The third emerging markets sector exchange-traded funds launched on Wednesday, this time adding top stocks from a composite index of 10 sectors spanning 15 countries.

The name of the new ETF is a mouthful – the Emerging Global Shares Dow Jones Emerging Markets Titans Composite Index Fund (NYSE Arca: EEG).  Its sponsor is Emerging Global Advisors, which is responsible for coming to market in May with the first sector-focused emerging markets ETFs so far.

Those are: the Emerging Global Shares Dow Jones Emerging Markets Energy Fund (NYSE Arca: EEO); and the Emerging Global Shares Dow Jones Emerging Markets Metals & Mining Titans Index Fund (NYSE Arca: EMT).  You can read more about those ETFs here.

EEG is designed to track the Dow Jones Emerging Markets Titans Composite Index. That benchmark includes the 100 top names by market capitalization sizes in major sectors across the developing marketplace. The sector weightings are modified in that no one name can have more than a 10% exposure in the fund.

The ETF will charge an annual expense ratio of 0.75%.

EEG differs in both its geographical complexion as well as its sector exposures in several subtle, yet possibly significant ways, from broader-based emerging markets ETFs.  For example, take the iShares MSCI Emerging Markets Index (NYSE: EEM). It has roughly the same in financials (23.89%) as EEG’s benchmark had at the end of the second quarter (22.35%).

But financials are the second-biggest sector in EEG, whereas it’s No. 1 in EEM. Oil and gas was the Dow Jones index’s largest sector weighting at slightly more than 29% (again, through June).  EEM has less than 16% in energy right now.

“Since we don’t include Taiwan, Korea and Israel – we don’t consider them emerging markets – our fund will have a little bit more exposure to the BRICs. That means we’ll have less in areas like telecom and a little more in resource-related sectors,” said Richard Kang, EGA’s research director.

Kang and the firm’s chief executive, Bob Holderith, discussed in detail how a composite sector emerging markets ETF might work – along with the company’s other plans to launch 10-plus related sector ETFs – in this Q&A story which ran at IndexUniverse.com in June.)

Entering the third quarter, the underlying benchmark for EEG had the following country makeup:

• China Offshore: 20.43%

• Brazil: 20.29%

• India : 18.15%

• Russia: 14.24%

• Mexico: 10.07%

• South Africa: 8.30%

• Chile: 2.74%

• Malaysia: 1.85%

• Indonesia: 1.53%

• Kuwait: 1.04%

The fund’s sector weightings of its underlying benchmark showed the following breakdown:

• Oil & Gas: 29.02%

• Financials: 22.35%

• Basic Materials: 11.36%

• Telecommunications: 10.70%

• Industrials: 5.55%

• Consumer Goods: 5.20%

• Technology: 4.93%

• Consumer Services: 4.80%

• Utilities: 4.25%

• Health Care: 1.84%

Right now, in the wake of MSCI’s reclassification of Israel as a developed market, I’m working on a rundown of the country classifications of four major index providers: MSCI, Dow Jones, FTSE and Standard & Poor’s.

The evolution of emerging markets (and sometimes devolution of developed markets—see Greece, which could lose developed-market status in the FTSE indexes) is just particularly fascinating to me. Take some of the frontier/emerging markets that the index providers cover at the very bottom rungs of the investability ladder: Latvia? Slovakia? Trinidad & Tobago? Mauritius?

Frankly, I’m dying to know what the investment stories are behind these tiny, tiny markets. And while I believe frontier markets (like, say, Vietnam) offer some awesome investment opportunities, is anyone really itching to sink some funds into an obscure eastern European country that probably has a smaller population than the number of visitors to my local mall on the day after Christmas?

I realize there are different rules and methodologies that each of the index providers use, but it all seems rather mysterious. For example, Dow Jones—which generally uses the International Monetary Fund’s designations—classifies Slovenia as a developed market, while MSCI has it labeled as a frontier market. That’s quite a disparity.

