The above phrase entered American culture following the 1992 Clinton presidential campaign. Democratic strategist James Carville coined the term in order to help keep the Clinton campaign focused on the perceived key issue of that presidential race, namely the health of the economy. Since that time, the phrase has been used in a wide range of capacities to help make a point or crystallise a debate. So too we have seen its emergence in Emerging Markets, as many participants look to explain the impressive performance of the asset class and gauge the sustainability of that performance.

Over the past month, we have seen many commentaries on the state of Emerging Markets and the durability of the strong returns that have characterised the asset class. Some of these have been focused on risks, such as the tightening of monetary policy currently underway in the U.S., Europe and most recently Japan, giving rise to the phrase, “It’s the liquidity, stupid.” Others have focused on supportive factors, including the improved health of emerging country balance sheets summing up arguments with “It’s the fundamentals, stupid.” At the same time, the current high level of commodity prices has given way to “It’s the external environment, stupid.” Finally, strong investor inflows into the asset class coupled with sovereign liability management operations have sparked the phrase “It’s the technicals, stupid.”

Where does PIMCO come out on the debate? Let’s take a closer look at each of these considerations, and we’ll see why we say, “It’s the combination, stupid.”

Fundamental Analysis
The health of emerging market economies has shown marked improvement over the past five years. Strong growth, relatively contained inflation and increased self-insurance have become hallmarks of the sector. As Chart 1 shows, EM real GDP growth has far outpaced G-7 rates since 2000, with 2006 expected to continue that trend.

Likewise, robust trade flows have led to marked improvements in external balance sheets and Emerging Markets economies are now running large and persistent current account surpluses, rather than the chronic current account deficits that plagued the sector in the mid 1990s. Importantly, this move to current account surpluses can now be seen (Chart 2) in all three major regions of Emerging Markets and is no longer just an Asian phenomenon, as one might assume.

As work from our emerging markets Forum Team, headed by PIMCO Emerging Markets Product Manager Lori Whiting, showed at our Cyclical Forum in March, aggregate Emerging Markets current account surpluses in 2005 were in the order of just under $500bn¹, in contrast to a $90bn deficit in 1998. And surpluses excluding China were also robust at just over $370bn, meaning that EM countries are not only important net exporters of capital to the developed world, but that EM countries ex-China funded roughly half of the $750bn U.S. current account deficit.²

The strength of these current account surpluses has flowed through the balance of payments, producing large and growing international reserve accumulations in Emerging Markets. This self-insurance has been instrumental in reducing the susceptibility to external shocks and signalling to international markets that the health of these economies is improving. Again, international reserve growth has not just been an Asian phenomenon. As displayed in Chart 3, Russia has gone from roughly $30bn of international reserves in 2000, to almost $200bn today; Brazil has moved from just over $30bn to close to $60bn; and Mexico, likewise, has doubled its reserves to almost $70bn since 2000.

Rating agencies have rewarded EM countries for these fundamental improvements, with sovereign upgrades outnumbering downgrades in EM by 2-1 since 2000 (shown in Chart 4, the ratio was over 3-1 in 2004 and almost 4-1 in 2005).



Technical Analysis
The benefits of international reserve accumulation are clear, and “it’s the fundamentals, stupid” is clearly supportive, as far as it goes. But reserve accumulation also involves a cost, in the form of negative carry, which is where “it’s the technicals, stupid” combines with fundamentals.³ These countries have billions of dollars of outstanding external debt issued at spreads of hundreds of basis points over USTs. Against this, the interest earned on investing these international reserves usually comes at risk-free rates. The inflection point at which the marginal benefit from an extra dollar of international reserves is outweighed by the carry costs of holding that extra dollar of debt is becoming a reality for many Emerging Market countries. As a result the last 12 months have seen a flurry of liability management operations and external debt-buybacks in Emerging Markets. And the pace of these announcements has picked up recently with operations from Brazil, Mexico, Colombia and Venezuela announced during a one-week blitz in February.

Buybacks and liability management programs have been coupled with programs from many of these countries to take advantage of favourable capital market conditions (relatively low risk free rates and high risk appetites) to aggressively satisfy 2006 external funding needs. In fact, the majority of Emerging Market countries have now fully completed 2006 external financing plans, further allowing these countries to focus on liability management operations for the remainder of the year.

Adding to the strong technicals are the still high levels of cash that Emerging Markets bonds will throw off to investors in the form of coupon and amortisation payments for the remainder of 2006. This and the paucity of new supply expected can be seen quite clearly in Chart 5, which represented the dynamic as of end-February for key emerging markets countries.

