As a point of reference, MSCI DM has risen 1.1% during this same period. Still, after diverging in both 2013 and 2014, DM and EM equities (as measured by MSCI) have now moved in tandem YTD in 2015. However, EM is well underperforming DM at -15.8% YTD vs. -2.8% YTD, respectively.

FOREIGN EQUITY FLOWS IN 2015

Data from local stock exchanges compiled by Bloomberg show that only two (India and Taiwan) of the major Asian EM countries are still seeing net positive foreign investor inflows this year, and are down sharply from the peaks. Virtually every EM country is experiencing y/y drops in equity inflows.

Q3 was a difficult quarter for EM, and Q4 is seeing continued outflows in November after a brief respite in October. According to data from the IIF, portfolio flows for EM moved back into negative territory in November as investors are estimated to have sold -$3.5 bln last month. This comes after they bought an estimated $13 bln worth of EM assets in October. While some semblance of calm had returned in October, we believe EM is back to seeing renewed selling pressures.

Source: Bloomberg, IIF

Note that 12-month total EM inflows fell to $42.9 bln in November from $79.3 bln in October, and is the lowest since August 2009. Most of the recent drop-off has been concentrated in debt, as equity flows appear to be stabilizing (for now) near the lows.

Source: Bloomberg, IIF

 

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.