## FINANCIAL MARKET UPDATE November 2003 ## Source details **Canonical URL:** [FINANCIAL MARKET UPDATE November 2003](https://www.imf.org/-/media/files/publications/fmu/1103.pdf) ## Other formats - [Markdown version](/-/media/files/publications/fmu/1103.pdf.md) - [Structured JSON version](/-/media/files/publications/fmu/1103.pdf.json) --- ### Overview - Data as of November 14, 2003 or as noted; update covers developments through the end of the third quarter of 2003. - Drivers: abundant global liquidity, strong economic growth, low inflation, and improving credit quality. - Investor behavior and consequences: - Increased preference for riskier assets. - Credit spreads on mature and emerging markets have narrowed. - Cost of default protection has fallen. - Global equity markets have rallied strongly since their trough in March. - Equity market volatility is low. ### External environment for emerging markets - Positive external factors: - Stronger global growth and low risk-free interest rates. - Investor comfort with macroeconomic policy direction in a number of key emerging markets. - Primary issuance by emerging market borrowers has risen but "remains commensurate with demand." - Many countries have prefunded borrowing targeted for 2004. - Drivers of investor interest: - Expectations for stronger global growth and corporate earnings rekindling interest in emerging market equities. - Prospects of currency gains in local fixed income markets. - Anticipation that reduced inflationary pressure will permit further policy interest rate declines. - Risks: - Momentum of flows into risky assets—partly induced by low policy rates—could push valuations beyond fundamentals. - If short-term interest rates rise substantially faster than currently anticipated, long-term bond yields could overshoot. - Continued U.S.-driven growth would increase need for foreign purchases of U.S. assets; an increased foreign risk premium on U.S. assets could accompany a declining dollar and rising bond yields. - The level and structure of debt in a number of emerging market countries remain vulnerabilities. - Social and political instability could threaten policy continuity in some emerging markets. - Market expectation: emerging markets will continue to be supported by favorable investor sentiment and stronger global growth. ### Markets expect a gradual shift toward tightening in major financial centers - Yield curves in Japan, the euro area, the United Kingdom and the United States remain steep. - United States: benchmark yield curve is particularly steep; interest rates adjusted for current inflation rates are negative out through maturities of three years. - Markets discount an eventual moderate shift toward tightening in the United States; similar gradual increases in short-term interest rates are evident for the euro area and Japan. - Except for Japan and the United Kingdom, the path of future short-term interest rates in the major markets remains below that discounted at the beginning of the year. - Implied volatility of options on short- and long-term U.S. interest rates has increased since the beginning of the year and is above long-term average levels. ### Real yields, inflation expectations, and implications - Real yields on inflation-linked bonds in the euro area, the United Kingdom, and the United States have risen from lows touched in mid-June when markets were concerned about possible deflation in the United States. - Despite improved global growth outlook, real yields remain at low levels. - Low real yields imply investors may be using a low risk-free real yield as the base for assessing valuations of other assets, including equities. - Inflation expectations—as proxied by the spread between real yields on inflation-indexed bonds and nominal yields on conventional counterparts—have increased since the beginning of the year, but the increase has been muted. - Market view: the eventual tightening cycle will be gradual and not disrupt asset prices. ### Low policy rates and abundant global liquidity influence investor behavior - Low short-term interest rates incentivize investment in risky assets and increased leverage. - Prolonged low short-term rates could push asset prices to levels not fully justified by fundamentals. - Investors searching for yield may underappreciate risks; low market volatility can mask true risk. - Despite substantial compression of credit spreads on mature and emerging market bonds, yields on such securities remain well above the cost of borrowed funds. - Evidence of investor behavior: - Continued large net withdrawal of funds from U.S. money market mutual funds. - Positive flows into bond mutual funds—including high-yield corporate and emerging market bond funds—though the pace of inflows has slowed since July, largely due to reduced flows to high grade and government bond funds. - Flows into equity mutual funds have increased during the year, supported by favorable first quarter profit reports. ### Dollar weakness and currency market dynamics - Market view: the dollar is in an extended period of decline. - The dollar stabilized mid-year as poor euro area economic data dragged the euro