Emerging markets track U.S. stocks once more; Argentina drops, Brazil slips; funds lose $523 million

By Paul Deckelman and Aaron Hochman-Zimmerman

New York, Aug. 3 - Emerging market debt remained linked to the fortunes of U.S. equity markets on Friday - as it had been all week.

Prices initially edging upward ahead of the release off July U.S. employment data, but then headed south in line with stocks when those worse-than-expected numbers came out and renewed what had been temporarily dormant investor fears that the U.S. subprime mortgage lending debacle would have powerful ripple effects throughout the U.S. economy and world credit markets.

Big losses were recorded Friday in Argentina's debt, and, more modestly, Brazil. South African debt players meantime worried about a possible rate hike. Indonesia's debt, however, and Philippines paper, seemed better earlier.

There was nothing in the primary market to stop investors from starting the weekend early.

But for some there was a healthier market sentiment that may help put minds at ease as the new week begins, but others saw no improvement.

However emerging markets-oriented bond funds posted their biggest weekly outflow since April, losing $523 million, according to EPFR Global. This week is the third consecutive week dollars left the market sector.

Subprime fears resurface

Fears that the subprime fiasco may pull other segments of the debt world down with it have been dogging EM bond investors for weeks now, with the market moving up and down in fits and starts, pretty much tracking Wall Street's ups and downs.

It had risen on both Wednesday and Thursday as stocks headed upward after having struggled earlier in the week, as, particularly at the end of the previous week.

But on Friday, EM changed course again, heading lower as stocks lost traction after the U.S. Labor Department reported that non-farm payrolls expanded by only 92,000 in July, less than the 126,000 rise seen the previous month and less also than the roughly 127,000 new jobs economists were looking for. Meanwhile, after having held steady at 4.5% for some months, the U.S. jobless rate rose to 4.6%.

That put stocks into a dive, with the bellwether Dow Jones Industrial Average slumping 281.42 points and other major indexes down in a similar fashion. Friday's slide accelerated after Standard & Poor's cut the credit-rating outlook for Bear Stearns Cos., citing the latter's exposure to the subprime lending woes.

With stocks heading downward, U.S. Treasuries gained handsomely, the yield on the benchmark 10-year notes falling by 9 basis points to 4.68%, while the two-year note's yield plunged by 15 bps to 4.43% - its lowest level in 18 months. Those falling Treasury yields in turn helped to drive up spreads between emerging market debt yields and comparable Treasuries, with the widely followed JP Morgan & Co. EMBI+ junk bond performance index indicating a risk spread of 220 bps, about 3 bps wider on the day.

Argentine bonds off

That spread-widening was especially seen in risky, high-beta credits like Argentina, whose benchmark dollar-denominated 8.28% notes due 2033 were quoted as having slid by nearly 2¾ points on the session to 84.05. While the price was dropping, the yield on those bonds was jumping by 30 bps to the 10.15% level.

The country's locally-denominated peso bonds were also lower, with the yield on its 5.83% inflation-linked paper due 2033 jumping 22 bps on the day to 7.66%, its all-time high level.

Prosecutor sees evidence of false data

Besides being affected by the usual market jitters, Argentina's debt has a further albatross around its neck in the form of extreme investor skepticism about the string of recently favorable inflation numbers released by Buenos Aires; given recent personnel changes in the government's economic statistics bureau, there have been allegations that political operatives doing the bidding of president Nestor Kirchner have been installed precisely to produce favorable data that appears to validate his policies. Kirchner denies that any books have been cooked, instead suggesting that the allegations are the work of bond investors looking to gin up returns for the inflation-linked bonds.

However, on Friday, press reports said an Argentine federal prosecutor investigating the allegations of rigged results reported to a supervising judge that some of the official data was indeed bogus.

Brazil bonds easier

Argentine debt was by no means the only downsider in the Latin sphere; even the normally better-performing Brazilian 11% benchmark bonds due 2040 was down a point, quoted at 129.5, while the costs of hedging against a possible default on those bonds via a credit default swaps contract was seen having risen by 4 bps to 112.5 bps.

South Africa fears rate hike

Outside of Latin America, bonds were also seen weaker in many markets, including South Africa, where investors fear that the central bank is set on raising its key interest rate when its policy-setting committee meets on Aug. 16.

Those fears were intensified by hawkish comments Thursday and Friday by the central bank's chairman.

That caused the yield of the most widely-traded bond, the R153, to rise to 9.325% from prior levels at 9.265%, while the short-term R196 security's yield moved up to 9.625% from 9.55% previously. South Africa's long-term R157 bond's yield increased to 8.63% from 8.595%.

