EM EQUITY ALLOCATION MODEL FOR Q4 2015

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KEY POINTS

  • Recent softness in US data and the delayed Fed lift-off have helped EM assets gain some traction in early Q4
  • We remain cautious on EM equities as we move into Q4 2015, but differentiation amongst countries could increase
  • Since our last quarterly model update on July 2, our proprietary EM equity portfolio has fallen -10.5%, outperforming MSCI EM, which has fallen -12.8% 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

Recent softness in US data and the delayed Fed lift-off have helped EM assets gain some traction in early Q4.  We saw similar price action in late Q1/early Q2, but those gains evaporated as the US economy improved and the prospect of Fed lift-off returned.  Will history repeat itself?  There will be two more US jobs reports before the December 16 FOMC meeting, and we believe there is a risk that the dovish market take on the Fed is premature.

Since the biggest risk to EM (the Fed rate hike cycle) still lies ahead, we believe the asset class remains vulnerable to renewed selling.  Besides the Fed-related risks, China concerns remain ongoing, potentially weighing on wider EM sentiment.  In addition, the recent increase in commodity prices, if sustained, could drive a wedge in the performance of countries within EM.
For now, we think investors should make use of this EM bounce to rebalance their portfolios.  Whatever the timing of Fed lift-off is, we still believe it is very important for investors to continue focusing on the fundamentals and also on hedging out currency risk when feasible.  Regionally, Latin America is the worst performer (-19.4% YTD), followed by Asia (-14.4% YTD) and then EMEA (-12.9% 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 July 2, our proprietary EM equity portfolio has fallen -10.5%, outperforming MSCI EM (-12.8%).  Overweighting Korea, Israel, the Philippines, and Malaysia 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 positions have hurt our model performance during this period?  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.  So did our neutral weightings for Turkey and Hungary.

As a point of reference, MSCI DM has fallen -5.4% 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 -11.6% vs. -4.5%, respectively.

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FOREIGN EQUITY INFLOWS IN 2015

Data from local stock exchanges compiled by Bloomberg show that several major Asian EM countries are still seeing net positive foreign investor inflows this year, albeit down from the peaks.  The exceptions are Indonesia, the Philippines and Thailand (see graph below).

That said, Q3 was a difficult quarter.  According to data from the IIF, portfolio flows into EM were negative for the third consecutive month in September.  Investors are estimated to have sold some $40 bln worth of EM assets in Q3, making it the worst quarter since Q4 of 2008, with half of that coming from the equity markets.  While some semblance of calm has returned in recent weeks, we believe EM remains vulnerable to renewed selling pressures.

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.