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Investor Beware

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If you still have doubts whether or not there is a massive bubble in emerging financial markets, just look at the eurobond market. The JPMorgan EMBI+ index, which measures the risk premium on hard currency-denominated emerging market bonds, narrowed to 156 basis points (bps) in late April, or about a percentage point and a half. For the sake of comparison, just two years ago it measured twice as high, or over 3 percentage points — which was, incidentally, also a record low, having fallen by more than a full percentage point over the previous year.

Some individual countries have recorded even more spectacular progress. Look at Brazil, for example. In late 2002, Brazilian eurobonds yielded 22 percentage points more than comparable U.S. Treasuries. Now, barely five years later, the spread has narrowed to less than 1.5 percentage points.

True, the sovereign credit rating on Brazil has been upgraded steadily from deep into the speculative grade category — signifying a high probability of a sovereign debt default — to BB-plus. This is just one notch below the investment grade category, which opens the way for a large number of institutional bond investors to purchase Brazilian government bonds.

However, when Mexico’s credit rating finally reached investment grade five years ago, its bonds traded at 300 bps over Treasuries. Brazil’s spread is less than half that, even before it has reached investment grade.

The benchmark dollar-denominated Brazilian government eurobond due 2015 yielded just 87 bps above comparable U.S. Treasuries.

Reserves Build-UpThe spike in risk premium on Brazilian eurobonds in 2002 was a special case. It followed debt default by Argentina in late 2001, the world’s largest to date, which ended up penalizing foreign holders of Argentina’s government bonds. At the time, Brazil was also about to elect a leftist president, Luiz Inacio Lula da Silva, who investors feared could repudiate the country’s foreign debt.

In the event, even though Lula was indeed elected, he opted for market reforms, not the usual leftist prescriptions. Brazil has curbed fiscal spending and promoted pro-growth policies. As a result, the country has been enjoying a large trade surplus. This year alone Brazil has accumulated more than $35 billion in foreign reserves, bringing the total to more than $120 billion. Its government, only recently one of the heaviest debtors among emerging economies, has now become a net creditor to the rest of the world.

Hard currency reserves have been boosted around the world. In the early 1990s, Poland hoped to achieve currency stability by maintaining reserve holdings of around $3 billion. Now, even Russia, a financial basket case in the late 1990s, has central bank reserves worth well over $300 billion. It should be recalled that during the 1997-1998 Asian financial crisis only China and Taiwan were able to thwart currency speculators — largely because of their large reserve holdings.

Booming EquitiesBased on widely accepted investment theories, pension funds in developed economies should allocate a substantial portion of their portfolios to emerging market equities. The reasoning goes as follows: Companies in mature economies have only limited profit growth potential, whereas emerging economies should maintain generally faster growth rates — albeit coming from a low base — and their companies should have more rapid earnings growth over the longer term.

The only caveat has always been that with faster growth came greater volatility. Indeed, periodic panics and currency devaluations have regularly wiped out all the spectacular previous gains.

The world looks like a very different place now. Globalization has spurred U.S. and Western European multinationals, and they are now enjoying very rapid profit growth. At the same time, emerging financial markets in Latin America, Asia and Eastern Europe suddenly look far more stable, even as they still offer strong returns.

More and more institutions and individual investors have bought into emerging markets in recent years — not just counting on quick price appreciation but for the long haul as well. Even though earnings growth in Central and Eastern Europe has started to slow, analysts still expect average earnings for companies in Brazil, Mexico and Chile — the three star performers in Latin America — to grow by at least around 20 percent this year.

The rally in emerging stock markets has been nothing short of spectacular. In Brazil, the past decade has been particularly good. The Bovespa index, which traded at 5,000 in the second half of 1998, had increased tenfold in domestic currency terms by May 2007. In Mexico City, the IPC index nearly tripled since the start of 2005. The broadly based MSCI index of emerging stock markets has more than tripled since the start of 2003, while the MSCI developed-market index merely doubled over the same time period.

Brave New WorldEmerging market analysts claim that we are living in a different world. Pro-market domestic policies, export-led economic growth and the willingness of the United States to run massive current account deficits and stoke the global financial engine with boundless dollars are at last providing a long-awaited period of sustainable economic development around the world. Meanwhile, despite local conflicts, radical movements and terrorist acts, the New World Order envisioned by Washington at the end of the Cold War has in fact emerged in most of Latin America, Asia and Eastern Europe.

Could we be witnessing the same process that spearheaded the rebuilding of Western Europe after World War II, only replicated on a much wider, truly global scale in emerging economies?

This would definitely be a best-case scenario, justifying all those paper-thin spreads on speculative grade-rated eurobonds and an unmitigated run-up in once exotic equity markets.

Whether or not this picture is correct over the long run, many of these assumptions are likely to be tested in the near-to-medium future. Credit has been historically cheap over the past five years, since the lengthy U.S. Treasury market rally, underway since 1982, finally peaked. Bond yields have been stable at low levels, with cheap credit spreading into eurobond markets and domestic bond markets even in developing economies. This effectively offered an opportunity for investors to buy an option on future profits — i.e., stocks — using low interest-rate loans.

Major central banks around the world have been gradually pushing their interest rates higher. The consensus view is that they are at or near the end of their tightening cycle. The U.S. Federal Reserve, for example, has left its Fed funds target rate on hold at 5.25 percent since mid-2006. U.K. rates are now at 5.5 percent, and short-term money is even cheaper in the euro-zone, despite steady tightening by the European Central Bank over the past three years. Such rate levels are quite moderate.

Nevertheless, hedge funds and private equity investors — all those who are frequently referred to as the “smart money” that tends to anticipate market trends — have been looking for ways to profit from an assumption that monetary policies around the world will be tightened far more rigorously. So-called “smart investors” increasingly believe that bond yields will spike a lot higher than mainstream economists are now predicting.

This could spell doom for all those who remain complacent about emerging markets. There is a lot more foreign money than ever before invested into the likes of Brazil, in a variety of financial instruments. Sky-high valuations, both in bonds and stocks, mean that investors are more likely to panic to salvage what they can of their gains in a market downturn. A sudden stampede out of such markets may be quite severe.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected] His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.