Lately, the majority of the focus has been on Israel and South Korea, though, and whether they will transition to developed-market status within the various classification systems. MSCI, of course, just promoted Israel to developed status last week, while keeping Korea in the emerging category. Given that the majority of internationally invested funds are benchmarked to MSCI indexes (at least in the U.S.), this issue has been followed fairly closely by investors. At the end of March, Israel was the ninth-largest country in the MSCI Emerging Markets Index, with a 4.0% weighting, and South Korea was the fourth-largest, with a 12.4% weighting.

Given the amount of money benchmarked to that index and the even greater amount benchmarked to the MSCI EAFE Index, which Israel now joins, that’s an awful lot of funds shifting around. South Korea is up for reconsideration in 2010 (as is Taiwan, another country straddling the emerging/developed divide).

But MSCI seems to be on the tail end of the trend: Dow Jones, S&P and FTSE all classify South Korea as a developed market, while only Dow Jones and FTSE put Israel into the developed bucket. S&P still has Israel as emerging. Of course, FTSE, S&P and Dow Jones have a lot fewer funds tracking or measured against their global indexes.

They can shift their country classifications with relative ease, as they deem appropriate, without a lot of reverberation. But if MSCI decides to promote a country to developed status, many, many billions of dollars are going to be moving around, with all sorts of economic consequences.

And not all of them will be positive: In Israel, there is concern that the country moving from relatively big-dog status in the emerging markets index to a minor position in the developed markets index will actually result in outflows from the local stock market.

(Read an article on the latest MSCI moves here. Also of interest might be a Bloomberg article on the subject here, and another article from an Israeli publication about a Deutsche Bank study on the potential negative impacts of the switch.)

Teva Pharmaceutical, Israel’s largest company, saw its price spike in June shortly before the official MSCI announcement, but there’s no telling what the longer-term effects will be. It will be interesting to see what happens with that, and even more interesting to compare the outcomes with what happens when South Korea—and its big stock, Samsung Electronics—is finally promoted to developed status.

Yeah, that was definitely the unrepentant nerd talking …

Consequently and although I am lukewarm about the idea of green shoots and second derivatives, I am more positive about the narrative presented by BlackRock Inc's Bob Doll when he points to the potential in emerging markets;

Emerging-market stocks may gain an average of 20 percent this year as they rebound faster and stronger than their peers in developed countries, said Bob Doll, vice chairman and chief investment officer for BlackRock Inc. The global economy has probably seen its worst in the past two quarters, with developing nations already starting to emerge from the recession, Doll told reporters in Singapore today.

“If in fact we have seen a bottom in markets and economies are going to recover, the emerging parts of the world will recover the most and the fastest,” Doll said. “After all, their recessions were largely unwanted inventory build-up and not the credit bust in the Western world.” The MSCI Emerging Markets Index has already gained 25 percent this year, with developing countries making up all 10 of the world’s best performers. That’s outpaced the 2.3 percent retreat in the Standard & Poor’s 500 Index.

Now, when it comes to the actual headline number presented, I would assume, for the media I won't venture an opinion. However, the general idea that emerging markets such as India, Brazil and Turkey are among those economies where growth conditions are, relatively, most favorable I am very much in agreement with. Clearly, this is not going to be one way street and as we learned from parsing the data from e.g. Mexico and Argentina it indicate how the swine flu may just have tipped over the economy in the case of the former whereas the latter also looks set to enter an actual recession. However, there are positive signs too, not least in the context of India which Edward recently put under the loop and concluded that conditions might just favor India to rise well above the rest of its peers. After looking at the data myself and from reading this, I am very much inclined to agree. So yes, I do think that emerging markets are going to fly; some of it will be based on real fundamentals and some of it will be the carry trade since in a world where some of the biggest central banks are commited to low nominal interest rates the environment for carry trades are perfect if and when volatility stays down. Just witness Deutche Bank's recommendation that investors sell Euros to buy into the Ruble and Forint (who are these people?!). Astute investors will thus always remember the story of Icarus, but the underlying current is still important here.

Apart from this I want to emphasise two points.