Philippines, Indonesia firmer

Earlier Friday in the Far East, bond prices had edged higher on bargain hunting and short covering, which took place before the release of the unexpectedly small U.S. non-farm payrolls increase.

Philippine government bonds were seen up about ½ point on the day, with the 2031 benchmark issue at 106.5 bid, 107.25 offered and its 2032s at 94.5 bid, 95.25 offered, while the cost of a 5-year CDS contract came in by 15 bps to a level of 183 bps.

Similar CDS contracts protecting investors in Indonesian debt came in even more, by some 18 bps, to around the 180 bps level, reflecting investor hopes that Moody's Investors Service will soon make good on the possibility that the ratings agency announced during the week, of raising the country's debt ratings, currently at the B1 level.

EM funds see big outlfow

Bond funds that specialize in EM debt saw aggregate outflows of some $523 million in the week ended Wednesday - the most since early April - according to data compiled by Emerging Portfolio Fund Research of Cambridge, Mass., reflecting "collapsing confidence on the part of debt investors," said managing director Brad Durham. EPFR tracks results from 433 funds to assemble its data.

"I think what happened to emerging market bonds was pretty similar to what happened to high yield bonds during the week," Durham said, "although high yield has more direct concern about fundamental [economic] issues. There still is not any concern yet about economic fundamentals in emerging markets."

Durham said that should the deterioration in the subprime lending sector spread more widely into the broader credit markets, resulting in a recession, "or, at least, falling growth, then we'll see just how bulletproof these emerging markets are."

He noted that economists and strategists "talk all the time" about how growth in global trade has been largely intra-regional among the emerging market countries, or between emerging market nations and non-U.S. developed countries, with "the U.S. piece of the pie in decline for a number of years" in terms of what percentage of EM exports come to America. "So if the U.S. goes into a bit of slide and U.S. consumers slow down [their spending], we'll test that theory a little bit. But I don't think we're on the verge of that happening."

He also noted that with the relatively slow volume in the financial markets during the summer months, "trends tend to get magnified" and may not be representative of the full reality.

Durham further noted that the vast bulk of the outflows from EM-oriented bond funds came in funds dealing with the traditional "hard currency" bonds denominated in dollars, euros or sterling, while funds oriented towards local currency-denominated bonds actually "swam against the tide" and produced modest inflows of $19 million.

Better tone seen

An emerging markets syndicate official echoed that view that funds have been moving into local currencies even as dollars leave.

"The tone is improved for certain," an emerging markets analyst specializing in Latin America said.

There are "better levels from bottom, significantly," the analyst said, adding that there is "money being put to work, cautiously."

Still the "market trades from headline to headline, sometimes whipsawing violently," the analyst said.

Another syndicate desk official agreed that things have been drifting in a positive direction as Friday closed, but added: "We're still not there yet."

Lacking direction

Confusion over the state of the market will continue to prevent serious commitment on the part of investors until stability is demonstrated, the syndicate official said.

"I don't think there's any direction left," a buyside source said about the past week, but conceded that Monday and Tuesday were more volatile than the end of the week.

"Equity continues to drive us," the buysider said, adding that the stock market followed the same pattern Friday as the two previous weeks and another sell off is expected from Asia Monday morning.

And selling in the United States is not over either, the buysider said.

"We are not too confident," said an emerging markets syndicate official about the chance for significant improvement in the coming week, still pointing to the likelihood of continuing trouble from the U.S. subprime market.

Next week looks to be "another washout," the syndicate official said.

In recent weeks, one of the strengths of emerging markets has been the retention of its liquidity.

"The current sell off has been characterized by a sharp liquidity freeze-up, yet few sovereigns are using the opportunity to conduct buybacks to restore liquidity," a market source said.

Spreads may permanently stay at higher levels due to the repricing of risk, the source said.

The indicators so far suggest that the market will eventually stabilize, the source added.

In that case, the CDS basis should compress, dislocations in relative country spreads should reverse and some of the more extreme movements in bond prices should correct, the source added.

Another market source feels that the loss of risk appetite among investors may continue to drag on.

Investors who are working from a "buy-on-dips" philosophy may find that as the dips continue their strategy was less beneficial than they had hoped.

"The latest bout of risk aversion is unlikely to be a flash in the pan," the source said.

Looking ahead, investors will likely begin to shift their attention towards country fundamentals instead of market technicals, another market source said.

The relative risk of credits was properly priced before the slowdown in July, and although spreads may widen, a similar dynamic should eventually fall into place, the source said.

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