By Joseph Hogue, CFA
Prognosticators and pundits are split about 50/50 when it comes to successfully predicting a recession. This might actually be good enough if it was a consistent 50/50, but unfortunately it’s not. UBS puts the odds of a new recession at 40%, while PIMCO’s Bill Gross is saying a double-dip is, “highly probable.” While I generally believe the economy will push through with above zero growth, that doesn’t mean I am not looking for winners and losers in the event of another downturn. Basic business cycle investing tells us that, within sectors, utilities and consumer staples should do well.
Typically investors shy away from emerging markets as the developed world heads to negative growth. While I would not recommend completely reducing emerging market exposure, these regions have done extremely well relative the developed market indices and should continue to do so, the data below will help you understand which markets may underperform given their reliance on the U.S. and Europe.
The table below shows exports of goods and services as a percentage of GDP for select countries and regions. The measure includes the value of merchandise, freight, insurance, transport, travel, royalties and fees associated with the exportation. The measure does not include compensation of employees, investment income, or transfer payments. Emerging markets have traditionally been dependent on exports for a large portion of economic growth. As recession hits the developed world and commodity prices come down, those countries with higher dependency on exports will underperform. The table shows relative strength in Brazil, India, and Latin America with exports accounting for an average of approximately 17% of GDP. East Asia & Pacific, Vietnam in particular, is more highly dependent on exports as a source of economic growth.
The next table below presents the percentage of total merchandise exports going to high-income economies, as defined by the World Bank as of July 2009. While economies in the emerging world are forecasted lower in 2012 than this year, they will still grow at a faster rate than those in the developing world. For this, it is not only important to measure an economy’s exports as a percentage of GDP but also the relative dependence of these exports on developed economies. Again, we are presented with relative weakness in East Asia & Pacific and Vietnam. If we use the data in the two tables together, we can find the percentage of the economy dependent on exports to high-income countries. Brazil, India, and the Latin America & Caribbean region are the least dependent on the developed world with only 5.3%, 12.8%, and 13.9% of the economy dependent on exports to the developed economies of the world. East Asia & Pacific and Vietnam are relatively more dependent on the developed world with 25.7% and 47.2% of their respective economies relying on exports to high-income countries.
The last table shows household final consumption expenditure as a percentage of GDP. Household final consumption is the market value of goods and services purchased by domestic households. It excludes real estate purchases but includes other durable goods purchases. The data can be used to measure the relative strength of domestic demand across countries and regions. The growth and future for emerging markets will depend on their ability to grow domestic demand and reduce their dependence on the economies in other parts of the world. Latin America has a higher relative percentage of GDP supported by domestic consumption, while East Asia & Pacific and China has a smaller consumer sector. Data for Vietnam is available but suspect due to conflicts with other data.
Using the data in the three tables above presents opportunities for asset allocation and possible long-short pair trades within country-specific and regional exchange traded funds. The iShares FTSE China 25 (FXI) holds the stock of 25 companies domiciled in China. The expense ratio is second highest of the group at .72% and pays a dividend yield of 1.9%. Sectors represented in the fund are heavily concentrated with financials (50.2%), telecommunications (20.1%), oil & gas (14.3%), and basic materials (12.7%) representing almost all of the holdings. Sector exposure within country specific funds is often concentrated as a result of market concentration and liquidity. The fund trades at a price to earnings ratio of 15.0 and has underperformed the SPDR S&P500 by 15.4% over the last 12 months.
The iShares MSCI Brazil ETF (EWZ) currently holds 86 stocks to correspond to the general performance, before fees, of publicly traded securities on the Brazilian market. The fund is heavily concentrated in a few sectors including materials (24.0%), financials (23.3%), energy (22.6%), and consumer staples (9.2%) but is slightly more diversified than the China fund. The fund trades at a P/E of 13.0 and has underperformed the S&P500 by 16.8% over the last 12 months. Given Brazil’s larger household spending and relatively lower dependence on exports to high-income countries, investors may consider a pair trade buying shares of the Brazil fund and shorting shares of the China fund.
The iShares S&P Latin America 40 (ILF) currently holds 34 stocks and seeks to replicate the performance of the Standard & Poor’s Latin America 40 Index. The fund is more diversified across sectors than either the Brazil or the China fund. Sector exposure includes materials (22.6%), financials (21.1%), consumer staples (17.6%), telecommunication services (12.3%), energy (11.1%), and utilities (7.6%). Despite this, the fund is not very diversified across the region with country exposures of Brazil (55.2%), Mexico (24.7%), and Chile (13.5%). The fund’s fees and expenses, at .5% are relatively lower compared to the other funds and its current dividend yield is 2.8%. The fund trades at a P/E of 15.8 and has underperformed the S&P500 by 8.7% over the last 12 months. Though the data above is generally positive for Latin America, the fund’s exposure to Mexico may hold back returns. Mexico is much more dependent on the United States for its exports and may underperform the rest of Latin America in a U.S. recession.
For this reason, a position in the LatAm fund could be paired with a short position in the iShares MSCI Mexico Investable Market (EWW). An important note here is the dependence of Latin America on Asian markets. While East Asia & Pacific countries might have a higher percentage of their GDP reliant on exports to high-income countries relative to LatAm, this is not to say that Latin American economies will not be affected indirectly through their Asian exports. As exports of final goods to the U.S. fall during a recession, then imports of resources to China must also be reduced. The reason I believe the Latin American economies will not suffer as much as the Asian economies is that some of the LatAm exports will still be needed to support the growth in domestic demand within the Asian countries.
The Market Vectors Vietnam ETF (VNM) holds 34 stocks with approximately 70% of the fund market cap in locally-listed companies. As with the other two country-specific funds, the VNM is not well-diversified across sectors with financials (37.0%), energy (25.6%), industrials (14.6%), and materials (7.9%). The majority of the fund (90.8%) is invested in medium-sized ($1-5 billion) and small (< $1 billion) companies. The fund is the most richly valued at a P/E of 19.1 times but also pays the highest dividend of 4.0%. The fund contractually caps the expense ratio at .76% and has underperformed the S&P500 by 31.4% over the last 12 months. The fund’s relative underperformance over the last year may help support it to an extent, but if economic conditions continue to deteriorate in the U.S. and Europe it could still see significant downside.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.