Wednesday, May 28th, 2014

Ask Me Another Question

We are not the only commentators to argue that it is impossible to reconcile the behaviour of US Treasuries and the US equity market. Our views on the likelihood and scale of an equity correction are well-known and there is no need to repeat them. For the moment, we can’t answer the main question, so using our best exam technique, we will find a question to which we do know the answer and write about that instead.

Our US and European asset allocation models have both promoted EM Equities to #3 in the rankings, up from #7 last week. In terms of exposure, the move is not as dramatic as it appears because there is a cluster of asset classes each with about 7% of the portfolio, and it has only taken an increase of 1.5% in weight to go from the bottom to the top of this group. However the moment is psychologically and thematically important. Emerging markets are now our favourite equity region. EM bonds have been our favourite bond category since early April and our overall exposure to emerging markets is 45% vs 55% for developed markets.

This is, of course, way beyond the portfolio constraints of most investors. But before it is dismissed as completely impractical, let’s ask if it make sense from a risk perspective. Our data show that the excess volatility of EM equities vs Treasuries is in the middle of its two-year range and falling, whereas the same number for US equities is close to the top of its range and rising. If there is a correction, and this relationship holds, we would expect EM equities to produce a better risk-adjusted return than US equities – in other words not fall as much as their long-term beta implies. So a move into EM equities could make sense from a risk-management perspective.

Our data suggest that EM equities are a more homogenous asset class than many investors think, and that if they get the simple EM vs DM question right, they don’t need to be very good at country selection. However we cover 18 individual countries ranging from Chile to China and Turkey to Thailand, so we are happy to go to the next level of detail.

Our models have a clear preference for Asia over Latin America and EMEA. Countries like India, Indonesia and the Philippines all have high and rising scores when compared with the All Word Index. Also in this quadrant are South Africa and Peru. The low and rising quadrant contains Malaysia, Brazil, Thailand, Turkey, Colombia, Mexico, Chile and Hungary. The low and falling /stable quadrant contains Russia, China, Poland and the Czech Republic. In general high scores have less risk but lower potential, low scores have more potential (provided the score is rising) but more risk. Apart from Pakistan, there are no emerging markets in the high and falling quadrant, but that is exactly where we find the US.

Emerging markets are more risky than developed markets, but we think investors should be reluctant to increase their exposure to US equities while the main indices are hitting new all-time highs. Instead they should look at EM equities where the total return is still 7% below its all-time high, which dates from April 2011. There are of course many individual countries where the drawdown from the all-time high is a multiple of that number.

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