Capital Ideas^TM

At the beginning of the year, the three major factors driving emerging market (EM) debt were US financial conditions, the dollar and global growth. All three look likely to have been changed by the current shock to the banking sector.

The US Federal Reserve (Fed) appears likely to temper its hawkish tone and potentially even start cutting interest rates before the end of the year, although credit conditions could still tighten if banks become more cautious about lending. Although a less hawkish Fed is, in theory, positive for EMs, tighter credit conditions, a US recession, a strong dollar and heightened risk aversion are likely to make for a less positive backdrop for EM debt.

On the hard currency side, the number of EMs simultaneously in distress is high, but these are generally smaller countries with idiosyncratic and generally well understood risks. The major EMs still look strong fundamentally and look less vulnerable to any contagion.

As for local currency debt, high starting yields and undervalued exchange rates should provide a buffer to volatility and the breadth and depth of the asset class should allow investors to effectively position their portfolios for their views.