## Financial Market Update — Sections 1 and 2

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---

### Overview and market backdrop
- Coverage: developments through November 25, 2005; updates since the September 2005 Global Financial Stability Report.
- Overall conditions:
  - Financial conditions in mature and emerging markets remained favorable, supported by expectations for sustained and broadening global growth, still abundant liquidity, and a continuing investor search for yield.
- Key risks flagged:
  - A turn in the interest rate and credit cycle could lead to distress for specific companies and possible amplification through credit derivative markets (including CDOs).
  - Mortgage markets (sub-prime) vulnerable as monetary tightening slows the U.S. housing market and riskier mortgage lending has proliferated.
  - Structural imbalances—particularly reliance on large foreign inflows to finance the U.S. current account deficit—could trigger or amplify a systemic repricing of risk (assessed as low probability at present).
  - Some emerging market countries with high debt stocks and high fiscal and/or current account deficits remain exposed if global liquidity is withdrawn.

### Energy market volatility and inflation dynamics
- Oil price and market expectations:
  - Energy prices rose to an all-time high above $70/bbl (WTI) in late August 2005; oil prices subsequently fell, fully retracing the rise that began in mid-July 2005.
  - Market participants expect oil prices to stay high, as reflected in speculative positioning and futures prices.
- Policy and inflation effects:
  - Policymakers signaled a firm monetary policy stance in response to higher “headline” inflation figures.
  - Market participants generally viewed higher energy prices as a tax on growth rather than an accelerant for inflation.
  - The gap between headline and core inflation rates widened in 2005 in both the United States and the euro area, increasing concerns about pass-through to other sectors.
- Inflation expectations and yields:
  - Market-derived expectations rose since the summer of 2005 but remained below levels seen earlier in the year.
  - Longer-term bond yields stayed low while short ends of yield curves rose, producing a marked flattening of yield curves in the United States and, to a lesser extent, in the euro area.

### Monetary policy expectations across mature markets
- United States:
  - Investors increased expectations for the end point of Fed tightening to 4.75 percent in the first half of 2006.
  - Short-term rates rose; the U.S. dollar appreciation since August 2005 was supported by U.S. growth and interest rate differentials.
- Euro area:
  - The ECB raised its policy rate by 0.25 percent to 2.25 percent.
  - Market expectations were for rates to reach about 3 percent by end-2006.
- Japan:
  - Markets began to anticipate the end of the zero interest rate policy as deflation was expected to recede next year.

### Corporate profitability, credit cycle, and credit derivatives
- Corporate earnings and balance sheets:
  - S&P 500 earnings estimates on track for a 15.9 percent year-on-year increase in Q3 2005.
  - Japanese company earnings expected to rise at double-digit rates; European earnings expected to rise at a slightly slower pace.
  - Corporate balance sheets globally improved due to robust profitability.
- Signs of a corporate credit cycle turning:
  - Federal Reserve survey (October 2005) showed a rising proportion of banks tightening lending criteria for business loans.
  - Ratio of credit ratings upgrades to downgrades dropped to its lowest in two years in Q3 2005.
  - Corporations increased balance sheet leverage via share buybacks, higher average dividends in U.S. and Japanese firms, and higher merger and acquisition activity (including leveraged buyouts).
  - Corporate funding gap rose in the United States, Europe, and Japan, moving from a recent surplus position.
- Credit derivatives:
  - Idiosyncratic credit events (including bankruptcies such as Delphi) caused losses in credit derivatives markets and on some CDO instruments, forcing portfolio liquidations and causing liquidity disturbances.
  - Credit derivatives have so far shown flexibility and resilience and help spread credit risk, but simultaneous idiosyncratic shocks could cause substantial corrections amplified by liquidity strains.

### U.S. dollar appreciation and capital flows
- Drivers of demand for U.S. dollar assets:
  - Foreign private purchases of U.S. fixed-income instruments rose steadily in 2005.
  - Asian central banks continued investment flows into U.S. markets in 2005, with the Pacific Rim region accumulating reserves amounting to $210 billion in the first three quarters of 2005.
  - Oil exporter windfalls from higher oil prices were estimated at about $20 billion in additional surpluses accumulating each month in 2005; data suggest much of the surplus may be accumulating in offshore dollar bank deposits.
  - Repatriation of corporate profits accelerated following the Homeland Investment Act (HIA); estimates of earnings to be repatriated ranged from $350 billion to $500 billion (exchange-rate and location effects make the foreign exchange impact difficult to estimate).

