"Carry on up the glacier"

Recent attention has been focused on the plight of a small economy on the periphery of the market and how its currency is being undermined by a large current account and budget deficit. This comment could refer to either Iceland or New Zealand. In the case of Iceland, the authorities have responded to an over-heating economy by raising rates. In New Zealand, the authorities have delayed rate cuts due to concerns over currency weakness.

Since the beginning of the year, with increased talk of monetary tightening in Japan, the markets have concerned themselves with the probability of a reduction in the so-called 'carry-trade'. The markets have broadly focused on those countries that have current account deficits and are therefore more reliant on overseas capital (see chart below).

Although Iceland and New Zealand are not strictly emerging markets, the worries about the reversal of the carry-trade are real enough and should concentrate investors' minds. Once the recent uncertainty dies down,probably after the Japanese year-end, then long-term investors can return to focusing on the improving fundamentals for some of the emerging markets.

This year will be different from the last two years when it didn't matter which emerging market you owned as long as it had a spread over G7 government bonds.

This year (like last year for corporate bonds) issuer selection will be crucial. The shift towards local currency investing will heighten the political uncertainty. Once elections are out of the way (or the bad news is priced in), then investors should get involved.

Here are our thoughts on some of the major emerging market countries.

Poland The minority government will occasional spoil the fun as it attempts to forge alliances with less well known parties, but essentially low inflation and relatively stable finances will prove attractive while euro convergence remains a likely possibility.

Hungary The recent election coupled with poor budgetary controls makes this market our least favoured.

Brazil High domestic rates, stable growth and time before the election (October) make this worth including for now.

South Africa The renewed strength in commodities has given the rand a new lease of life, taking it away from all the carry-trade concerns.Also a lack of political risk can allow South Africa to stand out.

Portfolio response: