■ Stay long GEM. With an 87% correlation between the Empire State Manufacturing Index and the widely watched ISM due on 2 November, history suggests staying long GEM and GEM cyclicals. The Empire State rose in October, and this suggests the ISM staying above the 50 expansion threshold. As discussed in our 24 August GEM Strategy report, previous episodes when the ISM rose above 50 on a sustained basis were associated with a 41% rally in GEM in the 12 months after and a 65% rally in GEM cyclicals over that time period. With GEM up 14% since the ISM rose above 50, this suggests 25% further upside (MSCI EM target of 1,200 versus 967 currently).
■ We highlight nine indicators of improving fundamentals. We believe the 70% YTD rally in GEM is driven by improving fundamentals ranging from “V”-shaped recoveries in the OECD Leading Indicator, German IFO business expectations, US corporate cash flows and China PMI to emerging market bond and TED spreads. GEM’s historical P/E, dividend yield and price-to-book are just above historical averages, and are not at extremes.
■ Stay long GEM cyclicals, particularly energy. We highlight energy as our favoured cyclical (our biggest Overweight). It is the most undervalued of the four cyclical sectors and is the only cyclical sector where historical P/E is below its historical average.
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