EM debt still has upside, but rewards may not justify risk, cautions Barclays' Jain

By Aaron Hochman-Zimmerman

New York, July 3 - Emerging markets has its share of opportunities, but the risks are high under current market conditions according to Gautam Jain, a strategist at Barclays Capital.

"The risk-reward ratio is not in your favor," he said.

With emerging market assets' valuation on the rich side, a rise in global risk aversion would take its toll, Jain said. With the VIX index rising and credit markets beginning to look "a little shaky," Jain's advice is to remain cautious, but to maintain long exposure for now.

The correction in emerging markets in recent weeks and during February and March following the sell-off in the U.S. sub-prime market was quite limited, Jain said. That response, he added, is evidence of how much things have improved, even in comparison with the correction in May and June of 2006.

The fiscal and external conditions are significantly better in many emerging market countries.

"People see these countries in a new light," Jain said.

Institutions have strengthened and, with few exceptions, political stability has become the norm.

"That's more than sufficiently reflected in the credit spreads," he said. The focus in recent years has shifted away from credit markets to local markets, where the potential returns are higher.

Despite strong fundamentals, credit spreads in countries like Brazil, Colombia and Peru offer little value, he said.

On the other hand, "Venezuela is the one to watch; it's widened a lot in the last few weeks," he said.

Recent events, including the possible departures of ConocoPhillips and ExxonMobil from the country's heavy oil projects, have caused spreads to widen significantly. At these levels, the political risk premium getting priced in by the market appears to be too high, Jain said.

Generally, if the recent bout of volatility fades, there could still be more upside in emerging debt despite the overstretched state of the markets since favorable liquidity conditions persist.

"Even in countries where spreads are low, they will probably move lower still," he said.

Overall, "the risk appetite is still high," he said. There is "a little jitteriness", but the continuing viability of the carry trade means there is still potential for upside.

"If credit conditions tighten, a greater correction than say the one in February-March is likely. However, we don't seem to be at that point yet," Jain said.

In the long term, because the average ratings for emerging markets continue to move higher, Jain feels that the return expectations have to be adjusted accordingly. Performance over time should be similar to the low end of the high-grade corporate market.

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