Reality check…
"...The rand is trading firmly around R/$5.00 this morning after it was announced late yesterday that Robert Mugabe's ruling Zanu PF party was defeated by the MDC in the Zimbabwean election.
"...President Thabo Mbeki also admitted that South Africa's policy of quiet diplomacy is not bearing any fruit and in a radical change, SANDF troops have been employed within the main regions of Zimbabwe to oppose the growing violence in the country.
"...This comes after President Mbeki also declared the previous Zimbabwean elections a "sham" and has said: "the time has come to reinstate law and order in a poverty stricken country that has been raided by a corrupt and deceitful government" ....if this only was real.
What is, however, real is the fact that markets have seen an enormous appetite for risk over the last few years, comparable to that of the late 1990's.
To put it very simply, as investors grow more confident regarding the macro economic environment, emerging markets become a more attractive destination for capital flows from developed countries.
The emerging market bond spread (EMBIS) essentially is the premium that these investors demand for the extra risk they take by investing in emerging market assets. As the demand for these emerging assets increase, the required risk premium declines.
In other words, if the US 10 year treasury is trading at a 4.60% yield and the risk premium is for example 380 basis points then this ratio would be 81.7%. This gives a better feel for the extent of the decline of the risk premium, and, is sitting at a six year low.
As money in the developed world became cheaper due to the decline in interest rates, the natural reaction was for capital to find greener pastures in the form of higher yields, elsewhere.
As economic growth surged across the globe, emerging markets also participated, which made the environment that much more attractive. Without repeating my colleague, Adrian Clayton's narrative from Monday, this cycle is not new and will possibly slow down as rising interest rates start impacting economic growth.
Although investors on the long end of the US yield curve have already experienced significant wealth destruction, as we expected, the suffering is not yet over.
The US economy is still in an expansionary phase and the excesses in the economy will result in inflationary pressure. Real interest rates are likely to normalise in the next 12 to 18 months due to further tightening by the Fed. This will put further pressure on US bonds and could potentially unwind the tight demand for financial assets in general, both in developed and emerging economies.
By looking at the inverse relationship between EMBI spreads and the S&P500 Index, it is evident and logical that the increased risk appetite has resulted in an increased demand for US equities, which will also slow if the risk appetite dissipates. This is not a doomsday forecast, but just something to be aware of.