### Mortgage markets and sub-prime concerns
- U.S. housing and mortgage market signals:
  - Monetary tightening was slowing the U.S. housing market by late 2005: homebuilder optimism fell to its lowest level in 18 months in November 2005, and some large builders forecast declining sales.
  - Benchmark mortgage rates rose to their highest levels since June 2004.
- Mortgage quality and securitization:
  - Lenders developed innovative mortgage terms to preserve access for marginal borrowers; the average credit quality of mortgages declined.
  - Low-quality mortgages (defined as nonagency subprime and alt-A mortgages) increased as a share of total originations in 2005 (estimated).
  - Regulators warned of risks to borrowers and cautioned lenders; regulatory influence over nonbank mortgage originators and securitizers is limited.
  - Subprime mortgages had experienced an unusually low default rate so far, but could become more risky as home prices cool and interest rates rise further.
  - Securitization has dispersed mortgage risks to a wider range of investors, cushioning the impact of moderate house price softening on financial markets.
  - Potential price corrections in new and complex mortgage-related products (low-quality MBS, synthetic ABS, and CDOs) could be severe, especially if liquidity disturbances occur; the ability of CDOs to absorb deterioration in the riskiest mortgage segments had yet to be tested.

### Emerging markets: resilience and remaining vulnerabilities
- Spreads and fundamentals:
  - Emerging market bond spreads tightened to record low levels through November 25, 2005.
  - Improvements in fundamentals since 2002 significantly reduced public debt-to-GDP ratios through strong economic growth, appreciating currencies, and, in many cases, strong primary fiscal surpluses.
  - External financing requirements for emerging market sovereigns and corporates continued to decline as commodity prices rise and global growth boosts remittances.
- Remaining vulnerabilities:
  - Some emerging market countries with high debt stocks and high fiscal and/or current account deficits remain exposed to a repricing of risk if global liquidity is withdrawn.

### Debt management actions and investor base
- Sovereign debt management measures:
  - Brazil issued its first local-currency global bond, alleviating concerns about the currency composition of its debt.
  - Mexico bought back $1.4 billion of external bonds and launched warrants offering investors the right to receive peso-denominated bonds in exchange for dollar-denominated bonds in one year.
  - Panama and Peru exchanged outstanding debt to lengthen maturity profiles.
  - Colombia and Mexico increased reliance on domestic debt to reduce currency mismatches.
- Investor base:
  - Strategic long-term investment in emerging markets, notably from pension funds, increased significantly and was on track in 2005 to exceed amounts invested the prior year.

### Market conditions, correlations, and risk sensitivity
- External financing remained accommodative during the recent Fed tightening cycle, but historically tight spreads increase exposure to global factors.
- In early October, emerging market debt spreads showed a stronger positive correlation with mature markets as U.S. inflationary expectations and growth uncertainty rose; flows into the asset class then turned positive and external debt spreads began to tighten again.
- Improvements in fundamentals and more resilient debt structures may reduce probability of systemic contagion crises, though individual countries with poorer fundamentals may be vulnerable to withdrawal of global liquidity and a rise in risk aversion.

### Asset performance: equities and local-currency debt
- Equities:
  - Emerging equity markets outperformed developed markets through the year: U.S. markets were flat on the year; European markets rose less than 5 percent.
  - Each major emerging market region (East Asia, Latin America, Emerging Europe and the Middle East) registered double-digit or near double-digit gains (measured in dollar terms).
  - Evidence suggests emerging equity returns became more independent from the U.S. market: the proportion of returns correlated with the U.S. market declined while the uncorrelated share rose.
- Local-currency debt:
  - Latin America: high nominal returns, stable or appreciating currencies versus the dollar, and easing policy rates produced very strong bond returns.
  - Emerging Europe: depreciation of local currencies against the dollar and rising local rates kept returns negative.

