Iceland Rhetoric Heating Up

A reader was kind enough to pass along the following commentary about the latest goings on with Iceland. Below that is my emailed response to the reader (subsequently proofread).

Cracks in Emerging Markets

Our Comment is by Eric Roseman, Investment Director of the Sovereign Society and editor of Global Mutual Fund Investor.

Dear A-Letter Reader:

"This time it's different." Those are the most dangerous four words in the investment business and always manage to surface towards the end of a secular bull market. Most recently, it was "supposed to be different" for technology stocks in the late 1990s, circumventing reality as prices soared to record levels each year from 1995 to 2000. And now, we have those wonderful emerging markets - only ten years ago coined "submerging markets."

From its low in October 2002, the MSCI Emerging Markets Index has skyrocketed 205% as every bourse from Brazil to Korea heads to the moon. Driven mostly by low interest rates, a boom in commodities and a series of credit upgrades for several high profile countries, the emerging markets are back. The bad news, however, is that we're probably closer to the cliff at this point as record mutual fund inflows suggest the end is near. Coupled with manic speculation in many markets, namely Moscow and Mumbai, everyone is jumping aboard the money train.

Cracks in the bull market have started to appear. On Feb. 22, Iceland's currency and debt markets suffered a first-class pounding following a credit downgrade by Fitch Ratings. The rating agency downgraded Iceland's local AAA-rated bonds to "negative" from "stable." Iceland's stock market managed to escape the sell off, but should investors continue to dump her currency, stocks in Reykjavik will most surely follow the currency to the basement.

Iceland, a classic example of a high-yield emerging market, has drawn much global fanfare over the last four years as investors chase higher income rates. Iceland's benchmark bonds pay a fat 10.75% or a hefty 6.2% premium compared to ten-year US Treasury debt. But in Iceland, a small economy highly dependent on fishing, the nature of the beast is now volatility.

A rising current account deficit triggered this week's sell-off of the Icelandic krona. Though many nations can run a negative trade balance for years - the United States is a prime example; some smaller countries have paid a dear price for not correcting their trade imbalances. This was the case in Asia in 1997 and 1998, Latin America in the 1970s and early 1980s, and Russia in 1994 and 1998.

This time, it's different. When everyone is buying the same market, speculating in the same trend and throwing record amounts of capital into an asset class, watch-out. Iceland is just the beginning as other weaker credits eventually come to surface.

ERIC N. ROSEMAN, Montreal, Quebec
Investment Director, The Sovereign Society Ltd.

Thanks for the email. I am not familiar with Mr. Roseman but he has some facts incorrect. Iceland's benchmark bonds do not yield 10.75%, far from it, the overnight rate is 10.75%. Fitch did not downgrade any debt, they changed the outlook from stable to negative, the outlook. The currency may have "suffered a first class pounding" but it has retraced about 40% of what was lost. USDISK was at 63 or so, went to 69 and is now in the mid 66's. The current account deficit did not trigger the selloff, it was Fitch lowering the outlook. A day or two after it lowered the outlook, it reaffirmed ratings for the four largest Icelandic banks.

All that being said, Iceland could have a rough go for a while but inflation has only been running in the 4's and the last report showed a slowdown from that level. GDP is likely to slow in 2007. I'm not too worried about catastrophic overheating. Some sort of correction may come to take the currency and stock market down and keep them down for a while but for now I am not dissuaded from the theme, as my holdings are small and I sold New Zealand which has a lot of similarities.

In addition to my emailed response I would repeat what I have written before which is that Iceland makes up a small portion of my holdings. If I am dead wrong here and the krona collapses and the stock market collapses, I will be disappointed. I will not have to delay retirement. Even if Iceland as an investment destination has no interest to you, the management of the risk taken should.

Some of the commentary floating out there talks about this being the end of the emerging market theme. That is not so obvious to me, but it could add more volatility than what is normal. I think the commodity based emerging markets would be less vulnerable because there is a real demand story behind those countries' growth. This contrasts with some of the emerging markets that are hot just because of growth expectations. Here I am thinking of places like eastern Europe (ex-Russia) and a lot of the technology dependent economies in Asia.