Emerging market debt flat on day despite equities fall

By Reshmi Basu and Paul A. Harris

New York, July 14 - Emerging market debt was resilient Friday, even as U.S. equities posted another triple-digit loss in response to higher crude oil prices and unrest in the Middle East.

Spreads were unchanged for the most part Friday, said a trader, who added that volumes were thin as the market braces itself for slew of U.S. data in the coming sessions.

During the session, the bellwether Brazilian bond due 2040 added 0.40 to 125.30 bid, 125.40 offered. The Russian bond due 2030 inched up 0.06 to 107.24 bid, 107.375 offered. And the Venezuelan bond due 2027 gained 0.30 to 119.85 bid, 120.15 offered.

Elsewhere, Lebanese bonds were creamed as Israel stepped up an offensive. During the session, the country's bond due 2009 lost 1.63 to 102.50 bid, 104.50 offered while the bond due 2011 gave up 4.63 to 95 bid, 97 offered.

Oil jumps above $78

Friday saw oil top $78 per barrel on the escalating tension in the Middle East.

The week has seen turmoil intensify across the region. Hezbollah leader Hassan Nasrallah pledged "war on every level" against Israel, after his Beirut offices were bombed in an air raid. Israel has accelerated its offensive to free two Israeli soldiers captured by Hezbollah.

The crisis in the Middle East has raised concerns over possible disruptions to the world oil supply, which has sent crude to record high levels and helped put U.S. equities in the red. As a result, sentiment across the emerging markets asset class has been nervous.

Higher oil prices mean that ultimately inflation and interest rates will go higher, resulting in a sharp decline in U.S. growth. Investors are now facing the troubling scenario that oil will likely reach extraordinary levels of $100 to $120 per barrel in the coming months, according to Jephraim P. Gundzik, president of Condor Advisers, Inc., which provides emerging markets investment risk analysis.

And emerging market investors need to brace for that scenario as the turmoil in the Middle East makes for an unsupportive environment. Furthermore, the market has become concerned that Iran might block oil exports in retaliation for being referred to the UN Security Council over the dispute about its nuclear ambitions.

"Iran is definitely calling the shots right now," Gundzik said.

Investors should be watching the events unfold in Lebanon and the Palestinian territory as well as how sanctions in Iran will evolve. He said he believes that market participants do not comprehend how quickly the situation is destabilizing.

"Iran has enormous leverage to even move that destabilization further," he said, adding that the country has the ability to blockade the Straits of Hormuz and prevent the oil exports out of the Gulf.

"I wouldn't be surprised to see them exercise that in the next couple of months, depending on what tack the U.S. takes with their sanctions.

"I think it's telling that the U.S. doesn't want to give Iran time to respond. They are so anxious to get sanctions slapped on."

Cut positions, says Gundzik

His advice to investors is to cut risk positions as soon as possible and to shy away from emerging market equities. He recommends that investors reduce positions to underweight, particularly in Asian emerging markets such as India, Indonesia, Philippines and Thailand.

"All those countries are going to see an upsurge in extremist-related violence over the next few months. I think what we saw in India was a sample of what is yet to come," he said, referring to Tuesday's bombing of Mumbai's rail network, which killed at least 179 people and wounded 800.

On general terms, investors' awareness of the shape of the current geopolitical environment is weak, said Gundzik, warning that investors are not preparing for the likelihood that all of this geopolitical turmoil will have a bearish impact on the world economy.

"The U.S. economy is going to come to a screeching halt. That will move oil prices down. But Russia, Venezuela and Iran essentially can control prices by reducing production," he said, adding that those three countries control 25% of oil exports.

In terms of investing, higher oil prices make oil producers look more attractive. But Gundzik cautions investors to keep in mind that oil prices will mostly come down by around the first quarter of 2007, even though the size of the decline may not be that much. Nonetheless, investors will likely face a global recession with Iran, Russia and Venezuela in the driver's seat when it comes to setting oil prices.

Change in Fed policy

The market is bracing for a pause in the tightening of U.S. monetary policy. The Federal Reserve may hike rates for the 18th straight time at its next meeting in August, but many believe that will be the last one as the current tightening cycle is nearing its end.

"The Fed is overwhelmingly politically motivated at the moment. They might even demure on the next tightening," Gundzik noted.

However, he is curious as to why market participants have not picked up on the change in the last Fed statement that accompanied its rate hike decision. He explained that over the last 20 to 25 years, the Fed's strategy has been to preempt inflation by tightening monetary policy.

"They are changing their policy by saying that they are going to wait and see how statistics or numbers come out in the months ahead and adjust policy according.

"So now they are going from forward-looking monetary policy to backward-looking monetary policy," he noted.

The implication of a change in policy translates into higher inflation numbers in the United States, something which investors are not prepared to consider at this point.

He noted that inflation above 5% is a very realistic possibility.

Risk reduction mode again?

Whether or not the risk reduction mode will intensify will depend on how investors react.

"I think things are going to get so bad that they are going to have to move pretty quickly and reduce their risk. Also the general pullback in risk being generated by the end of quantitative/monetary policy easing in Japan is taking a lot of liquidity out of emerging markets," Gundzik told Prospect News.

He added that many players who borrowed funds in yen at practically zero interest rates will unwind their emerging market trades this year.

On Friday, the Bank of Japan put an end to its zero-interest rate policy, raising its key-lending rate to 0.25% from zero percent.

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