Brazil Update

The current account has continued to weaken but strong capital inflows have helped support the currency. The size of the deficit is just shy of USD$20 billion while portfolio inflows are approximately USD$ 35 billion! The capital account remains strong and well diversified. Much like other emerging market countries, Brazil is affected by the demand for commodities both locally and abroad. There are some signs that commodity prices may have peaked. This has been a key driver of the rapid improvement in the country over the past several years. High export prices have continued to support economic fundamentals. Although the commodity cycle may show signs of decelerating, this will impact emerging market countries differently. Latin America as a whole will continue to see growth in excess of 5%. Brazil should continue to see strong economic performance as continued demand for raw materials, especially from China, will drive growth. Higher productivity gains should help keep GDP growth in the 5% range. Inflation in Brazil is running above 6% putting the central bank in a tightening mode. High resource utilization and labor force participation could put pressure on wage inflation going forward.

Expect to see at least another 175 bp of tightening by monetary authorities. Hopefully, this will see inflation reduced to 5% or less during 2009. However, with interest rates of 13% currently in place, and the possibility of 15% by year end, don't expect to see the exchange rate move any higher than the mid 1.60's.

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Issuer: IADB      10.75% cpn       02/07/2011       @ 11.00% YTM Moody's rating: Aaa       S&P rating: AAA

South Africa

Monetary tightening undertaken by the South African Reserve Board did not derail economic performance in the second quarter of this year. GDP growth surprised to the upside at a 4.9% rate. However, this will probably be unsustainable as the full effect of the earlier, tighter monetary policy will cap higher growth. Manufacturing and mining remain positive overall while wholesale and retail sectors have been soft and expect to remain so through the end of the year. The full year GDP growth is expected to reach about 3.5%; an attractive rate but weak next to the 5.1% level recorded last year. There are several factors that need to be monitored in the near term. Inflation continues to be a focus for the central bank. The consensus view is that we have seen the peak in rates and the next move should see the start of the easing cycle. CPI inflation is forecast to be below 6.0% by the 3rd qtr of 2009. The end of the tightening cycle should cause the yield curve to invert. That is an important sign for investors to be long bonds. The likely outcome is for the bond market to outperform.

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 National Treasury announced on August 11th that the government of South Africa would guarantee the outstanding debt of Eskom, the utility giant, and its newly issued debt as well. Moody's rates the South African government A2 which is 3 notches above Eskom's Baa2. The government guarantee would restore Eskom paper to quasi government status. However, the ability of domestic funds to absorb all of the planned issuance of Eskom could “crowd out” other public sector issuers. This may potentially constrain the appetite for Eskom paper.

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 has 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.

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Issuer: ASIA       10.50% cpn       08/18/2010       @ 10.20% YTM Moody's rating: Aaa       S&P rating: AAA

Turkey

Turkey's ruling party, AKP, was elected by a large margin in July 2007. The platform was viewed as very business friendly and focused on continued strong economic performance. This was short-lived as the losing party filed a lawsuit in March 2008 accusing the AKP of violating Turkey's separation of “church and state” and called for the government to be dissolved. The long awaited business friendly policy implementation was placed on a back seat as the legal wrangling handcuffed the current government. The decision whether to dissolve the current government was not expected until the end of September. The Supreme Court, recognizing the impact of a continued delay, decided earlier this month to dismiss the lawsuit. The impact of the decision was not un-noticed by the foreign exchange markets as the currency moved from 1.285 TRY to 1.21 TRY within a few trading sessions. The outlook for Turkey has improved sharply following the closure of the AKP case. Strong investor demand for the currency has been one of the surprises in emerging markets this year. This has helped to reduce headline inflation that was trending to 9.2% earlier this year. The central bank had to temporarily shift from an easing cycle to a tightening bias in monetary policy. It appears that inflation has peaked, bringing the central bank focus back to rate cutting. Although it is too early to see a change in policy, we believe that the government will look to start cutting aggressively in 2009. Productivity gains will continue to help offset inflation pressures while export and tourist performance will help stabilize the current account.

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.

Investor long positions in Turkish assets should be supportive of the currency. Continue to buy on dips and look to the mid-sector – longer term bonds as they will see a more significant rally in the absence of reduced political noise. Look to a year end FX rate of 1.10 TRY.

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Issuer: EIB       12.00% cpn       02/10/2010       @ 16.40% YTM Moody's rating: Aaa       S & P rating: AAA

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 be a focal point for the central bank. The recent price increases in food and energy have pushed the core inflation rate over 10%, well outside the target rate sought by the government. The Deputy Governor of the central bank stated that the country could live with a GDP growth rate of 6.00% (deemed as low by typical growth measures) but not with the CPI at or above 10%. Strong domestic demand will offset any reduction in exports as the economy is proving more resilient than forecast. Second qtr. GDP grew at 5.4% which translates to an annualized 6.4% growth rate although this is expected to moderate for the remainder of the year. Since economic growth is in the range targeted by the central bank, there will likely be a stronger focus on slowing inflation. The current head of the central bank used a combination of tighter credit and currency appreciation in 2003 to control inflation. Slowing the growth of money is a rare policy move for the Bank of Indonesia which is decidedly expansionary as a rule. This action, together with FX appreciation, will be the key management tools used going forward. Historically, currency appreciation has had a dramatic influence on inflation expectations.

Investors who have rupiah denominated paper will probably see more rate hikes to 10% by mid 2009; that should be currency supportive. Appreciation of the rupiah would help to combat inflation pressures and reduce the negative income effect to households. Previously, the central bank indicated that it preferred a trading range of 9000-9500 for the USD/IDR. We believe that continued foreign investment flows will see the rupiah stay within this band or tighter through year end.

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Issuer: KFW       7.50% cpn       07/17/2012       @ 9.20% YTM Moody's rating: Aaa       S & P rating: AAA

Russia

Russian GDP growth reached 8.5% through the first quarter of 2008 and recent data point to a 7.5% rate for 2008. Economic activity has remained strong and will continue above growth potential (6.50%) adding to inflationary pressures. Although some data suggest a slowing down in the momentum of the economy, commodity prices would have to fall significantly before starting to have any impact on the Russian outlook. Consumer demand has so far been very firm with strong wage growth and falling unemployment levels. However, this will continue to fuel inflation to above 13% for the balance of the year. Surprisingly, the government is planning on additional wage increases for 2009! The Central Bank of Russia has no choice but to continue to increase interest rates and increase reserve requirements as it moves away from an exchange rate target. Don't be shocked to see rate hikes of 100 points or more in the first few months of 2009. Previous rate hikes have not had much impact without currency appreciation. The ruble will be under longer term pressure to strengthen more than previously allowed. How far can the currency appreciate? Well, a rough metric to use for Russia, according to the central bank is:

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

Theoretically, you would need substantial currency appreciation to eliminate inflation. This is new territory for Russian central bankers. We 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. One of the main sources of inflation has been very high food prices. However, good harvests have been reported sending seasonal fruit and vegetable prices lower. Additional high crop yields for the rest of the year should start to decelerate inflationary pressures.

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.

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Issuer: IBRD       6.75% cpn       05/27/2011       @ 6.75% YTM Moody's rating: Aaa       S & P rating: AAA