Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

Picking winners: how macro matters for asset performance

Avoiding financial crises is critical when investing in emerging markets. That’s why we developed the Country Risk Model, a general health check that helps us steer clear of economies with too many imbalances and symptoms of overheating. The model provides valuable trading signals outside full-blown crises too.

How is Indonesia today? Or any other emerging market? To answer these questions, we measure each emerging economy against 40 indicators that have been shown to predict financial crises: current account balances, credit growth, and banks’ foreign debt to name just a few. Each indicator has a critical threshold and the more thresholds a country breaches, the worse its health.

These measurements help us answer the question of whether healthy economies outperform sick ones. When we compared each economy’s currency performance in the year following a health check, it turned out that our measure of economic health explained 43% of the return variation across countries. We also found that a country that breaches only 10 out of the 40 thresholds outperforms a country that breaches 20 thresholds by six percentage points. Similar effects are observable for credit and equity performance.

In practice, of course, we do not blindly follow one model when deciding on our trades. Rather, we combine models with other signals and – more importantly – our judgements.

For example, we have liked the Indonesian rupiah for some time given that the country scores highly on our Country Risk Model. The currency also looked slightly undervalued when comparing Indonesia’s inflation and productivity gains with trading partners. However, a current account deficit close to 3% of GDP kept us on the fence. So when high-frequency data indicated an impending improvement in the current account in early May, we decided to go long the currency in our more unconstrained portfolios. Since then the rupiah has strengthened significantly, and we have started to take some profit lately.