Sell-side analysts confronted with the widening of sovereign spreads, weakening currencies and floundering equity and bond markets across emerging markets this week, now accept the decline goes beyond a market correction into a new era of more expensive credit. In a special report, ratings agency Fitch argued that the switch by emerging sovereigns to domestic funding means that they are largely shielded from the current volatility, since they only need to raise $7 billion from international capital markets for the rest of 2007. This demand comes from the less liquid eastern European states, mainly Turkey, whilst Asian and Latin American countries have already achieved their external funding needs this year. However, the sovereign team argues that private borrowing requirements over the next year will be significant, with $380 billion of corporate and financial sector external debt maturing over the next eighteen months. As a result, Fitch cautions: “In a time of sharply deteriorating capital market access for EM borrowers, the burden of external debt service for non-sovereign borrowers has the potential to generate significant balance-of-payments pressures.”
However, emerging central bank reserves, which amount to $3.2 trillion, are more than enough to act as a lender of last resort if the turmoil worsens significantly. “Sovereigns could potentially act as suppliers of last resort of foreign currency in the event that EM private-sector borrowers face a sustained lock-out from global capital markets. Recent statements by the Kazakh authorities that they stand ready to provide foreign-exchange liquidity to the banks in the event of refinancing problems illustrate this point well.”
The emerging markets research team at RBC argues that, since EMs remain hostage to the external financial market backdrop and it is unclear at this stage whether this is merely a correction or the beginning of a cyclical shift: “staying neutral/short EM is most prudent at this time but with the view that value may open up later this year.”
Challenges for monetary policy
Daiwa Securities argues that the present bout of volatility complicates monetary policymaking. “In recent months, currency strength has played an important role in containing inflation or facilitating disinflation in many countries. With investor sentiment having taken a turn for the worse and many EM currencies now much weaker than just one month ago, and their future path highly uncertain, central bankers have to evaluate the likely impact of forex market developments on import prices.”
Outlook on equities
The equities research team at Nomura laments the flight away from emerging equities: “Investors seem to go to the developed indices which are dominated by companies with higher gearing and lower margins: counter-intuitive in our view.”
But they argue a significant rise in sovereign risk premiums appears unlikely and maintain their bullish recommendations to take strategic stakes in EM equities. “The sectors we like are cyclicals with exposure to the economics of the Chindia story and those domestic plays which have little exposure to events in the US.” In particular, they believe that infrastructure spending is likely to continue to provide opportunities for investors, as export-led growth across EM will continue and spending will only be derailed if there is a large increase in the cost of capital, which they argue is currently unlikely.
Buy-side view
Jerome Booth at Ashmore Investment Management, argues there is substantial value in emerging equities, but cautions there is also significant potential for more downside and volatility. Instead, “the best risk return, particularly for the very bearish, may be in local currency debt. Especially if US interest rates fall, the dollar could weaken substantially over the next few months. The Euro may also suffer. Emerging currencies are expected to rally strongly in such an environment.”