EM EQUITY ALLOCATION MODEL FOR Q3 2017 – UPDATE

 Blog icons-EM Equity Allocation Model

  • Soft US data and delays to fiscal stimulus plans from the Trump administration has led to further softening of Fed tightening expectations
  • The correlation between EM and DM stocks is currently 0.55 and just below the year’s high around 0.60 posted in August
  • Our 1-rated grouping (outperformers) for Q3 2017 consists of Hong Kong, Singapore, China, Korea, and Czech Republic
  • Our 5-rated grouping (underperformers) for Q3 2017 consists of Colombia, Peru, Mexico, Brazil, and South Africa
  • Since our last quarterly model update on July 17, our proprietary EM equity portfolio has risen 2.5%, underperforming MSCI EM (+3.0%)

EM EQUITY OUTLOOK

Soft US data and delays to fiscal stimulus plans from the Trump administration has led to further softening of Fed tightening expectations.  Markets no longer view another hike in 2017 as likely.  Indeed, less than one hike is currently priced in for 2018 followed by less than one in 2019.  Some investors believe the Fed is done tightening.

The US 10-year yield has moved below 2.10% to the lowest since November 2016.  The benign global liquidity backdrop helped propel the S&P 500 to new record highs last month, but it has so far been unable to build on those gains.

MSCI EM made a new cycle high last week, and is currently up 26% YTD.  It is trading at levels last seen in September 2014, and is on track to test the high for that month near 1104.  After that is the April 2011 high near 1212.

It’s worth noting that the correlation between EM and DM stocks is currently 0.55, just below the year’s high around 0.60 posted in August.  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 on DM than it was in the recent past.

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 30% YTD), followed by Latin America (up 23.5%) and then EMEA (up 13%).

Our 1-rated grouping (outperformers) for Q3 2017 consists of Hong Kong, Singapore, China, Korea, and Czech Republic.  Czech Republic improved from 2 to 1, Egypt and Turkey both improved from 3 to 2, and India improved from 5 to 4.  We note that of the top 10 countries, 6 are in Asia and 4 are in EMEA.

Our 5-rated grouping (underperformers) for Q3 2017 consists of Colombia, Peru, Mexico, Brazil, and South Africa.   Peru worsened from 4 to 5 while Poland worsened from 2 to 3.  Pakistan enters our model universe at 3, replacing Israel.  We note that of the bottom 10 countries, 5 are in Latin America, 2 are in Asia, and 3 are in EMEA.

Our next quarterly update for Q4 2017 will come out at the beginning of October.    

MODEL PERFORMANCE

Since our last quarterly model update on July 17, our proprietary EM equity portfolio has risen 2.5%, underperforming MSCI EM (+3.0%).  Overweighting China helped, as it outperformed during this period and has a relatively large weight in our model portfolio.  Underweighting India and Mexico also helped our return, as they underperformed during this period with relatively large weights.

What positions hurt our model performance during this period?  Our overweight positions for Korea and Taiwan hurt the most, as they underperformed with relatively large weights.  Overweighting UAE, Czech Republic, Egypt, and the Philippines hurt, as they underperformed but with relatively small weights.  Underweighting Brazil, Russia, and South Africa hurt our performance too, as they outperformed with relatively large weights.  Underweighting Chile and Peru also hurt, as the outperformed during this period, albeit with relatively small weights.

Win 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 23 of the 24 countries (excluding Greece) in the MSCI EM Index as well as 2 (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 Pakistan to Emerging Market (EM) status has led us to reformulate our coverage.  We eliminated Israel from our model universe to make room for Pakistan.

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.