EM EQUITY ALLOCATION MODEL FOR Q4 2016 – UPDATE

Blog icons-EM Equity Allocation Model

  • After the US election surprise, EM has been on the ropes
  • Two mitigating factors for EM equities are 1) higher commodity prices and 2) rising DM equity markets
  • Whatever the pace and scope of Fed tightening is, we still believe it is very important for investors to continue focusing on country fundamentals
  • Our 1-rated grouping (outperformers) for Q4 2016 consists of Czech Republic, Korea, Israel, Singapore and China
  • Our 5-rated grouping (underperformers) for Q4 2016 consists of Turkey, Russia, Egypt, South Africa and Brazil

EM EQUITY OUTLOOK

After the US election surprise, EM has been on the ropes. The prospect of significant fiscal stimulus from the incoming administration has led to a steepening of the yield curve. The Fed is likely to be more hawkish as a result. It likely to hike next week and follow that up with at least two hikes next year. EM rarely does well in a rising US rate environment, and so we expect selling pressures to continue.

Two mitigating factors for EM equities are 1) higher commodity prices and 2) rising DM equity markets. It remains to be seen whether the OPEC output cuts will stick. However, potential for greater US infrastructure spending coupled with a stabilizing Chinese economy has helped industrial metals rebound.

So far in 2016, EM and DM are moving together. The correlation between MSCI EM and MSCI DM (daily percentage change) is currently running around 0.56. While down from the year’s peak near 0.85 over the summer, the correlation is still high enough for the ongoing DM rally to lend EM some support. Note that EM is outperforming DM at +9.9% YTD vs. +4.1% YTD, respectively.

Whatever the pace and scope of Fed tightening is, we still believe it is very important for investors to continue focusing on country fundamentals and also on hedging out currency risk whenever feasible. Regionally, Latin America is the best equity performer so far in 2016 (up 24.3%), followed by EMEA (10.1%) and then Asia (7.1% YTD). We expect this performance trend to reverse a bit as we move into 2017.

Our 1-rated grouping (outperformers) for Q4 2016 consists of Czech Republic, Korea, Poland, Israel, and Singapore. Israel improved from 2 to 1, while China worsened from 1 to 2.  

Our 5-rated grouping (underperformers) for Q4 2016 consists of Turkey, Russia, Egypt, South Africa, and Brazil. Indonesia improved from 5 to 4, while Turkey worsened from 4 to 5.

Other noteworthy moves include Taiwan, which improved from 3 to 2. India and Thailand also improved, both from 4 to 3. On the other hand, Chile worsened from 2 to 3 while Qatar and Colombia both worsened from 3 to 4.

Our next model update for Q1 2017 will come out at the beginning of January.

MODEL PERFORMANCE 

Since our last quarterly model update on October 26, our proprietary EM equity portfolio has fallen -1.6%, outperforming MSCI EM (-3.5%). Overweighting Korea and Taiwan helped our portfolio, as they outperformed during this period and had a relatively large weight in our model portfolio. Our EM portfolio was also helped by overweighting Poland and the UAE, as they both outperformed during this period, albeit with relatively small weights. On the other hand, underweighting Brazil, Mexico, and Indonesia helped as they underperformed and had fairly large weights.

What positions hurt our model performance during this period? Our underweight positions for South Africa and Russia were the biggest negative factors, as they outperformed within EM during this period and had relatively large weights. Our EM portfolio was also hurt by underweighting Egypt and Peru, as they both outperformed during this period, albeit with relatively small weights.

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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.

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.