EM EQUITY ALLOCATION MODEL FOR Q2 2017 – UPDATE

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  • Soft US data and delays to fiscal stimulus plans from the Trump administration has led to a rethink of Fed tightening expectations
  • It’s worth noting that the correlation between EM and DM stocks is currently around 0.5
  • One big negative factor for EM equities this past quarter has been lower commodity prices
  • Our 1-rated grouping (outperformers) for Q2 2017 consists of Singapore, Korea, Hong Kong, Israel, and China
  • Our 5-rated grouping (underperformers) for Q2 2017 consists of India, Colombia, Mexico, Brazil, and South Africa

EM EQUITY OUTLOOK

Soft US data and delays to fiscal stimulus plans from the Trump administration has led to a rethink of Fed tightening expectations.  While a June hike is still largely priced in, markets no longer view another hike in H2 as likely.  Indeed, only one hike is currently priced in for 2018 followed by only one in 2019.  The benign global backdrop has helped propel the S&P 500 to new record highs this week.

It’s worth noting that the correlation between EM and DM stocks is currently nearing the year’s high around 0.50.  This is still down from a high of 0.85 posted last summer, but rising correlations suggest that the EM equity outlook has become more dependent of DM than it was in the recent past.

One big negative factor for EM equities this past quarter has been lower commodity prices.  Here, the outlook remains very volatile as markets struggle with the possibility of persistent excess global supply in several industrial commodities.  WTI oil is down 15% from the April 12 peak, while iron ore is down 35% from the April 5 high.

MSCI EM made a new cycle high last week, and is currently up 18% YTD.  It is trading at levels last seen in May 2015, and is on track to test the May 2015 high near 1069.  After that is the September 2014 high near 1104.

As the global backdrop hopefully clears up in the coming months, we still believe it is very important for investors to continue focusing on country fundamentals and on hedging out currency risk whenever feasible.  Regionally, Asia is the best equity performer so far in 2017 (up 22.6% YTD), followed by Latin America (up 7.4%) and then EMEA (up 5.3%).

Our 1-rated grouping (outperformers) for Q2 2017 consists of Singapore, Korea, Hong Kong, Israel, and China.  Both Hong Kong and Israel improved from 2 to 1, while Czech Republic and Poland both worsened from 1 to 2.  Other changes of note were Malaysia and Indonesia both improving from 4 to 3, while both Egypt and Turkey improved from 5 to 3.  We note that of the top 10 countries, 6 are in Asia and 4 are in EMEA.

Our 5-rated grouping (underperformers) for Q2 2017 consists of India, Colombia, Mexico, Brazil, and South Africa.   India fell from 3 to 5, while Colombia and Mexico both worsened from 4 to 5.  Russia improved from 5 to 4.  Other changes of note were Qatar, Thailand, and Chile all worsening from 3 to 4.  We note that of the bottom 10 countries, 5 are in Latin America and 3 are in EMEA.  The other 2 are in Asia.

Our next model update for Q3 2017 will come out at the beginning of July.   

MODEL PERFORMANCE

Since our last quarterly model update on April 17, our proprietary EM equity portfolio has risen 6.3%, slightly outperforming MSCI EM (+5.5%).  Overweighting Korea and China helped, as they outperformed during this period and had relatively large weights in our model portfolio.  Underweighting Brazil, South Africa, Russia, India, and Mexico also helped our return, as these markets underperformed during this period with relatively large weights.

What positions hurt our model performance during this period?  Our overweight position for Taiwan was a negative factor, as it underperformed within EM during this period and had a relatively large weight.  Overweighting UAE, Czech Republic, Poland, and the Philippines also hurt, as they underperformed but with relatively small weights.  Underweighting Peru hurt our performance too, as it outperformed modestly during this period.

EM Equity Allocation Model 

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 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.