OREANDA-NEWS. October 6, 2011. Since our last CIS eurobond strategy report – when we warned investors about growing risk aversion and market nervousness – the situation has worsened. The markets remain under stress, stimulating further risk aversion around the globe. All main risk indicators show a significant deterioration of investor sentiment and growing structural problems in key economies. The European interbank market is losing confidence and the perception of sovereign credit quality among European majors is steadily worsening.

Investor expectations and leading economic indicators are downbeat. The focus has shifted from whether we are going to have a crisis to what kind of crisis it will be: stagnation or recession. A combination of high debt levels, an economic slowdown, inefficient monetary policy and flaccid fiscal policy form a seriously risky foundation for EM eurobond dynamics.

“Excessive debt” disease. The key global economies (with peripheral Europe in focus) are infected with sovereign excessive indebtedness disease. This became especially acute when corporate debt migrated to the higher, sovereign level. The range of methods to cure the disease is limited and basically includes default, refinancing and economic growth. The first is too radical and would have grave short-run consequences. The second option is perhaps the most possible and could result in temporary relief on DM and EM capital markets, but it would not solve the problem. We think the third option is essential to fully eradicate the disease.

Stimulating economic growth is tough in current circumstances. Most instruments available either lead to further debt increases or to social unrest which is especially dangerous for governments in a pre-election year. As a result, the monetary policy toolkit is limited to expanding money supply. Another instrument to stimulate economic growth is the currency exchange rate.

In our opinion the most effective and timely way to stimulate economic growth is to increase net exports by means of the exchange rate. We expect the US and EU to become more active in adjusting their FX rates to achieve comparative advantages in international trade. The most obvious player in this game is China with its massive exports to DM. ‘Currency wars’ might lead to an escalation of inflation, which would not be good for the bond market.

We shouldn’t hope for China to save the world economy. First of all, China has always had a soft peg to the US dollar and it will definitely not shrink from any ‘currency wars’. Secondly, China could face serious economic problems itself. The key risks lie in the banking and real estate sectors. Problems in one of the last hopes for the world economy would cause a massive sell-off in EM, we believe.

Remove CIS eurobonds from your portfolio, if possible. If not, liquid Russian BB and BBB corporate and sovereign eurobonds with short durations are preferred from the point of view of minimising any negative market impact.