First I think that the points above underpin the general idea that whatever global economy which will emerge in the wake of the current crisis, it will one in which the sources of global demand, yield, and capacity will be more diverse than before. This is of course the positive spin to the fundamental question of who and where global demand will come in the future, not least to satisfy the excess savings which will emerge as more economies become dependent on exports to grow.

Secondly, I want to touch briefly on a related topic which has been dominating the debate on an on-off basis lately. Specifically, I am talking about the prospect of the Chinese Yuan as the future global reserve currency (surpassing the USD) which was given new life recently in the form of a NYT op-ed by Nouriel Roubini in which the (self)-proclaimed economic oracle predicts that we are now entering an Asian century with China as the dominating the economic power. Stefan Karlsson also moves in to steal some of Mr. Roubini's thunder dryly noting that the idea of the Yuan as global reserve currency is not new as he himself predicted it four years ago. Finally, there is Jeffrey Sachs (hat tip: Mark Thoma) who also muses on the prospect of a more diversified global monetary system with the Yuan in a dominant role. 

It is always customary to begin with the points you agree with and let me be very clear here. The days of unilaterally sponsored demand by the US and the subsequent role of the USD is over. There is just no way in which the US can rise to command the same role in the global economy as it did before the subprime crisis hailed the initial fall from grace. However, the idea that China alone will rise from the ashes of this crisis to take over from the US is a fallacy. 

In essence and all the technical issues aside of whether China will choose to issue debt denominated in RMB, whether the focus of trade credits and transactions in general will move towards a favor of RMB etc, any one candidate for reserve currency status would clearly need an open capital account and almost surely, in the present context, the stomach to run a current account deficit. So let us chew on this a bit. If China become the sole economy to "take over" from the US it would mean that China should run a rather substantial external deficit. 

Basically, there are many aspects of being a reserve currency but one surely is the ability to be a net debtor nation. It goes with the territory I would say and especially in whatever "new" global edifice we will be looking at. I think this is what Roubini is missing even if his other points of a more structural and institutional nature are true; clearly China is a force to be reckoned with, but then notice this;

China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth.

You can almost smell the carry trade and yield here. There sure looks to be a healthy cake to chew on here, but the thing is that the astute commenters above are not thinking about the fact that within the next decades China will age at an unprecedented speed (perhaps even faster than Japan!). Now, I am not sure whether or not this demographics stuff has trickled down yet but in this context it is important. Clearly, there will be growth in China and she will ascend to command a larger role, but if she opens the capital account we will have the world's biggest firework and a huge version of Latvia. I am  sorry, but if you don't factor in the demographics here you are getting nowhere.

Consequently, I think that Bretton Woods III is a lame duck in so far as it is made up of one currency to take over the USD; there is just no ONE economy out able to shoulder the load. This is what has changed now, the US (or Anglo-Saxons if you will) cannot carry us anymore. Rather I imagine that it will be a basket and although China will be an important part of that basket we also need to look at India, Brazil, Turkey, Chile and a number of other economies. If the discourse solidifies towards China as the economy to single handedly pull the global economy and stage a process of rebalancing it won't be pretty once markets start to factor in the demographic fundamentals in China.

David Kreinces is a portfolio manager with ETF Portfolio Management. Before founding the Newbury Park, Calif.-based firm in 2007, he was a portfolio manager in Merrill Lynch's global private client group, specializing in absolute return strategies using exchange-traded funds.

Kreinces is one of a growing number of independent portfolio advisers offering all-ETF portfolios that implement hedging strategies.To find out more about his unique quantitative-based methodology, IndexUniverse.com's Managing Editor Murray Coleman recently caught up with him at ETF Portfolio Management's southern California headquarters.

IU.com: How do you implement ETFs in absolute return strategies?

Kreinces: Our strategies are built around quantitative, rules-based models. And they don't use leverage at all. That's an important point. By not using leverage, we feel like our ability to limit volatility and control portfolio risk is greatly enhanced. But this has been an unusual period. In the past 18 months, we've had record activity in terms of shifting positions. During this time, it has been rare for us to hold funds for more than a few weeks at a time. But this isn't designed as a short-term trading strategy.