lower; stabilization was temporary. - Market view persists that the dollar must decline further over the medium term to correct global imbalances. - G-7 communiqué introduced a new dynamic: Asian currencies are playing a larger role in the dollar’s adjustment. - The yen has moved to a new, more appreciated, trading range. - Expectations of eventual appreciation of the Chinese yuan and the Hong Kong dollar are reflected in forward currency markets. - Speculative flows have pushed the Hong Kong SAR inter-bank offered rate (HIBOR) well below LIBOR. - Investor positioning: - Options market skew favors further appreciation of the yen, though bias is down from September peaks. - Futures markets show speculative accounts holding relatively large net short positions on the U.S. dollar; the bulk mirror long yen positions. ### Improved credit quality and spread compression - Search for yield and strengthening corporate balance sheets and earnings have led to marked compression of credit spreads on corporate bonds in the United States and Europe. - U.S. corporations have raised substantial new financing, mostly for refinancing and balance sheet repair. - Stronger balance sheets and rising earnings have contributed to lower default rates and an improving trend in ratings changes. - Spread compression has been most pronounced at the lower end of the credit spectrum. - Cost of credit default swap (CDS) protection has declined this year, mirroring bond spread patterns. - Default risk perceptions: - The cost of insurance against default by issuers rated below investment grade has fallen particularly sharply. - The spread between high-yield and investment-grade issuers has narrowed considerably. ### Emerging market default probabilities and bond performance - Market perception: a much lower probability of default among emerging markets. - The average five-year default probability implied by spreads on a range of emerging market CDS is about half that expected 12 months ago. - The decline has been driven mainly by reductions in default probabilities on Latin American sovereign issuers. - Bond performance and flows: - High-yielding emerging market bonds have generated much stronger returns than high-grade counterparts year-to-date. - Institutional inflows into secondary markets support spread compression; emerging market bonds' strong risk-adjusted returns and low correlations with other asset classes attract institutional allocations. - Crossover investor flows (from corporate bond investors) are more reactive to current market developments; hedge funds are increasingly active though less significant than in 1997. - Retail inflows to emerging market mutual funds resumed after heavy withdrawals during June/August that coincided with a U.S. treasury market sell-off. - Structural improvements attracting investors: - Measures addressing high debt levels and unstable debt structures, boosting reserves, and adapting exchange rate arrangements to capital account openness have improved perceptions of emerging market creditworthiness. - Secular improvement in emerging market credit ratings: after a lull earlier in the year, a series of credit rating upgrades in the third quarter reinforced the trend; the average rating of emerging market issuers is now firmly anchored at double B. - Improved credit quality may accelerate structural changes in the investor base, with increasing participation by crossover investors as the market integrates with the global fixed-income universe. - Valuation risks: - Emerging bonds risk becoming overvalued; credit spreads are near historic lows in most emerging market countries. - For the market as a whole, the spread on the EMBI+ index is well below its long-run average. - Emerging market bonds still compare favorably with similarly rated mature corporate bonds, but investors increasingly favor higher-yielding emerging market credits to capture further spread compression. ### Equity market prospects - Global equity markets have rebounded sharply since March, primarily due to an improved outlook for corporate earnings and balance sheet strengthening in mature markets. - Implied volatility of options on European and U.S. equity markets is low, indicating investor expectations that earnings will continue to support equity market performance. ### Corporate performance and investment prospects - Corporate earnings have risen in mature markets, exceeding expectations in part due to earlier write-offs and conservative forecasts. - Markets expect U.S. corporate profits to continue to rise next year, although at more normal rates. - Signs of increasing U.S. corporate capital expenditure are present, spurred by rising profits and cash flows, strengthened balance sheets, and signs of stronger economic growth. - Europe: corporate free cash flow has increased; progress in deleveraging continues; little pressure on firms to increase dividends, positioning European firms to increase investment as demand rises. - Improved financial positions of European corporations could fuel increased merger and acquisition activity aimed at restructuring and consolidation in key sectors. - Japan: foreign inflows into