EMERGING MARKETS WEEK-Inflation to cause economic slowdown

Sun Jul 27, 2008 1:48pm EDT
By Manuela Badawy
NEW YORK, July 27 (Reuters) - Latin America is likely to see a mild slowdown in economic growth this week on the back of an erosion of real wages and higher inflation, including higher food prices.
This could put a damper on investor sentiment and pressure sovereign debt prices. However, emerging market paper will likely be entwined with the U.S. market.
"There are ongoing concerns about credit and the overall stability of financial institutions in the United States, and that tends to continue to affect sentiment," said Enrique Alvarez, head of Latin America debt strategy at IDEAglobal.
In addition, Latin American debt in general is starting to see rises in interest rates, which is pulling growth back somewhat. This is due to faltering domestic demand, analysts said.
"Tighter monetary policy in almost all countries, coupled with the negative income effect of higher food and energy prices, explains a large portion of the slowdown seen in domestic demand this year," analysts at Bulltick Capital Markets in Miami wrote in a research note.
The latest country to raise rates was Colombia
On Friday, its central bank increased its key interest rate by 25 basis points to 10 percent, its highest level since September 2001. The bank also lowered its forecast for gross domestic product growth in 2008 to between 3.3 percent and 5.3 percent from the previous 4 percent to 6 percent. The economy grew 7.5 percent in 2007.
Colombia's yield spreads, an important gauge of investors' aversion to risk, tightened nine basis points on Friday to 199 basis points over comparable U.S. Treasuries, according to JP Morgan's Emerging Markets Bond Index Plus (EMBI+) 11EMJ .JPMEMBIPLUS.
Higher interest rates in Latin America are favorable to investors who can borrow short-term money at low rates and then invest it in higher-yielding securities such as emerging market debt to profit from the difference in rates, a practice know as a "carry trade."
"Despite the already impressive run seen in the foreign exchange markets, the very high positive carry has continued to allow investors to resist higher stop-loss targets. In our view, only very sharp volatility will be able to force investors to flee places such as Brazil, Chile, or Mexico," Bulltick said in their report.
So far this year, emerging sovereign debt investors have gained a mere 0.325 percent of their original investment, according to the EMBI+. On their Brazilian bonds investors have gained 2.75 percent, while on their Mexican paper they have received just below 1 percent.
But analysts said sometimes it's good to be mediocre.
"Emerging market bonds have delivered mediocre total returns year-to-date. However, those returns are significantly better than those offered by its investment grade and high yield siblings," Guillermo Mondino, an analyst for Lehman Brothers, said in a research note.
"The outperformance of the emerging market bond asset class is not just recent; it has outperformed since the start of the capital market turbulence."
Investors are likely to keep an eye on Monday on Brazil's current account balance for June; on Tuesday for Mexico's IGAE economic activity for May; and on Wednesday for Mexico's central bank quarterly inflation report, Brazil's July wholesale inflation and June budget surplus.
On Thursday, they will watch the minutes from Copom, Brazil's monetary-policy committee, Chile's June unemployment and June industrial production; and on Friday, Mexico's central bank monthly poll on inflation expectations and Brazil's industrial output. (Editing by Jeffrey Benkoe)