Emerging markets to see increased risks on U.S. slowdown, says IIF

By Reshmi Basu

New York, Sept. 15 - Despite the positive growth performance this year of the Eurozone, Japan and large parts of emerging markets, in particular Asia, there are downside risks to the global economic outlook as the U.S. economy looks to stall, according to report published by the Institute of International Finance (IIF).

The report noted that investors are becoming more discriminating in taking positions across emerging markets than in the previous year, reflected by the decline of cross correlations of asset price movements during the recent sell-off seen in May and June and during the subsequent recovery period.

However even though the asset class demonstrated a maturity during that period, supported by an improved fundamental picture, emerging markets must face a new reality. That reality is one of decreased liquidity, which in turn is reshaping the perception of balance of risks and rewards. The report predicted that the outlook is for lower trading volumes as the global economy slows and as liquidity tightens.

"More generally, the ongoing tightening of global liquidity conditions is bringing about a change in investment strategies, away from an emphasis on carry trades, toward fundamentals-driven approaches," added the report.

Already, the asset class is seeing less issuance. So far, for the first eight months of this year, overall bond issuance is at $69 billion, coming short of the $85 billion for the same period last year. Since most sovereigns have met their financing requirements for the year, issuances in 2006 are unlikely to top $128 billion seen in 2005, even as corporates have stepped up their borrowings. Corporate issuance makes up 60% of total emerging market bond issuance this year.

Separately, the IIF reported that emerging market debt showed more resilience than its counterparts. At the end of March, the spread on the JP Morgan EMBI Global index pierced an all-time low of 174 basis points versus U.S. Treasuries. Following the sell-off, spreads spiked to its yearly high of 232 basis points on June 27, 2 more basis points above where the index started last year.

As of Sept. 1, the spread is back down to 197 basis points.

On a regional basis, the report noted that Latin America has outperformed the other indices, posting total returns of 7% for the first eight months. Asia is in second with around 5% of total returns.

In Latin America, Argentina has been the best performer in the region, even as the country has faced criticism from the International Monetary Fund about its unorthodox policies. The Philippines has emerged as the best performer in Asia.

And lagging both Asia and Latin America is emerging Europe, recording less that 2% of total returns through August of this year. Hungary has been the worst performer in the year. And Russia has barely outperformed the region, recording 2.3% of total returns.

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