### Issuance, amortization, and financing coverage — selected statistics
- Table and chart highlights (figures preserved as stated):
  - Gross issuance by asset (year-to-date): 322.0 (In billions of U.S. dollars).
  - Net issuance by asset (year-to-date): 233.9 (In billions of U.S. dollars).
- Selected secondary market sequences from Table 1:
  - EMBI Global spread (bps): 735 728 725 403 347 414 482 409 347 382 373 235 281 235 242 230.
  - Merrill Lynch High Yield spread (bps): 890 795 871 418 310 438 404 384 310 352 385 354 366 354 361 372.
  - U.S. 10 yr. Treasury Yield (yield in %): 5.12 5.05 3.82 4.25 4.22 3.84 4.58 4.12 4.22 4.60 4.48 3.92 4.33 4.02 4.33 4.55.
- Table 2 sovereign external issuance estimates (selected totals):
  - Total Planned (US$ mn): 60,475; Actual (US$ mn): 52,123; Remaining (US$ mn): 8,352; Actual to Planned (percent): 86%.
  - Asia: Planned 7,600; Actual 7,642; Remaining (42); Actual to Planned 101%.
  - Emerging Europe: Planned 26,400; Actual 23,625; Remaining 2,775; Actual to Planned 89%.
  - Latin America: Planned 16,875; Actual 17,226; Remaining (351); Actual to Planned 102%.
  - Middle East & Africa: Planned 9,600; Actual 3,631; Remaining 5,969; Actual to Planned 38%.
  - Country examples:
    - Brazil: Planned 6,000; Actual 6,198; Remaining (198); Actual to Planned 103%.
    - Mexico: Planned 2,000; Actual 2,000; Remaining -; Actual to Planned 100%.
    - Turkey: Planned 6,000; Actual 5,576; Remaining 424; Actual to Planned 93%.
    - Venezuela: Planned 3,000; Actual 3,000; Remaining (0); Actual to Planned 100%.
    - Vietnam: Planned 250; Actual 750; Remaining (500); Actual to Planned 300%.
- Table 2 notes:
  - Issuance data are as of end-October, 2005, close-of-business London. Secondary markets data are as of November 25, 2005, close-of-business New York.
  - JPMorgan data used with permission; totals reflect JPMorgan Chase & Co. compilation.

*Financial Market Update, International Capital Markets Department, Global Markets Analysis Division; data as of November 25, 2005.*

### Section 1

### Financial Market Update — Section 1

### Overview and market backdrop
- The Financial Market Update covers developments through November 25, 2005, and updates financial market developments since the September 2005 Global Financial Stability Report.
- Since September 2005, financial conditions in mature and emerging markets remained favorable, supported by expectations for sustained and broadening global growth, still abundant liquidity, and a continuing investor search for yield.
- Key risks flagged despite benign conditions:
  - A turn in the interest rate and credit cycle could lead to distress for specific companies, with possible amplification through credit derivative markets (including CDOs).
  - Mortgage markets (sub-prime) are vulnerable as monetary tightening slows the U.S. housing market and riskier mortgage lending has proliferated.
  - Structural imbalances—particularly reliance on large foreign inflows to finance the U.S. current account deficit—could trigger or amplify a systemic repricing of risk (assessed as low probability at present).
  - Some emerging market countries with high debt stocks and high fiscal and/or current account deficits remain exposed if global liquidity is withdrawn.

### Energy market volatility and inflation dynamics
- Energy prices rose to an all-time high above $70/bbl (WTI) in late August 2005; oil prices subsequently fell, fully retracing the rise that began in mid-July 2005.
- Market participants expect oil prices to stay high, as reflected in speculative positioning and futures prices.
- Policymakers signaled a firm monetary policy stance in response to higher “headline” inflation figures; market participants generally viewed higher energy prices as a tax on growth rather than an accelerant for inflation.
- The gap between headline and core inflation rates widened in 2005 in both the United States and the euro area, increasing concerns about pass-through to other sectors.
- Inflation expectations:
  - Market-derived expectations rose since the summer of 2005 but remained below levels seen earlier in the year.
  - Longer-term bond yields stayed low while short ends of yield curves rose, producing a marked flattening of yield curves in the United States and, to a lesser extent, in the euro area.

### Monetary policy expectations across mature markets
- United States:
  - Investors increased expectations for the end point of Fed tightening to 4.75 percent in the first half of 2006.
  - Short-term rates rose; the U.S. dollar appreciation since August 2005 was supported by U.S. growth and interest rate differentials.
- Euro area:
  - The ECB raised its policy rate by 0.25 percent to 2.25 percent.
  - Market expectations were for rates to reach about 3 percent by end-2006.
- Japan:
  - Markets began to anticipate the end of the zero interest rate policy as deflation was expected to recede next year.

### Corporate profitability, credit cycle, and credit derivatives
- Corporate earnings:
  - Earnings estimates for the S&P 500 were on track for a 15.9 percent year-on-year increase in the third quarter of 2005.
  - Japanese company earnings expected to rise at double-digit rates; European earnings expected to rise at a slightly slower pace.
  - Corporate balance sheets globally improved due to robust profitability.
- Corporate credit cycle turning:
  - Federal Reserve survey (October 2005) showed a rising proportion of banks tightening lending criteria for business loans.
  - The ratio of credit ratings upgrades to downgrades dropped to its lowest in two years in Q3 2005.
  - Corporations increased balance sheet leverage via share buybacks, higher average dividends in U.S. and Japanese firms, and higher merger and acquisition activity (including leveraged buyouts).
  - The corporate funding gap rose in the United States, Europe, and Japan, moving from a recent surplus position.
- Credit derivatives:
  - Recent idiosyncratic credit events (including bankruptcies such as Delphi) caused losses in credit derivatives markets and on some CDO instruments, forcing portfolio liquidations and causing liquidity disturbances.
  - Credit derivatives have so far shown flexibility and resilience and help spread credit risk, but simultaneous idiosyncratic shocks could cause substantial corrections amplified by liquidity strains.

