Emerging markets have produced strong gains over the pastthree years but are likely to be hit particularly hard by global recession. So how should investors offset the risks of any likely slowdown?The bulls are running rampant in emerging markets. The MSCI Emerging Markets index rose by 10.9% during the first quarter of 2006, in sterling terms, continuing the strong gains from previous years. Emerging markets are a leveraged bet on the world economy and are currently enjoying particularly good performance. But they still tend to suffer bigger losses in global recessions. If investors have concerns about the world economy but still want exposure to this dynamic sector, is there a sensible compromise? Emerging economies are much more financially robust than they were previously and are not as vulnerable to the crises that undermined them in the 1990s. Threats to the global economy include disease pandemics such as Sars and bird flu, terrorism, war and soaring commodity prices, especially oil. A cooling property market bodes ill for American consumers and the massive US trade and public deficits threaten to cause a financial crisis. Despite developing their own economic power, emerging markets would still be hit by an American recession. There are positive factors, too. The latest statements from the Federal Reserve point to American interest rates peaking soon, and much of the oil price rise is demand-led because of the strong global economy, contrasting with the stagflationary rises seen in the 1970s that were caused by supply shocks. Furthermore, the economic support provided by American consumers could be substituted with capital expenditure from cash-rich corporations. Commodities have rallied since 2003 and the impact on emerging markets of this most cyclical of assets should be considered. Commodity prices are a key factor for emerging markets. The energy and materials sectors account for more than a quarter of the MSCI Emerging Markets index, and this proportion is significantly higher in certain markets. In Russia, Brazil and South Africa, these sectors account for 75%, 55% and 36% of total market capitalisation respectively, while they represent 32% of the stock market in China and 22% in India. Commodities have rallies for several reasons. The world economy, and China’s in particular, has grown rapidly, sucking in ever more resources. According to the International Monetary Fund, the global economy grew by 4.8% in 2005, the highest growth rate for 30 years. The lack of investment in the broader resources sector over the past decade has restricted supply in the face of this growing demand. The weak dollar has exaggerated the boom, as most commodities are priced in dollars. Political factors have also had an impact, especially in the energy sector, where the ongoing security worries in the Middle East and Nigeria have contributed to a strong oil price. This confluence of factors has helped many companies make windfall profits. Two fundamental results of this are first that the high debt levels of the past have been cut back significantly, reducing the financial leverage of many companies, while allowing some countries to alleviate their own debt positions. And second, money is now available to invest in significant capacity expansion and alternative sources. The commodity boom, and the resulting increase in equity prices, has placed valuations at historically high levels. In the short term, one might argue that this is justified, given the windfall profits and reduction in financial leverage, but in the longer term commodity prices are still cyclical. Increases in capacity are the inevitable supply-side response to high commodity prices and strong cashflows, while demand, political and currency factors may also revert. While commodity prices may be unlikely to fall back to historical lows and could fluctuate around a higher average, certain valuations ignore the risk that energy and materials prices may fall. Emerging market commodities companies do have a comparative advantage in that they are some of the lowest-cost producers in the world, with access to rich resources. The risk to the asset class has fallen as a result of the lower average. It is sensible, however, to bear in mind long-term valuations for the sector. Emerging markets are often regarded as a growth story and during periods of speculative excess, when stock markets are rising strongly, valuation fundamentals can be ignored by the markets. India is a good example of an emerging market that looks particularly expensive. Amid this excess, the increasing importance of dividends is often overlooked. The two graphs show how dividend payouts as a percentage of share prices have been rising since March 2003 in Thailand and Brazil. This development is increasingly typical of emerging markets. Investors who want exposure to the high growth story of emerging markets but wish to invest in a cautious way should be encouraged by this development. Emerging markets have been criticised in the past for their corporate accountability, but it is hard to fake a dividend payout. Such a valuation approach could not be expected to outperform a benchmark or most other managers in such periods. But in the longer term, particularly in slightly rising or down markets, stocks and markets identified by high and growing dividend streams are most likely to outperform.