EM EQUITY ALLOCATION MODEL FOR Q4 2017

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  • Firmer US data has led markets to recalibrate their Fed tightening expectations
  • MSCI EM is making new cycle highs today, and is currently up 31% YTD
  • Our 1-rated grouping (outperformers) for Q4 2017 consists of Hong Kong, Singapore, Czech Republic, Korea, and China
  • Our 5-rated grouping (underperformers) for Q4 2017 consists of Peru, India, Brazil, Mexico, and South Africa
  • Since our last quarterly model update on July 17, our proprietary EM equity portfolio has risen 7.1%, outperforming MSCI EM (up 6.6%)

EM EQUITY OUTLOOK

Firmer US data has led markets to recalibrate their Fed tightening expectations.  The US 2-year yield of 1.51% today is the highest since October 2008.  The US 10-year yield moved close to 2.0% last month but has since turned higher and moved close to the May/June high near 2.40% before drifting lower to 2.32% today.

Markets have almost fully priced in a third hike for 2017 in December.  Yet, only one hike is currently priced in for 2018 followed by less than one more in all of 2019 and 2020 combined.  Clearly, some investors believe the Fed to be basically done tightening after a December move.

This perceived benign global liquidity backdrop has helped propel the S&P 500 to new record highs today.  The Fed Dot Plot sees one more hike in 2017, three in 2018, two in 2019, and one in 2020.  However, the Fed Funds futures strip shows that the market still does not fully believe the Fed.

MSCI EM is making new cycle highs today, and is currently up 31% YTD.  It is trading at levels last seen in August 2011, and is on track to test the April 2011 high near 1212.

It’s worth noting that the correlation between EM and DM stocks is currently 0.52, edging lower from 0.55 in September and the year’s high around 0.60 in August.  This is also down from a high of 0.85 posted last summer, but the relatively high correlation suggests 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 36% YTD), followed by Latin America (up 26%) and then EMEA (up 11.5%).

Our 1-rated grouping (outperformers) for Q4 2017 consists of Hong Kong, Singapore, Czech Republic, Korea, and China.  We note that of the top 10 countries, 6 are in Asia and 4 are in EMEA.  Hungary and Pakistan both improved from 3 to 2, while Qatar jumped from 4 to 2.  On the other hand, both the Philippines and UAE dropped from 2 to 3.

Our 5-rated grouping (underperformers) for Q4 2017 consists of Peru, India, Brazil, Mexico, and South Africa.  India worsened from 4 to 5, while Egypt sank from 2 to 4.  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 Q1 2018 will come out at the beginning of January.     

MODEL PERFORMANCE

Since our last quarterly model update on July 17, our proprietary EM equity portfolio has risen 7.1%, outperforming MSCI EM (up 6.6%).  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 Turkey also 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 Thailand, Chile, and Peru also hurt as the outperformed during this period, albeit with relatively small weights.

EMEquity_10_17_table

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.