Emerging markets a bright
spot in credit chaos By Walter T
Molano
The markets took a nasty tumble
last week, as the US credit boom came to a sudden
stop. Bond deals were canceled, private-equity
transactions were shelved and initial public
offerings were put on hold. The loss of momentum
resulted in a severe correction in the equity and
debt markets.
There was a ray of hope on
Friday morning, after the release of the
second-quarter data on the US gross domestic
product. The US economy grew 3.4% year on year,
slightly better than the
3.2%
growth projections.
However, the optimism
turned dark by the afternoon. Mortgage companies
such as Countrywide reported a sharp increase in
defaults. The shares of financial companies
plunged, causing the Dow Jones Industrial Average
to post the largest drop in more than five years.
The much-awaited credit crunch is under way. The
problem is that no one knows how deep it goes
before it hits bottom.
Fortunately, the US
Federal Reserve has a lot of ammunition to
dispense, but it must be prudent in its actions.
It cannot act too early. The US must undergo a
massive deleveraging to clean up its balance
sheet. At the same time, the Fed cannot wait too
long. Otherwise, the US economy will endure
structural damage to its financial system. This is
where the Fed under chairman Ben Bernanke will
earn its stripes. In the meantime, the market will
continue to hemorrhage.
The problems in
the US financial system are massive. The pipeline
has an estimated US$500 billion in high-yield
bonds and loans that need to be completed before
the end of the year. Many of them were refinances
of existing obligations. Unfortunately, most
bankers consider the US credit markets to be
closed until 2008. This means that there could be
a massive dip in credit quality and an increase in
corporate defaults. At the same time, there are
several hundred billion dollars of mortgages that
will reset before the end of the year.
Most of these mortgages were issued at
discounted interest rates, and in some cases the
new rates will be twice as high. Given the new
restrictions in lending practices and the decline
in housing prices, many of these borrowers cannot
obtain alternative forms of financing. The result
will be increases in non-performing loans.
The problems in the US credit market are
ripping through the economy, depressing
consumption and putting pressure on financial
institutions. Financial institutions lost hundreds
of billions of dollars in capitalization last
week, and many people consider the correction to
be only in the initial stages.
Against
this backdrop, the emerging markets continue to be
a compelling story. The debacle in the US is
putting China in the driver's seat, and this is
good for commodity producers. Nevertheless, the
emerging markets could not escape the fallout, and
there were large losses across the board. Much of
the selling came from crossover accounts as they
pared back non-core positions.
Many
portfolio managers also sold out of their
emerging- market positions to build up cash to buy
heavily discounted assets in the United States.
Last of all, given that there was still a bid for
emerging -market assets, they were used as a hedge
against the meltdown in the US.
Fortunately, dedicated investors are
stepping into the fray, buying up assets across
the board. Although there are concerns about the
ongoing crisis, there has been no evidence of
divestitures by dedicated accounts. We continue to
see enormous value in the asset class, with unique
buying opportunities in Argentine assets and local
currency products.
Still, we must
recognize the extent of the damage being caused by
the US deleveraging process and acknowledge that
there is more pain to come. This will create
mark-to-market problems for our asset class, but
the fundamental story remains as compelling as
ever.
(Copyright 2007 Walter T Molano, The
Emerging Market Adviser.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
