"Can't see the wood for the trees"

The fixed income markets have grown over the last eight years fuelled by low inflation and abundant liquidity. The core markets have become like the trunk of a tree from which investors have branched out into riskier markets of corporate bonds and emerging markets (EM).

The prolonged period of synchronised growth has been fuelled by a number of supports. Some of these supports are being withdrawn but some will remain, leaving some countries more vulnerable than others. The supports that have helped the tree develop are as follows:

Clearly the first one is being removed fairly aggressively, but there is still, however, plenty of liquidity to go around. The next three supports are more market specific. For example, the 150% rise in copper prices over the last year has had a direct impact on exporting countries such as Chile. The rise in the value of copper has led to a 72% increase in exports last year and is one of the reasons why the current account surplus is set to double this year. Commodity prices will have to fall substantially more than their recent 20% correction to make a material dent in this improvement in credit quality.

Global growth and, more importantly western growth, has had a big impact on EM countries and their ability to pay down debt.

This is not only through the high level of demand from commodities but also from an increasingly diverse customer base. An over-reliance on one region (the US) is not healthy, and the more the regions are able to grow domestically and the more wealth that is re-cycled internally the better. The transfer of wealth from countries that need the commodities (including energy) to those that have them has led to an increased investment in domestic economies. The world still remains heavily reliant on the US consumer, but this time it is less so. A slowdown in US consumer spending will cause a global slowdown but not a recession.

Since the Asian crisis of 1998 many (although not all) EM governments have adopted more frugal fiscal policies. They approach this period of slower growth in a better financial position. However, there are some exceptions.

The growth of populist policies in some Latin American countries is a cause for concern, such as Venezuela, Bolivia, Ecuador and even Argentina. In between are countries that are vulnerable if they do not adapt such as Hungary, Turkey, Poland and South Africa. It is important to look for clear evidence that they are strengthening their roots by reducing their spending programmes and increasing revenue-raising possibilities. Hungary is a good example of a deficit reduction package that if, fully implemented, will reduce the country's reliance on international capital but will also need a response from the central bank by cutting rates. The central bank will be more inclined to let the currency decline especially if the government is able to get its fiscal measure through. This will eventually represent an opportunity but , for now, it is best avoided.

In the absence of volatility, ever-increasing usage of leverage is seen as a good thing - especially for the equity holders. As long as a company can carry on servicing its debt by reducing costs and recycling cash then everyone is happy. This increase in the cost of borrowing weakens the issuer and makes it more vulnerable. In a storm, the tree will shake and the extremities will oscillate more wildly. The branches that are more vulnerable are those that are rotten inside. In the case of high yield, it is possible to find a growing number of companies that have leveraged their balance sheets without necessarily increasing their revenue streams and have weak business models. This makes them more vulnerable to an economic slowdown.

Portfolio Response:

(Source: - Merrill Lynch index data Dec 1997 to Jun 2006)