the Japanese equity market have been strong, reflecting expectations for improved economic growth and corporate earnings and the prospect of currency gains; yen appreciation has hurt share prices of firms heavily dependent on exports. ### Financial sector conditions - The financial sector has performed well, particularly U.S. banks. - Securitization has removed many assets from bank balance sheets that previously would have been held throughout the economic cycle. - Stronger risk management practices have resulted in much lower provisions by major banks compared with previous cyclical downturns. - The earlier decline in loan growth appears to be stabilizing with the recovery, even in Germany. - Bank shares in Europe and the United States have strengthened during the market upturn. - European insurance companies are gaining favor as refocused business lines and cost cutting have helped boost profits and balance sheets have shown modest improvement. ### Equity valuations and comparison with bond yields - Forward price/earnings (P/E) ratios in mature and emerging markets are at or below their 13-year averages; those averages include bubble-year valuations and should be viewed with caution. - When the earnings yield of the U.S. equity market based on prospective earnings is compared with yields on 10-year U.S. treasuries, equity market valuations appear more favorable. - This favorable valuation depends on earnings forecasts being vindicated and yields remaining low. - Greater uncertainty surrounds the future level of bond yields than the earnings outlook. ### Emerging market primary issuance and funding patterns - Gross funding by emerging markets on international capital markets surged in the third quarter, raising cumulative annual issuance above levels witnessed in the last two years. - Primary bond market volumes were robust, supported by a rebound in corporate issuance in Asia and Latin America. - Equity issuance revived from near-collapse in the first two quarters of 2003 and reached levels reminiscent of those prior to the bursting of the equity price bubble. - Syndicated loan commitments built on a strong second quarter, buoyed by lending to Emerging Europe, Middle East, and Africa; lenders remained reluctant to extend financing in Latin America. - Issuer behavior: - Low financing costs, receptive investors, and expectations that interest rates will rise over the medium term led issuers to pre-finance 2004 funding requirements and use many new bond issues for liability management to improve maturity profiles and terms of external debt. - Around 87 percent of third-quarter new issues were dollar-denominated, compared with only some 70 percent earlier in the year. - The second half of 2003 confirmed that collective action clauses (CACs) are developing into an industry standard for bonds issued under New York law. - Equity issuance was dominated by Asian firms, accounting for 98 percent of all total new issuance; firms in Taiwan Province of China were particularly active. - Net lending: net lending to emerging markets rebounded sharply from levels of the past two years, with net lending booming in EMEA and to a lesser extent in Asia, but contracting in Latin America. ### Foreign direct investment and portfolio flows - Net FDI flows to emerging markets for the year as a whole are expected to be some 10 percent lower than 2002, and about 27 percent less than 1999. - FDI flows to Latin America are expected to decline this year by almost 20 percent from 2002. - The share of foreign ownership of U.S. assets is at record levels. - Foreign portfolio inflows into the United States have become increasingly dominated by bond flows, and net equity flows have become negative. - With U.S. inflows dominated by purchases of fixed income securities, a sustained reduction in inflows could result in a combination of higher bond yields and a weaker dollar. ### Key risks, scenarios, and vulnerabilities - Three main risks that could undermine the favorable outlook: - Excessive asset valuations from a prolonged period of low interest rates as investors move along the risk spectrum seeking yield; investors in mature and emerging credit markets increasingly favor higher yielding credits. - An eventual shift to global tightening that is more abrupt than anticipated, which could undercut asset valuations and contribute to market volatility; a spike in government bond yields in the United States and other mature markets could cause credit spreads to rise and increase the cost of capital for borrowers. - A sharper-than-anticipated decline in the dollar. Speculative short dollar positions remain at high levels; if global growth remains led primarily by the United States, external imbalances could rise and dependence on foreign flows would increase. - Scenario: A decline in the dollar driven by a drop in foreign portfolio inflows would reverberate across asset markets, potentially producing higher bond yields and a weaker dollar given the current composition of U.S. inflows. *International Monetary Fund, Financial Market Update, International Capital Markets Department, Global Markets Analysis Division, November 2003.