### U.S. dollar appreciation and capital flows
- The U.S. dollar appreciated since August 2005, supported by growth and interest rate differentials favoring the United States and robust investment inflows.
- Important sources of demand for U.S. dollar assets:
  - Foreign private purchases of U.S. fixed-income instruments rose steadily in 2005.
  - Asian central banks continued investment flows into U.S. markets in 2005, with the Pacific Rim region accumulating reserves amounting to $210 billion in the first three quarters of 2005.
  - Oil exporter windfalls from higher oil prices were estimated at about $20 billion in additional surpluses accumulating each month in 2005; data suggest much of the surplus may be accumulating in offshore dollar bank deposits.
  - Repatriation of corporate profits accelerated following the Homeland Investment Act (HIA); estimates of earnings to be repatriated ranged from $350 billion to $500 billion (exchange-rate and location effects make the foreign exchange impact difficult to estimate).

### Mortgage markets and sub-prime concerns
- U.S. housing market:
  - Monetary tightening was slowing the U.S. housing market by late 2005: homebuilder optimism fell to its lowest level in 18 months in November 2005, and some large builders forecast declining sales.
  - Benchmark mortgage rates rose to their highest levels since June 2004.
- Mortgage quality and securitization:
  - Lenders developed innovative mortgage terms to preserve access for marginal borrowers; the average credit quality of mortgages declined.
  - Low-quality mortgages (defined as nonagency subprime and alt-A mortgages) increased as a share of total originations in 2005 (estimated).
  - Regulators warned of risks to borrowers and cautioned lenders; regulatory influence over nonbank mortgage originators and securitizers is limited.
  - Subprime mortgages had experienced an unusually low default rate so far, but could become more risky as home prices cool and interest rates rise further.
  - Securitization has dispersed mortgage risks to a wider range of investors, cushioning the impact of moderate house price softening on financial markets.
  - However, potential price corrections in new and complex mortgage-related products (low-quality MBS, synthetic ABS, and CDOs) could be severe, especially if liquidity disturbances occur; the ability of CDOs to absorb deterioration in the riskiest mortgage segments had yet to be tested.

### Emerging markets: resilience and remaining vulnerabilities
- Emerging market bond spreads tightened to record low levels on improving fundamentals and the search for yield through November 25, 2005.
- Supportive factors:
  - Sovereign external financing needs were virtually covered for 2005 and prefinancing was well advanced for 2006.
  - Active debt management improved debt structures.
  - Ongoing secular demand for emerging market external and local currency bonds continued to support the asset class.
- Remaining vulnerabilities:
  - Some emerging market countries still had high debt stocks and high fiscal and/or current account deficits and therefore could be exposed to a repricing of risk as global liquidity is withdrawn.

*Financial Market Update, International Capital Markets Department, Global Markets Analysis Division; data as of November 25, 2005.*

### Section 2

### Section 2

### Emerging market resilience and fundamentals
- Emerging market external bond spreads fell to all-time lows despite rising U.S. short-term rates.
- Improvements in fundamentals since 2002 have significantly reduced public debt-to-GDP ratios through strong economic growth, appreciating currencies, and, in many cases, strong primary fiscal surpluses.
- External financing requirements for emerging market sovereigns and corporates have continued to decline as commodity prices rise and global growth boosts remittances from overseas workers.
- Some emerging market countries remain vulnerable to increased risk aversion, especially those with high debt ratios and weak current account or fiscal positions.

### Debt management actions and investor base
- Several emerging market sovereigns in Latin America implemented active debt management operations that reduced debt-related vulnerabilities:
  - Brazil issued its first local-currency global bond, alleviating concerns about the currency composition of its debt.
  - Mexico bought back $1.4 billion of external bonds and launched warrants offering investors the right to receive peso-denominated bonds in exchange for dollar-denominated bonds in one year.
  - Panama and Peru exchanged outstanding debt to lengthen maturity profiles.
  - Colombia and Mexico increased reliance on domestic debt to reduce currency mismatches.
- Strategic long-term investment in emerging markets, notably from pension funds, has increased significantly and was on track in 2005 to exceed amounts invested the prior year.

