"Fighting for their freedom"

The independence of South America came after the victory of an emerging continent against a dominant foreign force (Spain), and the hard work of the likes of independence leader Simon Bolivar (El Libertador). But with the current markets buoyed by strong global liquidity, and worried about a U.S. economic slowdown, the question today is will emerging markets show independence or be dragged down?

The U.S. economic slowdown is continuing. The employment statistics do not yet reflect the extent of the housing market slowdown, which is puzzling and this may suggest there is more momentum than first thought. Whilst this mystery is played out, the rest of the world marches strongly ahead, with especially rampant growth in China, European business indicators are reaching new highs and Middle East spending on infrastructure and overseas assets is as strong as ever. Continued global growth lends support to the emerging markets and spreads on hard currency debt have returned to the narrows (see chart).

However, the short-term picture could prove to be difficult for those countries whose fortunes are linked to the U.S. through commodity prices. A slowdown in the U.S. and fears of tightening of monetary policy in China might suggest at first glance that the current low level of interest rate differential is not enough protection for owning emerging market debt. However, these concerns may prove transitory.

The U.S. housing problem is made in the U.S. and can be fixed in the U.S. There is already talk of state and federal support for those borrowers who were duped into taking out mortgages they couldn't afford by mortgage companies. Also if the broader U.S. economy continues to suffer, then the Federal Reserve has the ability to ride to the rescue by cutting rates aggressively. Meanwhile the long-term support for emerging market debt continues and allows for greater separation from U.S. domestic affairs. Here are a few of the longer-term drivers for Emerging Market Debt.

In all, 40% of external emerging market debt is now Investment Grade (i.e. BBB- or above). This has risen from +1.6% in 1993. 1 The average rating of local currency debt is A-. This improvement in credit quality partially supports the narrowing in credit spreads.

Back in the 90's the main buyers of emerging market debt were outside of the country. Now increasingly local pension demand is taking the place of foreign holdings and creating a more stable holdings base. Local pension plans are less likely to flee the market on global concerns and are increasingly holding longer dated debt. This enables governments to lengthen their issuing programs and makes them less reliant on short-term funding.

In terms of GDP, Brazil and Russia are similar sizes to Australia and Mexico, South Korea and India are slightly bigger. Meanwhile their growth rates are substantially higher. Obviously their populations are significantly higher and younger, but their per capita income is growing at a very rapid pace.

The local currency emerging markets continue to grow rapidly at a time when reliance on external borrowings decline. The effect of this is to reduce the emerging market country's reliance on overseas investors, and create a less volatile asset class. Less volatility means less premium demanded by investors. Despite this the historical reliance on US$ funding means that they would receive a significant benefit if the U.S. were to cut rates.

This is an area where we have made comments before. Essentially the strong current account surpluses are allowing emerging market countries to build significant reserves, which can be used to weather the next storm. The Philippines have successfully reached a point at which they no longer have any International Monetary Fund (IMF) borrowings - the first time in four and half decades.

Emerging debt markets can de-couple from a U.S. economic growth slowdown, especially if this brings about rapid interest rate cuts. Lower oil prices and a period of monetary tightening by the Chinese, which causes a reversal in the global liquidity story, is a different matter.

1 Merrill Lynch