EM Sentiment Strong

Since we last gauged the sentiment of our surveyed banks to EM external debt markets back in the summer, confidence has understandably picked up, as reflected by the rise in our global index to 99.7, from 97.9. Indeed, since the volatile days of May and June, the outlook for US interest rates has calmed dramatically, as the US economy has entered a period of economic slowdown, with real GDP growth slipping to an annualised rate of 1.6% in Q306. As a result, we maintain our view of a 4.50% Fed funds rate by end-2007, down from its current level of 5.25%. The Treasury market too is gunning for a degree of easing in the not too distant future, with the 10-year yield trading below 4.60%, from a peak of 5.24% in June. This has, of course, been highly supportive of EM external debt, with the spread of the EMBI+ now close to its all-time low of 173bps+UST seen on May 1. The benchmark Brazilian US$ Global 27 bond has bounced from the 117.00 level - the low point of the sell-off - to make a fresh high at 137.00. With good support at 135.00, the technical picture suggests further upside, in the short-term at least. The EM debt rally has coincided with a 1000 point jump in the Dow Jones, with both US and foreign investors showing confidence in corporate America and in a soft landing scenario for the US market. Any indication that the US economy is heading for a more severe slowdown - which could also come from overly tight Fed policy going forward - would negatively affect US equities, commodity prices in general and hence EM debt. Interestingly, though, it is the fall in Brent crude from its August peak of US$78.00/bbl that helped send the Dow to new highs, underpinning the rally in Treasuries and EM debt. That said, this was a case of oil falling from an extremely high level, and one that was clearly detrimental to the global economy. Oil around US$60.00/bbl is still good news for EM energy exporters, but a more significant decline in the commodity would be a signal of much slower US, and global, growth. On this point, we are generally mildly bearish towards commodities in 2007, suggesting that EM will face some headwinds, especially in light of current market valuations. However, we see US growth at 3.0% next year and global growth at just under 5.0%. This means that any correction should not turn into a bear market.

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