Bottom Line: Spread too thin


WASHINGTON, April 1 (UPI) -- On March 10, Jeff Gundlach of Trust Company of the West issued a timely alert about U.S. Treasury yields that made en passent reference to a record-low spread between U.S. debt and higher risk emerging market debt.

(Full disclosure: Gundlach lived next door to me at college, where helped me and many other Dartmouth students survive calculus).


Good call, Gundlach: Emerging market debt and equities have declined 10 percent in recent weeks. The question for investors, as always, is, what next? Is the recent dip a slight correction, or the beginning of a 2-3 year trend?


Momentum-chasers, even during the sharp correction of recent weeks, have lacked Gundlach's long-term perspective.

"We've got a good situation in emerging markets right now," Treasury Undersecretary John Taylor remarked later on Bloomberg. Taylor pointed to strong growth in the emerging countries, a valid observation.

But a decline in growth in countries like China, to, say, 7 percent from 9-10 percent, would still be a sharp reduction in growth. India has seen growth rates creep down for several years; Thailand, Korea, and others may well have peaked. Growth is still growth, but declining rates are still declining rates.


And, of course, there are other fundamentals that go into a risk-reward and trend-assessment analysis. Terrorism; U.S. interest rates: ideopolitical turmoil from Asia (Beining's apetite for Taiwan, North Korea's appetite for nukes) to the boiling-over Caucuses; the Latin left tsunami, determined to frustrate, damage, and humiliate the U.S. We haven't even mentioned the risk (10 percent? 20?) of a collapse of the European Union in votes this year. And then there's the Middle East.

Yet in recent months, analysts talking about high-risk debt have sounded like one of those late-night real estate salesmen.

"Emerging market risk has declined substantially," Zsolt Papp of ABM Amro commented on March 28, "after Argentina."

"After" Argentina?

The country escaped a first court test of its coup d'ebtat on private holders of its debt this week in New York court. It may be in court, though, for years. There are dozens of other cases around the U.S. and Europe, and the ruling by Judge Griesa carefully opened the door to an appeal.

Even if the case is resolved in Argentina's favor, and fast, it's hard to see how one country managing to strong-arm 76 percent of its creditors into taking 30 cents on the dollar, and the other 24 percent of its creditors, taking nothing, is going to inspire confidence in other developing-country debtors.



A review of Gundlach's table and of other data from SRS Global reveals several general historical trends for an emerging markets peak and correction -- or, turnaround.


1. U.S. interest rates, politics lead

Emerging debt has been at historically low spreads for more than a year, as such cool heads as the late Walt Wriston observed in 2003-2004. They often stay there during declining (2001-2003) or real negative (2003-2004) U.S. rates.

But even a small Fed rate increase (1994) can help touch off a currency crisis: Mexico, that December.

As well, a weakening presidency in the U.S., the prime catalyst of the Democratic Century, can have an impact.

In 1997-98, the Fed wasn't proactively raising rates on the short end, much. But the Clinton impeachment crisis, and associated stall in the International Monetary Fund recap, helped turn a correction into a rout.

So did the Fed's clear emerging intention to pop tech "irrational exhuberancy," which raised the heat on countries like Thailand and Korea. My own research firm at the time, the late Emerging Markets Group, warned repeatedly of an "Asian currency dominoe" effect.

What seems to matter most is the beginning date of a U.S. rate rise or political squabble or defeat for the White House (such as Social Security reform, potentially).


Strictly speaking, this month's correction in emerging markets is arriving late -- though the re-election of Mr. Bush last fall, and the fact that real rates were still negative until recently, may have helped delay the usual consequences.

2. Dominoes are dominoes

In 2001, the spread again turned from historical lows to historical highs, as the U.S. over-tightening pushed Argentina and Turkey into the arms of the IMF. But these weren't the only debtors to suffer: the emerging market debt spread rose to 9 percent from less than 5 percent, a near doubling.

(9/11 helped, but the dominoes were already aligned. And note that an aggressive Fed easing, and rally in emerging market equities, began almost immediately, followed by a weakening dollar. The dollar's decline in recent years helped emerging markets up. It follows that a dollar rally will place opposite pressures on developing-country markets).

Indeed, Mexico's stock market, thanks to a massive bailout from the U.S., corrected rather sharply following its 1994-95 peso debacle. Other Latin countries, which didn't engineer a devaluation and didn't get bailout help, suffered just as big a hit, and less of the upside in following years.

3. The moves are fast and sharp.


The rise in emerging market yield spreads described above happened quickly. More than 80 percent of the 2001 increase described above took place in just four months.

During the 1997-98 Asian collapse, the move in the yield spread to more than 11 percentage points from less than 3 took place likewise in four months. The 1994-95 Mexican peso collapse pushed the spread to 11 percentage points from less than 7 in only two months.

This year's Fed rate actions long overdue given the rise in commodities, decline in the dollar, and outlook for inflation. But it will carry consequences, the more so for starting too late and moving too slowly.

The first to go will be highly vulnerable Third World banks -- such as AIG and General Motors. What's bad for GM in the morning will be bad for emerging markets by the afternoon.

Look for a lot of commentaries in coming weeks, some hopefully cooing that China is "no Argentina," some asserting that the Philippines, Thailand, or Turkey are.

When a downturn occurs, it's only natural that the worst-run S and Ls, or investment banks, or mutual funds, or insurance companies, or whomever, take the first hit. If you can find the right countries, you'll do better. But don't kid yourself: The rain won't fall equally on the just and the unjust, but everyone will get a little wet.



Emerging market debt and equities may have some mini-rallies in the coming months, but Bottom Line doesn't expect the Morgan Stanley Index ishares to break through, or probably even get close to, their recent high of $220. Those rallies will be not a buy, but a short, opportunity.

How the dominoes fall across regions and particular countries?

That's something all investors, debt and equity and currency, should review in detail now as the Fed rate hikes, strengthening U.S. dollar, and Argentina fallout damage spreads across the world. (Bottom Line advised this on March 11 and again on March 15.)

Briefly, it would seem like Latin America is a sell, South and East Asia mixed -- with both buys (Indonesia, Pakistan) where political and policy reforms are just starting or have strong momentum, and sells (China, Korea) where there's a growth slowdown coming, and high potential for strategic turmoil.

As the price of copper and coal return to somewhat normal levels, keep an eye on those lethally-run Chinese mines, a cauldron of worker resentment. The same in Peru and Bolivia, though more-developed Chile may escape the worst of the damage in an election year.


But these particular calls are "subject to further review," and will be developed further in a future analysis. For now, for the first time since 2001 save a brief "hold" in spring-summer ("Short on global longs," April 2004), emerging markets are not a buy.

As a general asset class, take profits in emerging markets and sell. Buy dollars, ammunitions-makers, and law firms, as the global explosion of litigation over sovereign debt and New York-listed ADRs gains inexorable steam.


(Gregory Fossedal is an advisor to international investors on global markets and ideopolitical risk. His clients, and funds he manages, may hold long and short positions in many of the investment securities and opportunities mentioned in his reports. Investors should perform their own due diligence and consult their own professional advisor before buying or selling any securities. Mr. Fossedal's opinions are entirely his own, and are not necessarily those of his clients or UPI. Furthermore, they are subject to change without notice.)

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