Emerging market financial assets, which have been among the best performing asset class over the past few years, continue to trade at lofty levels. They do so despite a stream of negative political news coming out of many emerging market countries that is all too reminiscent of the dark days of the mid-1990s. They also do so despite ever increasing signs of a US-led global economic slowdown and the consequent meltdown in prices of internationally traded commodities, which are still the very lifeblood of many emerging market economies.

Resident Fellow Desmond Lachman

The list of recent disturbing political news coming out of the emerging markets is impressive. Among the more eye-catching is a military coup in Thailand, the assassination of a deputy central bank governor in Russia, the fall of a government in Poland, the admission by a Hungarian Prime Minister that his government had consistently lied about the country's public finances, and the President of Ecuador publicly debating whether or not his country should default on its external debt.

To make matters worse, a whole series of recent elections in Latin America has revealed the public's growing impatience with the orthodox policies to which their governments had hewed, while in Eastern Europe many countries seem to be losing the will to comply with the requirements of joining the European Union. These developments pose the risk of undermining the great strides that many of the Latin American and East European countries have made over the past four years to strengthen their public finances and to reduce their external vulnerabilities.

The emerging market's deteriorating political outlook is coinciding with ever-increasing signs that we are coming to the end of the unusually strong global economic recovery that buoyed the emerging market economies over the past three years. The most immediate threat to the global recovery is the present unwinding in the US housing bubble. Over the past five years, unusually low interest rates have fueled an unprecedented 70 percent real increase in US housing prices. It has to be a disturbing portent for the global economy that US house prices are now actually declining on a year-over-year basis, while the inventories of unsold homes soars to record levels.

The prospective further bursting of the US housing bubble is hardly the only cloud presently hanging over the global economic recovery. Rather, that recovery could be adversely impacted by a disorderly unwinding of the historically large US payment imbalance that could lead to a rout of the US dollar. It could also be derailed by rising protectionist pressures against China, which doggedly insists on maintaining a grossly undervalued currency in an effort to keep its export machine humming.

The likelihood that the world economy might be headed for a significant slowdown is already reflected in a very strong rally in global bond markets. It is also reflected in a rather abrupt decline in commodity prices from the very high levels that they reached last May. Indeed, international oil prices have declined from a peak of US$78 a barrel in May to their present level of around US$60 a barrel, while over the same period, non-oil commodity prices, as measured by the CRB index, have declined by over 20 percent.

There would appear to be two possible explanations why emerging market financial assets are holding in so well despite the deteriorating political situation and despite the gathering storm clouds in the global economy. The more benign explanation is that emerging market economies are now in a very much stronger economic position than they have ever been before. This is thanks to their steady implementation of structural reforms and the pursuit of orthodox macro-economic policies over the last few years. With the notable exceptions of countries like Hungary and Turkey, most emerging markets presently have relatively strong public finances and small external borrowing needs.

The more troubling explanation of the relative strength in emerging market assets at a time of adverse political development is that financial markets in general are not pricing risk appropriately. In an environment of still ample global liquidity, markets continue to pursue yield and in that pursuit turn a blind eye to the risks underlying the assets that they are buying. This pursuit of yield is reflected in the tight levels of the high-yield market and the buoyancy of the equity markets. It is also strikingly reflected in relatively narrow credit spreads on troubled East European countries as well as in the appreciated levels of currencies like that of New Zealand, whose high interest rates deflect attention from the gaping deficit in its balance of payments.

Bitter experience would suggest that emerging market policymakers would be making a grave error in premising their economic policies on the assumption that the extremely benign external environment of the past few years will indefinitely persist. We already have abundant signs of the risk of a significant US economic slowdown while the unwinding of speculative commodity positions appears to be in full train. If those trends persist, one has to expect a very much greater degree of discrimination in the markets than at present between countries with sound and countries with shaky underlying political and economic fundamentals.

Desmond Lachman is a resident fellow at AEI.