* ### Section 1 ### FINANCIAL MARKET UPDATE November 2003 ### Overview - Data as of November 14, 2003 or as noted; update covers developments through the end of the third quarter of 2003. - Driven by abundant global liquidity, strong economic growth, low inflation, and improving credit quality, investors have increasingly favored riskier assets. - Consequences observed: - Credit spreads on mature and emerging markets have narrowed. - The cost of default protection has fallen. - Global equity markets have rallied strongly since their trough in March. - Equity market volatility is low. ### External environment for emerging markets - Stronger global growth and low risk-free interest rates provide a positive external environment for emerging markets. - Investors appear comforted by the direction of macroeconomic policies in a number of key emerging markets. - Primary issuance by emerging market borrowers has risen but "remains commensurate with demand." - Many countries have prefunded borrowing targeted for 2004. - Drivers of investor interest in emerging market assets: - Expectations for stronger global growth and corporate earnings rekindling interest in emerging market equities. - Prospects of currency gains in local fixed income markets. - Anticipation that reduced inflationary pressure will permit further policy interest rate declines. - Risks highlighted: - Momentum of flows into risky assets—partly induced by low policy rates—could push valuations beyond fundamentals. - If short-term interest rates rise substantially faster than currently anticipated, long-term bond yields could overshoot. - Continued U.S.-driven growth would increase need for foreign purchases of U.S. assets; an increased foreign risk premium on U.S. assets could accompany a declining dollar and rising bond yields. - The level and structure of debt in a number of emerging market countries remain vulnerabilities. - Social and political instability could threaten policy continuity in some emerging markets. - Current market expectation: emerging markets will continue to be supported by favorable investor sentiment and stronger global growth. ### Markets expect a gradual shift toward tightening in major financial centers - Yield curves in Japan, the euro area, the United Kingdom and the United States remain steep. - United States: benchmark yield curve is particularly steep; interest rates adjusted for current inflation rates are negative out through maturities of three years. - Markets are discounting an eventual moderate shift toward tightening in the United States, and similar gradual increases in short-term interest rates are evident for the euro area and Japan. - Except for Japan and the United Kingdom, the path of future short-term interest rates in the major markets remains below that discounted at the beginning of the year. - Implied volatility of options on short- and long-term U.S. interest rates has increased since the beginning of the year and is above long-term average levels. ### Real yields, inflation expectations, and implications - Real yields on inflation-linked bonds in the euro area, the United Kingdom, and the United States have risen from lows touched in mid-June when markets were concerned about possible deflation in the United States. - Despite improved global growth outlook, real yields remain at low levels. - Low real yields imply investors may be using a low risk-free real yield as the base for assessing valuations of other assets, including equities. - Inflation expectations—as proxied by the spread between real yields on inflation-indexed bonds and nominal yields on conventional counterparts—have increased since the beginning of the year, but the increase has been muted. - Market view remains that the eventual tightening cycle will be gradual and not disrupt asset prices. ### Low policy rates and abundant global liquidity influence investor behavior - Low short-term interest rates incentivize investment in risky assets and increased leverage. - If short-term rates remain low for a prolonged period, asset prices could be pushed to levels not fully justified by fundamentals. - Investors searching for yield may underappreciate risks; low market volatility can mask true risk. - Despite substantial compression of credit spreads on mature and emerging market bonds, yields on such securities remain well above the cost of borrowed funds. - Evidence of investor behavior: - Continued large net withdrawal of funds from U.S. money market mutual funds. - Positive flows into bond mutual funds—including high-yield corporate and emerging market bond funds—though the pace of inflows has slowed since July, largely due to reduced flows to high grade and government bond funds. - Flows into equity mutual funds have increased during the year, supported by favorable first quarter profit reports. ### Dollar weakness and currency market dynamics - Markets view the dollar as in an extended period of decline. - The dollar stabilized mid-year as poor euro area economic data dragged the euro lower, but stabilization was temporary; market view persists that the dollar must decline further over the medium term to correct global