Emerging Market Equity Allocation Model for Q1 2014

(from my colleagues Dr. Win Thin and Ilan Solot)


EM and DM equities diverged in 2013, as MSCI EM (-5%) and MSCI DM (+24%) moved in opposite directions for the first year since 1998. This divergence has ended (for now) in 2014, with MSCI EM at -2.7% through Tuesday and MSCI DM at -0.6%. So far this year, the positive performance of European indices has been counterbalanced by the negative performances of Japan, Australia, and the US to a lesser degree. We note that MSCI indices measure dollar returns, taking into account both equity and FX movements for dollar-based investors.

Near-term, we believe tapering and US growth outlook will continue to be the main drivers for EM stocks which, in aggregate, will find it hard to gain much traction. Portfolio adjustments favoring DM at the expense of EM are likely to continue in the coming months, and so it seems likely that the two indices will move back to divergent trends before eventually converging, perhaps late this year.

Within EM, there has also been greater divergence of returns, continuing the trend that began in 2012 after two straight years of highly correlated EM returns. The standard deviation of MSCI country returns within EM was near 20% in both 2012 and 2013, the highest since 2009. However, this falls well short of the average standard deviation near 29% dating back to 1996. It remains to be seen whether or not this is a secular trend due to a greater degree of business cycle correlations.

We note that May 22 was a true turning point for EM last year. The multi-year EM bull market was predicated on 1) strong EM fundamentals, 2) poor DM fundamentals, and 3) plentiful global liquidity. Over the course of late 2012 and early 2013, we saw a marked turnaround in fundamentals as more and more EM countries were downgraded, even as the outlook for Japan and the euro zone improved. Bernanke’s speech highlighting the likelihood of tapering on May 22 was the final straw. Even though tapering is not tightening, the inflection point in Fed policy was enough to roil markets. We do not think a multi-year EM bull market can be reversed in a matter of months, which is why we remain negative on EM for much of 2014.


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 20 of the 21 countries in the MSCI EM Index as well as 3 (Israel, Hong Kong, and Singapore) from the MSCI DM Index and 2 (Argentina and Pakistan) from the MSCI Frontier Markets 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 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, per capita GDP, inflation, retail sales, index of economic freedom, FDI, and ease of doing business. 

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. Others were chosen as leading indicators of economic growth.


From 9/30/13 to 1/14/14, the MSCI EM Index fell -1.2% while the MSCI DM Index rose 7.0%. Looking at regional EM performance, MSCI Asia rose 0.9% during this period, MSCI Latin America fell -6.0%, and MSCI EMEA fell -3.2%. Looking at regional DM performance, MSCI US rose 9.2% during this period, MSCI Europe rose 9.6%, and MSCI Japan rose 0.7%. 

Within our model universe of 25 EM countries, those five that were in the top fifth of our rankings with a 1 rating (VERY OVERWEIGHT equity position) rose an average 1.0% during this period. Those with a 2 rating (SLIGHTLY OVERWEIGHT) fell an average -7.6%, while those with a 3 rating (NEUTRAL) fell an average -1.2%. This compares to an average gain of 7.7% during the same period for those with a 4 rating (UNDERWEIGHT) and an average gain of 2.4% for those with a 5 rating (VERY UNDERWEIGHT). 

At first blush, our equity model had mixed results this past quarter in identifying equity outperformers and underperformers. We do note that very strong performances for 5-rated Egypt (up 25.0%) and 4-rated Pakistan (up 15.6%) helped skew the results a bit. Netting them out of their respective categories led to an average loss of -3.2% for the 5-rated group and an average gain of 5.8% for the 4-rated group. Over the long run, our model has shown a more consistent ability to pick winners and losers, and believe that will be the case for Q1 2014 despite these mixed results for Q4 2013. 


We remain very cautious on EM this year, as Fed tapering has moved US monetary policy past a key inflection point. While the Fed has taken pains to stress that tapering is not tightening, we believe investors will continue to re-price assets across many markets as the Fed takes a step back from full speed ahead QE. As usual, we believe it will be very important for investors to focus on the fundamentals. 

We continue to believe that countries with poor fundamentals will suffer more this year. Our 5-rated grouping for Q1 2014 consists of Hungary, Brazil, South Africa, Egypt, and Pakistan. Conversely, our 1-rated grouping for Q1 2014 consists of Singapore, Hong Kong, China, Peru, and Malaysia. Note that because of equal scores for some, there are six countries that rated 2 this quarter and four that are rated 4.

Emerging Market Equity Allocation Model for Q1 2014 Emerging Market Equity Allocation Model for Q1 2014 Reviewed by Marc Chandler on January 15, 2014 Rating: 5
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