Based on our quantitative analysis using stock prices in the U.S. dollar terms, country effect dominates sector effect when it comes to emerging market equities⌠As such, country analysis still pays large dividends in EM, and getting the country macro backdrop and dynamics right remains critical to EM equity investors.â
-BCA Research, 23 March 2016
In a timely reminder of why we do what we do, one of our preferred independent research providers, BCA Research, released a report to its clients that strongly states the importance of top-down, country-driven research in emerging market equity investing. In a further echo of our views, BCA identified that this effect does not exist in developed equity markets, where sector effects are more powerful.
This is not only our view, formed through investing in EM equities since the mid-1990s, but is also supported by a significant body of academic financial literature. âCountry and industry factors in returns: evidence from emerging marketsâ stocksâ, Serra (2000) is the most-cited paper, but there are many other papers, using a variety of methodologies, all converging on the same viewpoint: âcountry pure effects are the most important factors driving the behavior of emerging marketsâ individual stock returnsâ (Serra).
The standard, or consensus, approach to EM equity is to focus on bottom-up company analysis and stock selection â finding the best companies â and top-down factors are a secondary consideration at best. The dominance of this view creates opportunity, as we feel that the bottom-up consensus alternatively ignores, and then overreacts to, top-down drivers. A particularly powerful recent example of this was the âtaper tantrumâ in May 2013. The bottom-up consensus went, in six weeks, from ignoring the large current account deficits in some emerging markets to indiscriminately selling those markets, irrespective of other top-down fundamentals, which created such a great buying opportunity in Indian equities in mid-2013.
We believe that many drivers of emerging market stocks sit at the country level: economic growth, fiscal and monetary policy, interest rates, currencies and political and institutional risk are all national effects. From a theoretical point of view, both currency moves and the role of interest rates in driving valuations are paramount in determining equity returns to international investors. In the last three years, the Taiwan dollar has depreciated by 7.8% against the US dollar, and the Taiwanese central bank has cut its policy rate by a total of 38bp. In the same period, the Brazilian real has depreciated by 43.7% against the US dollar, and the Brazilian central bank has hiked its policy rate by a total of 700bp. Care to guess which market has performed better?
In the last three years, the price return of the MSCI Taiwan index has been +5.1% (in US dollar terms) compared to -51.0% for the MSCI Brazil index. We believe that it is identifying top -down opportunities that it is the key opportunity in EM equity investing (rather than trying to be top-quartile stock-pickers in, in this example, Brazil). Our process is driven by a rigorous and regular analysis of a diverse set of country-level factors. Not every decision will be correct in both outcome and timing, but we believe that top-down, country-level effects in EM equities are powerful, sustained and underexploited, as the academic and research literature continues to argue.
The views expressed are those of the portfolio manager as of April 2016, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