Including the recent Brady buy-back announcements from Brazil and Venezuela, an estimated $35bn will be returned to EM investors over the next six months in the form of coupons, amortisations and liability management exercises.

Not to be ignored is the important development of local markets sources of financing for many of these countries. While once characterised as an option for only the highest rated EM countries, local markets have grown as a large, stable and meaningful source of financing for a growing list of sovereign names. Along with the privatisation of many local pension fund systems that has provided a dedicated buyer for local assets, foreign investor participation has grown substantially in these markets over recent years. These developments have allowed many countries to replace external debt with local debt, further improving the technicals of the external market, and contributing to improved resilience to external shocks as the “original sin” of accumulating liabilities in foreign currencies is mitigated.

Finally, the technical picture has been given a boost by a broadening of the investor base in Emerging Markets, not only geographically, but by investor type. At PIMCO we have witnessed substantial interest in the asset class from the U.S., Europe, Asia and the Middle East. And U.S. mutual fund inflows have not only been robust on the institutional front, but on the retail side as well, as a graph of AMG fund flows data reveals in Chart 6.



External Environment
The external environment has certainly been a tailwind for much of the emerging markets asset class over the past three years. Much of this can be directly or indirectly connected to China’s emergence as a major force in shaping asset prices and flows. The so-called “Bretton Woods II” vendor-financing arrangement between the U.S. and China has helped keep interest rates low, global consumption robust and commodity prices rising. Emerging Market countries have been direct beneficiaries of this arrangement as well, first through direct trade linkages with China, second through associated positive terms of trades shocks for many of these countries, and third through easy monetary conditions globally.

While much is made of the record trade deficit of the U.S. with China, less attention is paid to China’s trade deficit with other Developing Countries, which reached $44bn in 2004 as seen in Chart 7.

China’s trade deficit with developing countries speaks directly to much of Emerging Markets’ relationship with China as a client or consumer, rather than a competitor or producer of goods.

More commonly noted is the effect of China’s emergence on commodity prices, especially oil and metals. While many EM countries directly benefit from resultant more favourable terms of trade, it is encouraging that many continue to use conservative estimates for commodity prices when formulating budgets. For example, the 2006 Mexican budget assumes a price of $36.5/bbl for its crude mix, while year-to-date, the mix has averaged $47.5/bbl.

Global Liquidity
Much has been made recently of the decision in Japan to end the Quantitative Easing framework. Given a backdrop of a “measured pace” of hikes in the U.S. that have taken Fed Funds from 1% to 4.5% over the past 20 months, and recent ECB tightening of its benchmark interest rate from 2% to 2.5%, the end of Quantitative Easing has raised fears in the market of a significant drain of global liquidity. Furthermore, the spectre of a policy mistake, once discussed just in the context of the U.S. rate cycle, is now topical throughout the G-3.

While the move higher in global interest rates certainly diminishes the attractiveness of “global carry trades,” there are reasons to believe that the current round of central bank tightening may not fully “remove the punch bowl.” Signs of a slowdown in the U.S. housing market and its knock-on effects on the consumer portends a nearby end to the rate hikes from the Fed. Weak consumption, negative real wage growth and low inflation are enduring realities in Euroland. And the sensitivity of fiscal dynamics to higher interest rates in the government sector in Japan may keep monetary policy accommodative, though the Zero Interest Rate Policy will likely come to a close by year end.

Investment Implications
So, if PIMCO’s answer to the question of EM performance is “it’s the combination, stupid,” where does that leave us in terms of investment implications for Emerging Markets debt?

The move to drain global liquidity has re-introduced risk aversion to the market. Certain countries in EM have been preparing for some time for a change in the external environment. Those that have been able to 1) increase international reserves self-insurance, 2) run current account surpluses, 3) address financing needs while external conditions are benign, and 4) replace external debt with more attractive local markets financing are well positioned to weather externally-induced volatility. Other credits that continue to run current account deficits, have significant financing needs in the external markets or are subject to a shock from higher commodity prices should be viewed with caution.

While the risks of a global liquidity drain are real, and all else equal argue for higher premiums in risky products, at PIMCO we believe in the basic proposition of underwriting this potentially higher externally-driven volatility through active management exposure to this secularly maturing asset class.

With a yield of 6.7%, almost half the credits now investment grade, large and growing levels of self-insurance, minimal financing needs for the rest of the year, a growing investor base (including non-commercial players), and a strategic complement to China, investments in Emerging Markets debt continue to be compelling.

Michael Gomez
Executive Vice President

¹ IMF WEO – April/September 2005

² Current account figures for Emerging Markets include OPEC economies