Investing In Emerging Markets: December 2006

Friday, December 22, 2006

A slowing global economy will erode but not eliminate bumper emerging market returns next year, with the uncertain U.S. economic outlook likely to cause some ups and downs in risk appetite.

Given rising U.S., euro zone and Japanese interest rates, 2006 was a stellar year. JP Morgan's sovereign bond index EMBI+ shows spreads over U.S. Treasuries at record narrow levels, with returns around 10 percent in dollar terms. On equities, Morgan Stanley's emerging index is also near a record high.

“Our view is that emerging markets will have another good year in 2007 but there are enough uncertainties out there to make it volatile from time to time,” said Sarah Hewin, senior economist at the American Express Bank in London.

Hewin said a soft U.S. landing, the continued Japanese and euro zone upswing and steady growth in most emerging markets, would keep the global backdrop benign, but she warned: “People are unsure which way the Fed will move and that means we will see some choppiness going forward.”

JP Morgan forecasts emerging dollar bond returns to drop to about 6 percent in 2007 but still recommends staying overweight as returns will outstrip those on Treasuries or euro zone bunds.

Andrew Howell, Citigroup head of emerging equities, expects EMEA stocks to return 15 percent next year versus 25 percent in 2006 and 15-20 percent returns in Latin America thanks to decent global growth, ample liquidity and still-reasonable valuations.

“We are thus willing to call for an unprecedented fifth year of gains in emerging markets,” he said.

Analysts also predict a continued boom in local currency debt which carries higher risk but offers double-digit yields. Over 60 percent of trade is now in the local segment.

“Investors will go more and more into local markets...with EMBI+ spreads at 172 bps you can't make much money there. Local markets are a necessary thing now if you want decent returns,” said Michael Ganske, portfolio manager at Deka Investments, which has over $7 billion in emerging market fixed income.

About 60 percent of this is in local currency bonds, a significant rise from a few years ago, he said.

RISKS

Potential risk factors next year could be anything from a U.S. recession – still seen as unlikely – to higher Japanese interest rates that would trigger the unwinding of carry trades. A significant economic slowdown could hit commodities, key for many developing states.

“I think the single biggest risk is the unwinding of leverage and there is a fair amount of that in the system,” said Kaushik Rudra, strategist at Lehman Brothers in London. “If the BOJ raises rates we could see some of the leverage come off.”

Interest rates of just 0.25 percent makes yen the currency of choice to fund overseas high-yield investments but a hawkish Bank of Japan sent tremors through the carry trade this year.

“Clearly, G7 markets pose the risk and it's probably going to be a factor one is not focused on,” Rudra said.

Most argue that the limited extent of the U.S. slowdown will keep the impact light while the Fed rate cuts expected from the middle of 2007 should unleash liquidity and support markets.

A more bearish view is of a global downturn, with Asian and the euro zone growth insufficient to counteract U.S. weakness.

In some ways the 2007 outlook may be less challenging than at the end of last year when U.S. and euro zone interest rates looked set to rise much further. Most believe now that U.S. rates have peaked and euro zone rates do not have far to go.

While the BOJ is seen raising rates by 50 bps, most feel this is priced in and will not rock the carry trade boat.

On the political front, except for Turkey and Russia the election cycle is over in most of central Europe and Latin America.

HUGE OVERWEIGHTS

The danger may in fact lie in huge overweight positions within emerging markets even if the trigger comes from outside. The sector is now crowded with heavily leveraged investors, many of whom have been lured into emerging markets for the first time recently.

Contagion and domino-effect selling may be in the past but the events of May and June showed how investors, burned in one market, will cash out even from stable countries to protect profits. Emerging markets suffered a hefty selloff on fears that global interest rates could rise faster and further than expected.

The large swing to local markets as well as the correlation between equities and emerging currencies exacerbate risks.

“If equities see a downturn globally, emerging currencies' sensitivity towards equity adjustment is going to be large... More leveraged investors have been getting involved so markets are a lot more vulnerable and more correlated,” said Rob Drijkoningen, head of emerging debt at ING Asset Management.

Then there is always the unexpected, that integral emerging markets feature. A textbook ruckus erupted in Thailand this week when the shock imposition of currency controls wiped 15 percent off equities in a single day.

“The thing with emerging markets still is that anything can happen and Thailand was a classic case of EM event risk,” Deka's Ganske said. “You may have short-term contagion if risk aversion increases but the important thing is to have a long-term bet.”

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