imbalances. - The G-7 communiqué introduced a new dynamic: Asian currencies are playing a larger role in the dollar’s adjustment. - The yen has moved to a new, more appreciated, trading range. - Expectations of eventual appreciation of the Chinese yuan and the Hong Kong dollar are reflected in forward currency markets. - Speculative flows have pushed the Hong Kong SAR inter-bank offered rate (HIBOR) well below LIBOR. - Investors are positioned expecting further dollar decline: - Options market skew favors further appreciation of the yen, though bias is down from September peaks. - Futures markets show speculative accounts holding relatively large net short positions on the U.S. dollar; the bulk mirror long yen positions. ### Improved credit quality and spread compression - Search for yield and strengthening corporate balance sheets and earnings have led to marked compression of credit spreads on corporate bonds in the United States and Europe. - U.S. corporations have raised substantial new financing, mostly for refinancing and balance sheet repair. - Stronger balance sheets and rising earnings have contributed to lower default rates and an improving trend in ratings changes. - Spread compression has been most pronounced at the lower end of the credit spectrum. - Cost of credit default swap (CDS) protection has declined this year, mirroring bond spread patterns. - Default risk perceptions: - The cost of insurance against default by issuers rated below investment grade has fallen particularly sharply. - The spread between high-yield and investment-grade issuers has narrowed considerably. ### Emerging market default probabilities and bond performance - Markets perceive a much lower probability of default among emerging markets. - The average five-year default probability implied by spreads on a range of emerging market CDS is about half that expected 12 months ago. - The decline has been driven mainly by reductions in default probabilities on Latin American sovereign issuers. - Emerging market bonds have been buoyed by flows and fundamentals: - High-yielding emerging market bonds have generated much stronger returns than high-grade counterparts year-to-date. - Institutional inflows into secondary markets support spread compression; emerging market bonds' strong risk-adjusted returns and low correlations with other asset classes attract institutional allocations. - Crossover investor flows (from corporate bond investors) are more reactive to current market developments; hedge funds are increasingly active though less significant than in 1997. - Retail inflows to emerging market mutual funds resumed after heavy withdrawals during June/August that coincided with a U.S. treasury market sell-off. - Structural improvements attracting investors: - Measures addressing high debt levels and unstable debt structures, boosting reserves, and adapting exchange rate arrangements to capital account openness have improved perceptions of emerging market creditworthiness. - Secular improvement in emerging market credit ratings: after a lull earlier in the year, a series of credit rating upgrades in the third quarter reinforced the trend; the average rating of emerging market issuers is now firmly anchored at double B. - Improved credit quality may accelerate structural changes in the investor base, with increasing participation by crossover investors as the market integrates with the global fixed-income universe. - Valuation risks: - Emerging bonds risk becoming overvalued; credit spreads are near historic lows in most emerging market countries. - For the market as a whole, the spread on the EMBI+ index is well below its long-run average. - Emerging market bonds still compare favorably with similarly rated mature corporate bonds, but investors increasingly favor higher-yielding emerging market credits to capture further spread compression. ### Equity market prospects - Global equity markets have rebounded sharply since March, primarily due to an improved outlook for corporate earnings and balance sheet strengthening in mature markets. - Implied volatility of options on European and U.S. equity markets is low, indicating investor expectations that earnings will continue to support equity market performance. *International Monetary Fund, Financial Market Update, International Capital Markets Department, Global Markets Analysis Division, November 2003.* ### Section 2 ### Section 2 ### Corporate performance and investment prospects - Corporate earnings have risen in mature markets, exceeding expectations in part due to earlier write-offs and conservative forecasts. - Markets expect U.S. corporate profits to continue to rise next year, although at more normal rates. - Signs of increasing U.S. corporate capital expenditure are present, spurred by: - rising profits and cash flows, - strengthened balance sheets, - signs of stronger economic growth. - Europe: corporate free cash flow has increased; progress in deleveraging continues; little pressure on firms to increase dividends, positioning European firms to increase investment as demand rises. - Improved financial positions of European corporations could fuel increased