In A Recession, Emerging Market Funds May Outperform The S&P

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 |  Includes: GAF, GMF, ILF, MES, SPY
by: Efficient Alpha
By Joseph Hogue, Efficient Alpha
A recession in the United States and Europe has always meant trouble for emerging markets. Not only do investors withdraw funds in a flight to quality, but the emerging markets’ exports decline causing macroeconomic factors to turn. In the past, the best time to get out of emerging markets has been as soon as analysts start talking about how fundamental market relationships have changed and how, “this time is different.”
As much as I would like to join the chorus, I do not believe the emerging markets have changed so much as to become immune to developed market fluctuations. The market does not believe so either as evidenced by the drop in emerging market funds over the last three months. What may surprise you is the drop in emerging market funds relative to the S&P500. As investors price in the likelihood of a recession in the United States, many emerging market funds have actually outperformed the developed market index. The table below shows the percentage loss in three emerging market funds and the SPDR S&P500 (NYSEARCA:SPY) over the last three months.

As I mentioned, I do not believe that emerging markets have yet become completely resistant to a recession in the United States or Europe and further weakness in developed economies will bring the above funds down further. There are several factors, however, contributing to why I believe emerging market funds will outperform the S&P500 if things do become worse.
In contrast to the U.S. Central Bank, emerging markets have been raising rates for the past year in an effort to cool overheating economies and fight inflation. Inflation in commodities, of particular importance in many emerging markets, has rebounded strongly since 2009. Oil rose to above $114 and inflation in food prices is behind much of the blame for the Arab Spring in the Middle East and North Africa Region (MENA). The central bank of Brazil has raised rates to 12.5% in nominal terms and rates in most countries in Latin America are between 4.5% and 7%. Despite the countries’ diligence against inflation, high rates are threatening economic growth as well. The unfolding economic environment in the developed markets will give the emerging markets room to hold steady or even decrease rates. Last week, the central banks of both Chile and Colombia held their rates steady. Further, in contrast to the rock-bottom current rates in the United States, emerging markets have room to cut rates in order to spur internal growth.
From an economic perspective, the emerging markets are much stronger than they have been during past crises. The table below shows the amount of short-term debt as a percentage of total reserves held within three emerging market regions for the years 1997 and 2009 according to World Bank statistics. Exports can decrease significantly during a recession, which causes a decline in the country’s financial health, making it difficult to pay debts coming due within the next 12 months. Over the past few years, emerging markets have added considerable reserves and should be able to withstand an extended period of decreased exports.

The percentage of an emerging region’s GDP from exports can help analyze the degree of dependence its economy has on other markets. Exports of goods and Services, as a percentage of GDP, for the three regions in 2009 were 21.1%, 24.9%, and 30.0% for Latin America & the Caribbean, East Asia & Pacific, and Sub-Saharan Africa respectively. Though the emerging world still depends on the developed markets for a good portion of its economic growth, exports to other emerging markets have grown considerably. Additionally, household consumption within the emerging markets has grown and now contributes to a large part of the regions’ economic well-being. The percentage of GDP derived from household consumption within each of the regions is 55.7%, 64.0%, and 66.9% in East Asia & Pacific, Latin America & the Caribbean, and Sub-Saharan Africa respectively.
The emerging markets rebounded rather quickly from the current recession and are relatively stronger than the developed markets. If a recession were to hit the United States in the next year and the emerging markets are able to maintain positive GDP growth and strong asset prices, investors will continue to shift assets to these markets. While a change in the definition of these regions as technically emerging is not forthcoming, investors should begin to see the relative strength in their economies and overweight portfolios accordingly. This means the recent drop in prices for the emerging region funds may be a buying opportunity even while further declines may occur.
I believe the best opportunities for regional exposure are within the funds listed in the table above. Investors are also able to construct a more customized exposure through country specific funds. The SPDR S&P Emerging Middle East & Africa (NYSEARCA:GAF) provides exposure to South Africa (88.5%), Egypt (5.7%), and Morocco (5.2%). To offset the overweight exposure to South Africa, investors can choose from one of the other regional funds such as the Market Vectors Gulf States ETF (NYSEARCA:MES) which provides exposure to Kuwait (41.5%), Qatar (26.6%), UAE (21.0%), Oman (4.7%), Bahrain (4.2%), and Yemen (2.0%).
SPDR S&P Emerging Asia Pacific (NYSEARCA:GMF) provides exposure to China (36.0%), Taiwan (27.0%), India (17.2%), Malaysia (7.8%), Indonesia (5.4%), Thailand (4.3%), and the Philippines (1.7%). The fund is well-diversified across sectors and has returned 23.6% over the last year.
Though the fund is only exposed to the equities of four countries in the region (Mexico, Brazil, Argentina, and Chile) the iShares S&P Latin America 40 Fund (ILF) has returned 77% over the last five years versus a loss of 8.6% for the S&P500 (SPY) during the same period. The fund holds $2.2 billion in assets making it the largest of the three funds and pays a dividend yield of 2.3%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.