Emerging market debt stabilizes on benign CPI number; Brazil sees volatility

By Reshmi Basu and Paul A. Harris

New York, Oct. 14 - The recent sell-off in emerging markets lost intensity Friday, helped by tamer consumer price index data in the United States. Meanwhile Brazilian bonds saw a volatile session.

The consumer price index, the government's main inflation gauge, jumped 1.2%. But consumer prices, excluding food and energy, increased just 0.1% in September, half the expected hike.

The subdued core numbers helped remove some of the tragic tone in emerging markets, said Enrique Alvarez, Latin America debt strategist for research firm IDEAglobal.

"The market, in general, has been sort of sideways in Brazil," he added.

"We were overall slightly down on the day, but in light of what the buildup was to CPI, we've gotten away with rather light punishment."

The numbers mean that the market can see some relief on the inflation story, which has prompted volatility and spread widening in recent sessions.

In another indicator of the recent troubles, emerging market bond funds saw their 15-week winning streak come to an end with outflows of a modest $23.6 million for the week ending Oct. 12, according to EmergingPortfolio.com Fund Research.

But now the economic data means that the inflation story goes back to the Fed.

"The Fed has been doing a big publicity blitz on inflation and on inflation being its focus," said Alvarez. "Now, you get a low core [CPI]. They provoked a build up to the number and it didn't come true in a certain sense," he said.

Brazil sees volatility

During the session, Brazilian bonds saw a lot of volatility as the market tested both directions, Alvarez observed.

But Brazilian bond prices resisted the downside, which means that only higher Treasury yields can push Brazil to lose support.

"That's important because in the meantime it looks like it's going to plateau at these levels," noted Alvarez.

A bounce for Brazil

A market source spotted Brazil's dollar-denominated 11% bond due 2040 at 118.0 bid, 118¼ offered on Friday, up from 117½ on Thursday. At session's end, the bond was bid at 118.10, up 0.65.

However the source noted that at the beginning of October the bond was trading well above 122.0.

Earlier in the week Moody's Investors Service raised its rating on Brazil's debt to Ba3 from B1, while maintaining a positive outlook on the rating. Meanwhile Fitch affirmed its rating of BB- and revised its outlook to positive from stable.

The source said that, while Brazil has traded off with the rest of the market - and may actually have taken a disproportionate hit - during the first half of October, it now has double-B ratings from all three rating agencies (Standard & Poor's also rates Brazil at BB-) and two positive outlooks.

When the current market correction is played out, the source said, Brazil may start trading like a double-B.

Elsewhere, Colombia came under pressure, despite showing resilience Thursday. The bond due 2008 was down 1½ points to 105 bid.

Peru saw selling on comments made by its finance minister that it would sell more paper to prepay a Japanese company. And the already volatile market did not react kindly. During the session, the Peru bond due 2012 was bid at 1153/4, down ¾ of a point while the bond due 2020 lost one point to 115 bid.

"And then you have Venezuela, which has been very curious today [Friday] because the market was off at least a couple of points this morning," remarked Alvarez, who added there were rumors of linkages to the commodities brokerage firm Refco.

Venezuela did retrace earlier losses. During the session, the Venezuela bond due 2027 fell half a point to 111.20 bid

Bearish EM outlook

The market is yet to see the end of rising oil prices, according to Jephraim P. Gundzik, president of Condor Advisers, which provides comprehensive emerging markets investment risk analysis to individuals and institutions worldwide. And that translates into a bearish outlook for emerging market debt.

"There isn't any real mechanism for oil consumers to conserve energy right now."

Gundzik notes that cheap financing has promoted a buying binge of gas-guzzling cars. And on top of that, interest-free and low-interest rate loans have created a new stock of energy-inefficient housing.

"It's hard to see factors that would reduce oil consumption in the U.S."

The same applies to China, the second largest oil consumer in the world, he adds.

It has new factories "that are churning out goods and they have rapid economic growth," he noted.

Gunzik said that unless there is a drastic setback in the U.S. economy, there is a bias towards an upside on demand. He even predicts that $100 per barrel is in the cards for next year. And furthermore, investors have underestimated the impact of Hurricane Katrina and Hurricane Rita, which essentially knocked out around 5% of the U.S.'s oil refining capacity.

He further noted that gasoline, natural gas and fuel oil shortages will lead to higher energy costs in the United States over the next few months.

"And I think that's going to feed rapidly into non-core consumer prices. So I think that's exactly what fortunately the Fed is looking at. That's why their bias is towards tightening."

He adds that energy price rises will have a dramatic impact on inflation.

"For emerging markets, you are talking about much higher inflation in the U.S., higher interest rates, both short-term and long-term. I think we're going to be seeing much slower economic growth towards the end of this year through 2006," he told Prospect News.

And Gundzik cautions that investors are unprepared for such a scenario.

"It's tough to leave the party when everything seems so good. But sooner or later, people are going to realize inflation is going up. And I think the bottom is going to fall out of a lot of these markets. And I think emerging markets will suffer inordinately just as they performed quite well over the last three years."

Previous sessions saw a lot of volatility on renewed inflation fears, but the market is trading just shy of a spread of 280 basis points on the JP Morgan EMBI+ Index.

"I think the EMBI will move around to 500 [basis points] over Treasuries...in the next six to 12 months," Gundzik predicted.

"Inflation has been dormant in the U.S for so long. People don't understand what the implications are."

Additionally, 2006 will see more volatility, stemming from upcoming elections. Already Mexico's Vicente Fox and Brazil's Luiz Inacio Lula da Silva's have become essentially lame ducks, he said.

His advice to investors is that those that have to stay vested in emerging markets should focus on oil producers.

He said he believes that Brazil is over-valued, given that it is a large oil consumer. On top of that, the country faces electricity shortages because it is enduring one of its worse droughts in 30-years.

"That's going to have a big impact on power generation, so growth is going to be much slower. Inflation is going to be higher. I don't even think people are contemplating those kinds of things."

His recommended strategy is to "focus on oil producers and trying to lighten up on those countries that are dependant on oil imports."

While many have boasted about the strong fundamentals in emerging economies, Gundzik notes that it is good fundamental story in the United States that is driving the market - i.e. relatively strong growth and inflation containment.

"That's being abstracted into other markets. No doubt that strong growth in the U.S. is pulling other economies along.

"Once, the U.S. economy slows, which is inevitable next year, it's going to change perceptions about emerging markets dramatically. Those good fundamentals are going to looking increasingly poor across the board."

Investors will pay more attention to headlines, he added.

In terms of recommendations, Gundzik likes the Russian story. He likes Argentina because its policies are domestically oriented.

However, he is bearish on Brazil and the Philippines. He added that Colombia will suffer from declining oil production and may turn into an oil importer as soon as next year.

And Turkey will face pressure under the scenario of higher global interest rates and inflation.

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