merger and acquisition activity aimed at restructuring and consolidation in key sectors. - Japan: foreign inflows into the Japanese equity market have been strong, reflecting expectations for improved economic growth and corporate earnings and the prospect of currency gains; yen appreciation has hurt share prices of firms heavily dependent on exports. ### Financial sector conditions - The financial sector has performed well, particularly U.S. banks. - Securitization has removed many assets from bank balance sheets that previously would have been held throughout the economic cycle. - Stronger risk management practices have resulted in much lower provisions by major banks compared with previous cyclical downturns. - The earlier decline in loan growth appears to be stabilizing with the recovery, even in Germany. - Bank shares in Europe and the United States have strengthened during the market upturn. - European insurance companies are gaining favor as refocused business lines and cost cutting have helped boost profits and balance sheets have shown modest improvement. ### Equity valuations and comparison with bond yields - Forward price/earnings (P/E) ratios in mature and emerging markets are at or below their 13-year averages; those averages include bubble-year valuations and should be viewed with caution. - When the earnings yield of the U.S. equity market based on prospective earnings is compared with yields on 10-year U.S. treasuries, equity market valuations appear more favorable. - This favorable valuation depends on: - earnings forecasts being vindicated, - yields remaining low. - Greater uncertainty surrounds the future level of bond yields than the earnings outlook. ### Emerging market primary issuance and funding patterns - Gross funding by emerging markets on international capital markets surged in the third quarter, raising cumulative annual issuance above levels witnessed in the last two years. - Primary bond market volumes were robust, supported by a rebound in corporate issuance in Asia and Latin America. - Equity issuance revived from near-collapse in the first two quarters of 2003 and reached levels reminiscent of those prior to the bursting of the equity price bubble. - Syndicated loan commitments built on a strong second quarter, buoyed by lending to Emerging Europe, Middle East, and Africa; lenders remained reluctant to extend financing in Latin America. - Low financing costs, receptive investors, and expectations that interest rates will rise over the medium term led issuers to: - pre-finance 2004 funding requirements, - use many new bond issues for liability management to improve maturity profiles and terms of external debt. - Around 87 percent of third-quarter new issues were dollar-denominated, compared with only some 70 percent earlier in the year. - The second half of 2003 confirmed that collective action clauses (CACs) are developing into an industry standard for bonds issued under New York law. - Equity issuance was dominated by Asian firms, accounting for 98 percent of all total new issuance; firms in Taiwan Province of China were particularly active. - Net lending to emerging markets rebounded sharply from levels of the past two years, with net lending booming in EMEA and to a lesser extent in Asia, but contracting in Latin America. ### Foreign direct investment and portfolio flows - Net FDI flows to emerging markets for the year as a whole are expected to be some 10 percent lower than 2002, and about 27 percent less than 1999. - FDI flows to Latin America are expected to decline this year by almost 20 percent from 2002. - The share of foreign ownership of U.S. assets is at record levels. - Foreign portfolio inflows into the United States have become increasingly dominated by bond flows, and net equity flows have become negative. - With U.S. inflows dominated by purchases of fixed income securities, a sustained reduction in inflows could result in a combination of higher bond yields and a weaker dollar. ### Key risks, scenarios, and vulnerabilities - Three main risks could undermine the favorable outlook: - Excessive asset valuations from a prolonged period of low interest rates, as investors move along the risk spectrum seeking yield; investors in mature and emerging credit markets increasingly favor higher yielding credits. - An eventual shift to global tightening that is more abrupt than anticipated, which could undercut asset valuations and contribute to market volatility; a spike in government bond yields in the United States and other mature markets could cause credit spreads to rise and increase the cost of capital for borrowers. - A sharper-than-anticipated decline in the dollar. Speculative short dollar positions remain at high levels; if global growth remains led primarily by the United States, external imbalances could rise and dependence on foreign flows would increase. - A decline in the dollar driven by a drop in foreign portfolio inflows would reverberate across asset markets, potentially producing higher bond yields and a weaker dollar given the current composition of U.S. inflows. --- _Source: https://www.imf.org/-/media/files/publications/fmu/1103.pdf_