By Mike Lenhoff 12/04/2007 00:00
Credit market spreads are largely determined by default risk. In this sense emerging market government debt has more in common with higher yielding corporate debt than with the debt guaranteed by, say, the US Treasury.

Think of what a US recession might mean for an emerging economy - and let’s exaggerate to make a point. A serious recession would weaken global trade. This, in turn, would put at risk the foreign exchange earnings of an emerging economy, weaken its capacity to service debt, possibly even robbing it of the wherewithal to pay it back. The forex markets would relish the thought of ravaging the currency. All bad news for credit risk.

Of course a US recession is not the consensus expectation, but the US economy is slowing and consensus forecasts for GDP growth for this year are being revised downwards. As pointed out in a recent note (A Change in Fed Policy in the Pipeline! 29th March 2007), the rapid loss of momentum in corporate earnings growth could soon affect investment, job creation and the growth of consumer spending. Something more than just a slowdown in the economy might lie ahead and, if so, this would impair the prospects for the global economy.

While spreads on US corporate debt have widened a little, the spreads on emerging market debt have not widened at all. Indeed, as the chart shows, the spreads have remained remarkably narrow and impressively stable through thick and thin for well over a year. Recently, they have narrowed even further.

Although bond markets often react to news flow, they can be acutely sensitive to the winds of change and their leading indicator properties are well known. If an ill wind is blowing, say because the outlook for the US economy is deteriorating, the spreads should be widening in view of the increase in credit risk attached to emerging market debt. One expects that from a higher yielding debt market, particularly one exposed to the US economy, be it directly or indirectly.

Either emerging market debt is an accident waiting to happen or the smart money reckons that the US economy’s limited phase of sub-trend growth will not degenerate into a hardship case for the global economy.

Emerging Asia, led by China and India, is chugging along quite nicely, perhaps too nicely considering the restraint that is being applied by their central banks. One’s still talking about GDP growth of around 8 and 10 percent plus respectively for India and China. Elsewhere in the emerging world, i.e., Latin America, Eastern Europe and the Middle East, growth is likely to be only a little less buoyant this year than last year, meaning GDP growth averaging not far short of 5 percent.

Among the major economies, forecasts for the eurozone are being revised up on the back of what is proving to be a positive growth surprise in Germany. In the UK the economy may be losing a little momentum but it is far from weak, and ditto for Japan. Both these economies are expected to growth by at least 2.5 percent this year, which for the UK is a little better than the long run average.

Sure, there has been a rapid loss of momentum in corporate earnings growth pretty well everywhere, but the bond markets no doubt recognize that this comes after three to four years of rapid and unsustainable double digit earnings growth. The adjustment in earnings to something more sustainable and more in keeping with what has been observed over the long run may make emerging market debt slightly more vulnerable to default risk than before but not materially so.

If the global economy is heading for trouble the spreads on emerging market debt should be widening, but they’re not. Should we take this to mean that the global economy is in good ‘nick’? I think we can.

So what’s the message? That we should be hoovering up emerging market debt? Not really! Our message is to stick with equity markets. They may be subject to more volatility, but with a global economy in good ‘nick’, that means they can go up as well as down.

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