### Market conditions, correlations, and risk sensitivity
- External financing conditions remained remarkably accommodative during the recent Fed tightening cycle, but historically tight spreads increase exposure to global factors.
- In early October (year not restated in the extract), emerging market debt spreads showed a stronger positive correlation with mature markets as U.S. inflationary expectations and growth uncertainty rose; subsequently, flows into the asset class turned positive and emerging market external debt spreads began to tighten again.
- Improvements in fundamentals and more resilient debt structures may reduce the probability of systemic contagion crises, though individual countries with poorer fundamentals may be vulnerable to withdrawal of global liquidity and a rise in risk aversion.

### Asset performance: equities and local-currency debt
- Emerging equity markets outperformed developed markets through the year:
  - U.S. markets were flat on the year; European markets rose less than 5 percent.
  - Each major emerging market region (East Asia, Latin America, Emerging Europe and the Middle East) registered double-digit or near double-digit gains (all measured in dollar terms).
- Evidence suggests emerging equity returns have become more independent from the U.S. market: the proportion of returns correlated with the U.S. market declined while the uncorrelated share rose.
- Local-currency debt returns were mixed:
  - Latin America: high nominal returns, stable or appreciating currencies versus the dollar, and easing policy rates produced very strong bond returns.
  - Emerging Europe: depreciation of local currencies against the dollar and rising local rates kept returns negative.

### Issuance, amortization, and financing coverage (selected statistics)
- Sovereign external financing needs were virtually covered for 2005 and prefinancing was well advanced for 2006; sovereigns in Latin America were estimated to have already met more than three quarters of their 2006 external debt financing needs.
- Cumulative gross annual issuance of bonds data indicate active issuance across 2002–2005 (figures depicted in charts but not restated here beyond chart annotations).
- Table 1 summary figures (as presented):
  - Gross issuance by asset (year-to-date): 322.0 (In billions of U.S. dollars) [table header shows year-to-date 322.0].
  - Net issuance by asset (year-to-date): 233.9 (In billions of U.S. dollars) [table header shows 233.9].
- Secondary markets (selected spreads and yields from Table 1):
  - EMBI Global spread (bps): sequence includes 735 728 725 403 347 414 482 409 347 382 373 235 281 235 242 230 (as listed).
  - Merrill Lynch High Yield spread (bps): sequence includes 890 795 871 418 310 438 404 384 310 352 385 354 366 354 361 372.
  - U.S. 10 yr. Treasury Yield (yield in %): 5.12 5.05 3.82 4.25 4.22 3.84 4.58 4.12 4.22 4.60 4.48 3.92 4.33 4.02 4.33 4.55.
  - Equity indices (selected cumulative returns shown in table): DOW, NASDAQ, MSCI Emerging Market Free, Asia, Latin America, EMEA (sequences of quarterly/period returns provided in the table).
- Table 2 sovereign external issuance estimates (selected country and regional totals):
  - Total Planned (US$ mn): 60,475; Actual (US$ mn): 52,123; Remaining (US$ mn): 8,352; Actual to Planned (percent): 86%.
  - Asia: Planned 7,600; Actual 7,642; Remaining (42); Actual to Planned 101%.
  - Emerging Europe: Planned 26,400; Actual 23,625; Remaining 2,775; Actual to Planned 89%.
  - Latin America: Planned 16,875; Actual 17,226; Remaining (351); Actual to Planned 102%.
  - Middle East & Africa: Planned 9,600; Actual 3,631; Remaining 5,969; Actual to Planned 38%.
  - Regional and country-level entries include many specific planned and actual figures (e.g., Brazil Planned 6,000 Actual 6,198 Remaining (198) Actual to Planned 103%; Mexico Planned 2,000 Actual 2,000 Remaining - Actual to Planned 100%; Turkey Planned 6,000 Actual 5,576 Remaining 424 Actual to Planned 93%; Venezuela Planned 3,000 Actual 3,000 Remaining (0) Actual to Planned 100%; Vietnam Planned 250 Actual 750 Remaining (500) Actual to Planned 300%) as listed in Table 2.
- Table 2 notes:
  - Issuance data are as of end-October, 2005, close-of-business London. Secondary markets data are as of November 25, 2005, close-of-business New York.
  - JPMorgan data used with permission; totals reflect JPMorgan Chase & Co. compilation.

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_Source: https://www.imf.org/-/media/files/publications/fmu/1205.pdf_