G3 interest rates are currently at historical lows. As a result, the outlook for emerging debt canno...
G3 interest rates are currently at historical lows. As a result, the outlook for emerging debt cannot be judged independently. It is expected that if the Fed Funds rate rises 200bp to 3% over the period of the next 9-12 months, this level would still be lower than what the mean emerging economies had to live with through the 1990s.
Fundamentally, emerging countries are now more strongly positioned compared to 1994, 1997 or 1998, when emerging countries experienced severe crises.
The balance of payment position of the emerging economies is currently in current account and balance of payments surplus position and the majority of the foreign exchange regimes are operating within a flexible regime compared to the fixed regime back in 1997/1998. Countries such as Korea, Taiwan, China, Brazil, Argentina, Venezuela, Russia and South Africa are all running current account surpluses and have central banks accumulation reserves. Furthermore, the emerging economies are exporting capital to more capital-abundant developed economies. Therefore, the fundamentals are improving in all the major EM economies.
At this stage, it is important to mention the average quality of emerging debt has risen as the share of BBB credits has recently crossed 42% of the total market capitalisation compared to 26% 12 months ago. This is a clear reflection of the improving credit trend in emerging economies versus a deteriorating picture, which we have experienced in the corporate credit market over the past three years.
In addition, the investor base is more stable than it used to be. Strategic, long-term investors have entered this maturing asset class over the last couple of years, which previously had not been the case. Also, the credit derivatives market has grown in liquidity and continues to mature, which helps to intermediate risk.
Despite these improving fundamentals, it is at present the external environment that is becoming the major driver of emerging debt. The signals from the US Treasury market have recently been negative for the emerging debt markets. The consensus seems to be shifting towards a more bearish interest rate environment and the market is already pricing the gradual Fed tightening as early as August 2004.
The degree of damage to emerging markets will depend on the following different scenarios:
• In a more benign scenario, the interest-rate normalization will be accompanied, and to a large extent driven, by the strengthening of world and US growth. The Fed remains patient in reducing liquidity, and the tightening cycle is gradual. The impact on emerging markets in this scenario should be fairly balanced. The pick-up in global growth and still relatively high liquidity should help sovereign spreads.
• The other scenario is that higher interest rates are forecast, but global growth does not exceed the already respectable forecasts. The higher interest rates would be a reflection of reduced fears of disinflation, and pick-up in inflationary pressures. This scenario is significantly more bearish for emerging debt markets. The higher rates will increase the financing costs of borrowing and under this scenario there could be a larger correction in emerging debt spreads. The credit, which would be affected the most, would be more vulnerable credits in terms of refinancing, mainly pointing to Latin America.
The overall technical picture of the market will increasingly play a very important role. For a while, under a scenario of potential negative shocks, the technical picture may actually dictate the performance of emerging debt. So far this month, there has been evidence of this factor, as emerging debt (as per the JP EMBI Global Index) has actually declined by 5.3%, which represents about 40bp of spread widening over the period of one month.
Fund managers have retained an underweight interest rate duration stance in our global emerging strategy. Although in terms of credit duration and regional/country exposures there remains concern about possible 'spread widening momentum' from current market levels and consequently see more scope for credit market correction. On that basis, fund managers current spread risk stance is to be underweight the market. Latin America (mainly Ecuador, Brazil) has been a big underweight relative to emerging Europe/Middle East and Asia. In addition, it is expected the current environment is more supportive of the performance of local markets over spread related products.
Finally, our investment strategy is ultimately focused on interest rate long positions in economies with structural support for falling inflation. The most important in our view being Argentina, Hungary and Poland.
In terms of foreign exchange risk, the focus is on G7 themes as well as exchange rate dynamics in the emerging markets world. From a current valuation perspective - determined as the real exchange rate undervaluation - Polish zloty, Slovak koruna, Argentinean peso and to a certain degree Brazilian real are very attractive.
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