Brazil Update

The upgrade of Brasil to investment grade took place when no-one was looking. Obligations of the country are now rated as BBB- by Standard & Poors. Although largely expected, the higher rating was not due until the end of the year. The markets reacted as expected with an immediate run-up in the Brasilian Stock Exchange of 6%! The Brasil currency followed the lead of the Stock Exchange appreciating over 3% on the day. These price advances naturally bring to mind the question of how much more appreciation is left. The higher rating has many positive implications for investors. Here are several reasons why you should look to increase your Brasil exposure.

1) There will be a large increase in liquidity in Brasil as foreign funds can now invest in Brasilian companies (previously prevented from investing in below investment grade assets)

2) We expect to see a sharp rise in the profitability of Brasilian companies as the cost of money decreases

3) An investment grade rating by two agencies will result in more investment flows into Brasil; another agency upgrade is widely anticipated

The reduction in country risk spread, as measured in the swap market, will be reflected by a significant fall in the long end of the interest rate curve. This will act as a support for further appreciation of the currency. Additionally, the central bank has indicated their intention for continued rate hikes. This is a clear signal of a country in charge of managing expanding economic growth. It is also a clear signal to purchase more Brasil assets.

South Africa

Market fundamentals remain positive overall. There are several factors that need to be monitored in the near term. Inflation continues to be a problem for the central bank with rates touching the 12% level. The two culprits in the inflation problem have been energy and food prices. The South African Reserve Board (SARB) responded by hiking rates last month 50 basis points to 12%. This rise in interest rates has provided some support to the rand. There has been a massive rally in the currency this past week as well as South African bonds having tightened by at least 10 basis points.

The outlook for metals prices remains quite strong. The South African metals industry should see continued strong demand growth as supply constraints are surfacing globally. Gold, platinum and coal have been adding to the GDP levels.

The implementation of higher electricity tariffs has not been fully priced in the performance of the economy. There has been a delay in the amount of increase that ESKOM, the energy provider for South Africa, can pass through to municipalities. Also, some confusion over the classification of who is excluded from the full tariff increase has further clouded the potential impact on the economy.

The country has been able to fund its current account deficit with portfolio investment. The pressures of inflation may reduce those flows although investor appetite for the bonds and currency over the past week surprised the market. Additional support for the bonds comes from the government agency overseeing pension investment for a large percentage of South African workers, as well as all government employees. The current value of the fund is approximately ZAR 200 billion. A large part portion of the monies are allocated to South African sovereign debt issues. This has provided strong price support which should continue into the future.

Turkey

Global financial markets have been focused on worldwide credit conditions over the last several months. The sub-prime fallout and potential economic contraction have been the main concern for investors in developed countries. Emerging markets, however, are experiencing higher growth rates as commodity prices remain at elevated levels. This has also fueled inflation growth which local governments are combating with rate hikes. Turkey is an interesting example of a country with increased inflation taking second place to political concerns.

The current government has been the focus of an attempt by the opposition party, which lost last year's election, to have the current ruling party declared non-compliant with the country's constitution. Most observers believe that the approach taken by the current government promises the highest chance of success and limited market volatility. However, political risk has been the main concern of investors. This has caused the currency to trade off recently and remain in a choppy trade range. Recent signals from the current government have analysts believing that the worst case has passed.

The government is moving forward with talks to join the European Union as well as their receipt of IMF funds. The Turkish economy has benefited from structural reforms put in place by the current government. Social security reform was a tremendous victory for the government that was passed through parliament despite opposition from BOTH parties. This was the final step the IMF required as a condition to receive approximately $4 billion. They are also moving forward with European Union talks to amend various sections of their judicial system.

The central bank is expected to raise interest rates as a counter to inflation. It is likely that there will be several 50 basis point rate hikes during the rest of the year. Although this is a departure from the previous central bank position, higher food and energy prices as well as the weaker lira gives the government room to adjust rates. Investor long positions in Turkish assets should be supportive of the currency. Continue to buy on dips and look to the mid-sector bonds as they would see a more significant rally with reduced political noise.

Indonesia

The Republic of Indonesia remains one of our relative value plays in our International investing portfolio. The inflation wild card is a key driver for investors looking to realize currency gains in the rupiah. Similar to other countries in the region, the inflation rate in Indonesia continues to move higher. The recent price increases in food and energy have pushed the core inflation rate over 8%, well outside the 4-6% target rate sought by the government. Strong consumer spending and consumption as well as continued investment inflows have pushed growth rates above 6% during 2007.

The first quarter of this year has returned a growth rate of 6.3% fueled by the high price of commodities. This is the double-edged sword of an expansionary fiscal policy; growth that acts as the fuel for inflation. Given this risk, the government has tipped their hand with their recent interest rate hike. Bank Indonesia unexpectedly moved its policy meeting forward and then raised rates 25 basis points yesterday. This is an about face from the 25 bp rate cut last December clearly indicating a shift in policy.

Investors who have rupiah denominated paper will probably see several more rate hikes that should be currency supportive. Appreciation of the rupiah would help to combat inflation pressures. Previously, the central bank indicated that it preferred a trading range of 9000-9500 for the USD/IDR. However, the recent change in policy by the Bank of Indonesia suggests that a stronger rupiah is not an unwelcome trend going forward.

Russia: DATELINE MOSCOW

Dimitry Medvedev will be sworn in as the president of Russia this week. However, his first official act has been decided before taking office. The oil and gas exporting giant has been fighting an uphill battle against inflation. It is widely believed that Medvedev will allow the central bank to let the Russian currency, the ruble, appreciate in the world market. Russia uses a currency basket to set their exchange rate. The basket is divided among the USD (55%) and the EURO (45%). During 2007, the central bank allowed the currency to appreciate 1.3% for the year. That was then and today is a different economic reality.

Russia is the world's biggest energy exporter. The economy has grown about 7.00% per year since Vladimir Putin, the former president, took office in 2000. At that time, oil was about $24 a barrel compared to about $120 per barrel today! This has resulted in surging growth accompanied by growing inflation. The last time the central bank allowed the currency to appreciate, last August, inflation was about 8.00%. Today, the inflation rate is closer to 14%. And this, despite 2 interest rate increases this year. Since interest rate increases haven't worked, currency appreciation is their next option.

How far can the currency appreciate? Well, a rough metric to use for Russia, according to the central bank is :

1 percentage point increase in the ruble against the currency basket cuts inflation by 0.3 percentage point.

Theoretically, you would need more than a 20% currency appreciation to eliminate inflation. This is new territory for Russian central bankers. I don't know if they are eager to see their currency rise at the expense of higher prices for their exports. However, there is no escaping the fact that they are limited in their options to control inflation.

Investors should take advantage of this opportunity and add ruble denominated investments to their portfolio. Supranational issuers like KFW, European Bank of Reconstruction & Development, Swedish Export Bank and others have bond issues in the Russian ruble. They are an excellent way of avoiding credit risk while participating in the potential gains from currency appreciation.