EM Equity Allocation Model Q2 Update

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

KEY POINTS

· * Given the likelihood of Fed tightening ahead, we remain cautious on EM Equities as we move closer to Q3 2015

* Measures of foreign investment inflows to EM slowed in May

· * Since our last quarterly model update on April 8, our proprietary EM equity portfolio has fallen -0.8%, outperforming MSCI EM, which has fallen -2.3% during the same period

* Our 5-rated grouping (underperformers) for Q2 2015 consists of Indonesia, Czech Republic, Egypt, Brazil, and South Africa

* Our 1-rated grouping (outperformers) for Q2 2015 consists of UAE, Korea, China, Singapore, and Hong Kong

EM EQUITY OUTLOOK

Recent softness in US data helped EM assets gain some traction in early Q2, but the feel-good vibe has evaporated as the likelihood of Fed lift-off in September has risen. After rising 14% from the March 13 low, MSCI EM has since given up over half of those gains since peaking April 27.

We saw the March-April USD softness as transitory, and have been vindicated by the price action in May-June. Since the biggest risk to EM (the Fed rate hike cycle) still lies ahead, we believe the asset class remains vulnerable to renewed selling. On the other hand, ongoing easing by the ECB and the PBOC (and perhaps the BOJ) should help underpin global equity markets.

After diverging in both 2013 and 2014, DM and EM equities (as measured by MSCI) have moved in tandem so far in 2015. EM is outperforming DM, 4.7% vs. 3.7% YTD, respectively.

We still believe it is very important for investors to continue focusing on the fundamentals and also on hedging out currency risk when feasible. We still favor Asia as a region, while Latin America and EMEA should continue to underperform.

Our 5-rated grouping (underperformers) for Q2 2015 consists of Indonesia, Czech Republic, Egypt, Brazil, and South Africa. Here, Czech Republic moved from 4 to 5, while Thailand and Indonesia swapped their 5 and 3 ratings, respectively.

Conversely, our 1-rated grouping (outperformers) for Q2 2015 consists of UAE, Korea, China, Singapore, and Hong Kong. Other noteworthy moves include Poland and Qatar, which swapped their 3 and 2 ratings, respectively. Also, Russia rose from 5 to 4. Our next model update for Q3 2015 will come out at the beginning of July.

MODEL PERFORMANCE

Since our last quarterly model update on April 8, our proprietary EM equity portfolio has fallen -0.8%, outperforming MSCI EM (-2.3%) by one and a half percentage points during this period. Overweighting UAE, China, Hong Kong, Taiwan, and Poland helped our portfolio, as they have performed well during this period. Our EM portfolio was also helped by under-weighting South Africa, Brazil, Indonesia, India, and Mexico as they have performed poorly during this period.

What other positions hurt our model performance so far this quarter? Our overweight positions for Korea, Singapore, Malaysia, Israel, and the Philippines were also a negative factor, as they underperformed within EM during this period. Underweight positions for Czech Republic and Egypt also took away from our model performance, as these markets outperformed within EM during this period.

As a point of reference, MSCI DM has risen 0.6% during this same period. Regionally, EMEA was the worst performer (-5.1%), followed by Latin America (-3.4%) and then Asia (-1.4%).

FOREIGN EQUITY INFLOWS IN 2015

According to the latest report by the IIF, portfolio investment in Emerging Markets slowed to $7.1 bln in May, after a $30 bln inflow in April that was the highest since November. Net inflows to EM debt markets were close to flat, so the $7 bln was almost entirely equity. Of that, Latin America saw the largest net inflows, followed by Asia, while Emerging Europe saw “substantial” outflows.

On a 12-month basis, EM debt investment fell to $143.1 bln and was the lowest since September 2014. Likewise, 12-month EM equity investment fell to $73.8 bln and was the lowest since December 2014.

Looking at higher frequency equity inflow data collected by Bloomberg for selected countries, we see that year-to-date inflows remain overwhelmingly positive, with the notable exception of Hungary.

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 recent 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 have eliminated Argentina and Pakistan from our model universe and have 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.

Over the long run, our old model showed a consistent ability to pick winners and losers, and we believe that will be the case for the new model as we move through 2015. 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.

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