Emerging market paper rallies on poor jobs data; investors worry about U.S. economic weakness

By Reshmi Basu and Paul A. Harris

New York, Aug. 6 - While weak job numbers sparked an emerging market debt rally Friday, new questions surfaced as to how the asset class will survive interest rate hikes on top of a cooling U.S. economy.

One word summed up Friday's session: "Jobs," said a trader.

The July non-farm payrolls report said employers created a paltry 32,000 jobs, falling way short of the expected 240,000 figure.

Those weak numbers ignited a rally in emerging markets debt during Friday's session.

The JP Morgan EMBI+ Index surged 1.09%. Its spread to Treasuries tightened four basis points to 463 basis points.

Latin America up, but for how long?

Latin American debt was up Friday in response to the weak job creation data. The Brazilian component of the EMBI was up 1.51% while its spread to Treasuries tightened 22 basis points to 584 basis points. Meanwhile Ecuador was up 1.37% and Venezuela rose 0.95%.

The Brazil C bond added 2.375 to 95.375 bid while its bond due 2040 was bid at 100, up 33/4.

As the market reaction indicated, for the next six months or so the fact that the U.S. economy is growing at a lower than expected rate will allow markets a smoother transition as the Federal Reserve lifts rates, said Alberto Bernal, head of Latin America research for think tank IDEAglobal.

The higher yielding emerging markets names, "for example Colombian and Brazilian bonds, will still be a very interesting investment opportunity for the dedicated accounts and for the crossover investors," Bernal said.

"That is one of the reasons why we have seen such a rally today [Friday] on bonds and why we are very likely to see additional rallies in the next few weeks because the jobs number basically downplays significantly the velocity of growth of the U.S. economy.

But in the long term, the fact that the U.S. economy is not growing strong is bad news for every single country because the U.S. economy will always be one of the most crucial engines of growth and wealth creation in the world, said Bernal.

Meanwhile, the economic numbers are pushing geopolitical risks to the background.

"If you look at the performance of Brazil today [Friday], the direction of the move has not been affected by the issues concerning [central bank president Henrique] Meirelles.

"Why is that so? The crossover investor, which is a very strong source of money for this market, is focused on very specific issues - meaning the search for yield.

"That will downplay every other thing that we are seeing right now.

"Just in the same way, oil prices have downplayed the risk of the referendum in Venezuela," Bernal told Prospect News.

Rumors surfaced Thursday that Meirelles may be forced to resign after a local magazine ran new reports about his alleged failure to disclose an offshore account.

Concerns over global slowdown

The issue now for investors is how they will position themselves as the rules of the game have changed. Investors must deal with higher interest rates and an economic slowdown. The so-called "soft patch" identified by Fed chairman Alan Greenspan has spilt into July.

"For now, EM should keep tracking USTs - spreads are a little tighter in some of the high beta credits, but overall the market is basically choosing to follow Treasuries," said an emerging markets analyst.

But he added he was "not sure whether the benefits of lower rates will offset the costs of an obviously soft U.S. economy.

"We now may be moving into a completely new scenario - last year and early this year, we had the best of both worlds, with low rates and a strengthening U.S. economy.

"Now, we have low rates again, but that's because the economy is not nearly as strong as many had expected," he added.

"Low rates will definitely help keep the bid for yield alive, but if global economic weakness becomes a serious concern, commodities are going to start to get hit along with stocks, and that's not going to be good for risky assets like EM," he noted.

The market is looking at the payroll number as a confirmation that there may be more of a slowdown ahead, according to a debt strategist. But the market is also trying to figure out how to digest the implications behind those figures, which suggest a slower global economy.

"We've had two negatives today - a very weak German industrial production number, suggesting that Europe is still not out of the doldrums," said the strategist.

"And now, we got this U.S payroll number that is indicating more of a slowdown there.

"And while you might think, well that might be good because the Fed won't raise interest rates so fast, that's the secondary concern.

"The primary concern is the strength of the world economy because a lot of these guys make their living in terms of hard currency generation in the commodity world.

"And the most extreme would be South Africa.

"Nonetheless, even for Argentina or Brazil, commodities are their top hard currency export earners.

"They've been in the sweet spot with very large billion dollar trade surpluses," he added.

A slower world economy would not be good for emerging markets.

"Emerging markets, by and large, still do best when the world is growing fast. And if that was to fade, then you'd see the risk premium rise.

"There's that question. Then there's this whole question of what if the Americans combine higher inflation and slower growth.

"What do the policy guys do? Then we have to worry about the dollar falling off the cliff," he added.

And a world that asks those kinds of questions is a world of rising risk aversion.

"Rising risk aversion is always bad for EM debt. So what we are trying to sort out here is the risk aversion trade.

"It's not necessarily identical with the carry trade. Most people focus on the carry trade leverage. Risk aversion has more than one dimension.

"People are sorting through all this on an illiquid Friday in August."

Looking at a high frequency chart over the last three days, there was a late sell-off at the end of Thursday on the Brazilian headline news, followed by short covering and then a move to higher prices on the back of payroll numbers Friday.

"But there's been no follow-through," the strategist observed. "And now we're off the highs. It's a market without conviction. People are going to sort through the secondary factors.

"You take it up because you know the carry trade guys are going to buy it but you think, what is the state of the world? Then it's a more confusing picture.

"Faster growth is good for emerging markets. Slower growth is not. It's as simple as that because it is almost impossible to argue that there isn't an equity element to the stories for these countries," he added.

"Going forward, there will be a lot of focus shifting back toward consumer sentiment numbers," the strategist said.

Banco do Brasil still on

Meanwhile an informed source told Prospect News that Banco do Brasil SA's planned deal "has not been officially postponed."

Banco do Brasil plans to issue $350 million 10-year subordinated notes (Baa1) via Credit Suisse First Boston and BB Securities.

On Thursday several market sources told Prospect News they believed the deal was not going to happen.

Friday one market source said: "Yesterday [Thursday] was not such a great day to issue, but after these payroll numbers, who wouldn't want to come to market?"

Bearish on Philippines

Meanwhile, Philippines bond prices suffered after the country reported that July inflation increased to 6%, higher than the market forecast.

A market source told Prospect News that the "outlook is bearish for the bonds."

The Philippines bond due 2016 fell 2.625 to 95 bid. Its component of the EMBI rose 0.19%. Its spread to Treasuries widened 11 basis points to 436 basis points.

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