| Emerging market bonds and equities can thrive in a changing environment |
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| 30/05/2004 | |
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With a 25.7% return in 2003 according to the JP Morgan Emerging Markets Bond Index, global emerging market bonds performed very well last year, outperforming the global stock market. However, the increasing likelihood of a rate hike by the Fed came as a chilling breeze for many markets. In spite of recent developments that negatively impact emerging market debt and equity, emerging markets should withstand the blows coming from this environment according to both fixed income and equity analysts. For Mohamed El-Erian, who oversees $14 billion as a managing director fixed income for emerging markets at PIMCO, the California-based investment manager, "while structural, financial, and political problems remain in many emerging markets and it is dangerous to generalise, cyclical developments are generally positive". Still market conditions are not what they used to be anymore, both for bonds and equities. Rates Three factors led to the strong performance of emerging markets since 2002, the year they started to continuously outperform developed markets. According to Maarten Jan Bakkum, emerging market strategist at ABN AMRO, low interest rates, a weak dollar and rising leading indicators all contributed to this strong performance. Now with a new market environment where all those factors have changed or are poised to change, emerging market bonds and equities may have a harder time to repeat the performance of the last years. "The next few quarters will be difficult for the emerging markets", says Maarten Jan Bakkum. Expectations of higher interest rate reflects the fact that global growth has picked up, which fuels emerging market exports, higher commodity prices and the prospects of higher foreign direct investment flows. In the short run, this should however leave both companies in emerging market with a harder time to levy money for their operations and investors with higher borrowing cost. "The time impact of this positive influence is more spread out than the negative impact of the technical factor" nuances PIMCO's El-Erian. "The prospect of a hike in US policy rates has put technical pressure on the market by triggering the unwinding of the leveraged global carry trade whereby certain investors (including hedge funds) borrowed at the front end of the US curve and bought credit and/or duration risk (including in emerging markets). This technical impact has been immediate; it has also been severe in view of the patchy liquidity conditions." "Market expectations have shifted dramatically, which means that the debt driver is also gone", says Maarten Jan Bakkum. Latin America could be one of the first to take the flak of those new market expectations. "When people gets very worried about global interest rates, they get worried about Latin America", adds Maarten Jan Bakkum. On the other hand, previously low interest rates means that many developing countries have already refinanced and reduced their debt burden and are now equipped to go through a period of relatively higher interest rates. Currency The dollar has also strengthened, and now seems to have reached a stable plateau. As shown in the bfinance consensus on rates (see link beside), most economists now hardly see a weakening dollar in the short term and bank on average on stable currency rates over the next six months. For emerging markets, the strengthening of the dollar in the emerging market means lesser inflationary pressure, local interest rates driven downward, and more liquidity, adding up to translate into more economic growth and more money for the stock market, making up for the likely loss due to higher US interest rate. Currency movement effects on emerging markets are well illustrated by the Brazilian case, where the real was quite stable in 2003 thanks to the intervention of the Brazilian authorities, who has faced a recent sell-off of Brazilian debt and currency. "It was difficult for the authority to keep the Real stable because the dollar was just weakening. It is not that Brazil was extremely healthy, but it was benefiting from a weak dollar", says Maarten Jan Bakkum. However the impact of a weakening Real sends shiver through the investor community. "In the current environment where the Real is, people get worried about inflation, interest rates might not be cut anymore so much as before: the whole cycle is turning the other way", adds Maarten Jan Bakkum. In Asia, the main focus of attention has been China in 2003, and should continue to be so throughout 2004, but risks abounds there too, and more than in Latin America and in Europe, Middle East and Africa (EMEA) according to Maarten Jan Bakkum. "Asia, at this stage is probably the most vulnerable because it is the most cyclical region of the three, because it is the most geared to global growth", he says. Besides that, there was the China driver in Asia which has created a little bit of a hype: people now gets worried about China. "It is possible that these worries are overdone", concedes the ABN AMRO strategist. If the Chinese engine slows down, then the commodity prices would go down, could spiral downward on the big providers, among which the Latin American countries. For the time being, "It is clear that the automatic, very strong driver of China has gone. Instead of that we get a lot of uncertainty and nervousness about the expectations of the Chinese economic growth", observes Marteen Jan Bakkum., and the high Asian expectations of many investors – around 6 to 7% growth - "means that if things turn negative, the downside risk is considerable." Adaptation Emerging markets, particularly the main ones, seem to be better equipped than ever before to go through a tougher economic environment. That may be due to the fact that emerging markets, although still rife with risk, are not exactly what they used to be anymore. What Mohamed El Erian calls the "four structural sins": a fixed exchange rate, a weak banking system, large fiscal deficits, and poor debt dynamics, have at least been partially eliminated in most emerging markets, which now have experienced policy makers that went through previous crises at their helm. "The vulnerability to external factors have fallen", agrees Jules Mort of Threadneedle Investment. In the end, for Mohamed El Erian, emerging market bonds remains an attractive asset class, subject to qualifications that affect the specifications of the investment strategy. "The asset class is still attractive because country fundamentals continue to improve, reinforcing the journey up the credit quality curve. This secular trend is being turbo-charged by the possible impact of high international commodity prices, which means that countries are not only improving their credit fundamentals but are also building up large financial cushions". J.L. |
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