A Sharp Weather Eye Advised on Emerging Markets

The last three years were very kind to investors in such emerging markets as Mexico, Turkey, South Africa, Brazil and others. High interest rates combined with soaring equity markets netted generous profits for these investors.
But debkafile‘s financial analyst warns investors that a sharp sell-off may be round the corner as American interest rates continue their upward march.
For two to three years, investors around the globe have been moving huge capital flows into emerging markets – through diverse channels: local currencies, stock purchases in those markets, local bonds (which carry high-yield), and real investments.
The turn to emerging markets had some economic logic. Historically low American interest rates drove investors ambitious for better returns in search of more attractive alternatives. Emerging markets offer plenty of incentives:
Flourishing economies in many emerging countries – witness the high-speed growth in China and Poland.
High interest rates (double digit) in such places as Turkey and Brazil where holders of local bonds are offered annual interest rates of 16% and 18%.
Prospective local currency revaluation. Investors in Chinese markets, for instance, look forward to the revaluation and strengthening of the Chinese Yuan.
Higher commodities prices in the commodities producer countries, like South Africa.
Planned entry to euro zone.This expectation applied to Hungary and Poland.
With so much on offer, what are the hazards of investing in emerging markets today? debkafile‘s financial analyst points to two main risks:
1. Continuous rate hikes in short-term US dollar interest rates. The result will eventually be to raise long-term interest rates on the dollar.
2. Some emerging markets look over-crowded.
Rate hikes in America are the most concrete, immediate risk
Short-term interest rates in America have gone up six times from their historical low of 1% a year ago to 2.5% today. Future contracts on interest rates are pricing 3.75% until the end of 2005. Some investment houses are predicting that US short-term rates will end the year as high as 4%. Long-term interest rates – as priced in American 10-year government bonds – have remained during all that period in the 3.80-4.40% range. Last Monday, February 28, the yield on long term bonds broke through the 4.30% mark and surged to almost 4.40%.
The imbalance between short rates and long rates also troubles Federal Reserve Chairman Alan Greenspan who in his semi-annual speech to the US Congress on February 16 called low yields in bonds a “conundrum “.
The main risk for investors in emerging markets is a possible sharp rise in long term US interest rates. This will touch off a massive sell-off in the emerging markets because higher American interest rates will inevitably make emerging, high-risk markets less attractive.
A year ago, in April-May 2004, the response to market concern over the pace of necessary US rate hikes was a 17% drop in the Turkish lira and 14% decline in the South African rand in the space of a month. This will tell investors in emerging markets how quickly sharp losses can accrue in a climate of renewed fears of inflationary risk and/or climbing long-term interest rates.
Over-crowded markets
In recent months, the run on emerging markets by investors after high yields has swelled. For example, according to the February 22 Chicago futures data, the Mexican peso’s long speculative positions shot up to a new all-time high.
It seems that world markets, and particularly emerging markets, are packed with investors dazzled by the high yields they offer and complacent enough to ignore the risk posed to their assets by rising interest rates in America.
A clear example is the continuous reduction of the risk premium (the spread between risk-free American bond price and emerging market bond price).
The liquidity problem in emerging markets in times of crisis cannot be overstated.
In normal times, nothing is simpler than investing and putting money aside in these markets. But the moment a crisis raises its head, or even an atmosphere of uncertainty, there will be a rush to withdraw funds, generating the effect of a huge crowd waiting for the same small elevator – as we saw in April-May- 2004. In this sort of situation, the profits earned over years can be wiped out in days.
debkafile‘s financial analyst sums up with a warning. Given the continuous short term dollar interest rate hikes and predictions of a rise in long term US interest rates, combined with the stampede of investors into emerging markets, there is a very real risk of a sharp and violent correction in the emerging markets in the coming weeks.
The currencies/markets that appear most vulnerable are Turkey and South Africa and, to a lesser degree, Poland, Hungary and Mexico.