IU.com: What's your fee structure for your various strategies?

Kreinces: Our core passive portfolios have no advisory fees. We offer three of these. One follows the basic recommendations for an all-ETF portfolio created by David Swensen, the manager of Yale University's endowment program. It basically follows the strategy described in his book, "Unconventional Success."

The second passive core portfolio is designed for novice investors and takes a more basic approach to diversification. A third passive portfolio takes a more diversified approach by not discriminating as much against emerging markets and commodities. Again, all three are passively managed buy-and-hold strategies using ETFs where our clients don't pay advisory fees.

IU.com: How do you make money then?

Kreinces: We make money because most clients, after seeing the results of our absolute return strategies, put at least a portion of their assets into those portfolios. After 2008, when the buy-and-hold strategy hit a pothole, about 90% of our client assets have moved into absolute return strategies.

IU.com: How much do you charge for those strategies?

Kreinces: Last year, we charged 50 basis points for our global growth model and 100 basis points for our long-short strategy and aggressive growth strategy. This year, they're all charging 200 basis points. That's because all of the strategies outperformed strongly in 2008. And we don't charge a performance fee.

IU.com: Can you provide a recent example of how you achieve positive returns in a down market?

Kreinces: Our global growth model in 2008 went into cash and stayed in cash for a large part of the year. When the model moved into equities, it was very selective about which ETFs it picked. Probably the broadly diversified ETFs we traded most often last year were the iShares MSCI Emerging Markets Index (NYSE: EEM), the iShares Russell 2000 Value Index (NYSE: IWN) and the iShares MidCap 400 Index (NYSE: IJH).

IU.com: What are you doing this year?

Kreinces: The global growth model is a long-only strategy. This year, it's long in large-cap growth. And what is driving that part of the market is technology. We use ETFs such as the PowerShares QQQ (Nasdaq: QQQQ) to capture large-growth with a tilt towards technology. We're also investing in emerging markets through EEM and the Vanguard Emerging Markets ETF (NYSE: VWO). But we continue to be very greatly invested in cash in the diversified global growth strategy.

IU.com: What are you doing in your aggressive growth strategy?

Kreinces: It's also a long-only absolute return strategy and rotates between sectors. Right now, it still has about a third of total assets in cash. In this model, we do have the ability to use more broad ETFs when the environment calls for it. That's the case now. We're using EEM with a heavy weighting on Brazil through the iShares MSCI Brazil Index (NYSE: EWZ). In this portfolio, we've also traded the Internet HOLDRS (NYSE: HHH). We don't hold them now, but our theme currently is to emphasize emerging markets and technology. We've traded SPDR Gold Shares (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV) in this model as well. But we don't hold either of those right now.

IU.com: What about your long-short portfolio?

Kreinces: It invests in concentrated countries and sectors as well as commodities. It also has the capacity to step back and go into broader ETFs. This model can go 100% long or 100% short. Right now, it's 100% long. We're not holding any individual commodity ETFs right now, preferring to gain that exposure through Brazil and other emerging markets that are strongly influenced by natural resources.

IU.com: What has made you turn so bullish in that strategy?

Kreinces: When the market is trending upward as strongly as it has been, we try to capture as much of that as possible. So our long-short model hasn't been in cash during the past five weeks. We're very much trying to listen to what the market is telling us. The nature of our long-short model—along with the other models—is that it doesn't try to outguess markets. We're clearly in an uptrend and that pattern hasn't broken enough to send us back to cash yet.

IU.com: You also have an overlay for your models based on your own views, don't you?

Kreinces: Yes, but that overlay is implemented only when markets are at extreme levels. Right now, our more subjective judgments are being used to override our objective, rules-based quantitative processes only to a very limited degree.

IU.com: Why is that?

Kreinces: Our goal is to follow our rules-based methodology as much as possible. But when the markets shock our models, we don't want to get whipsawed around—that's expensive. So part of our risk controls are to allow for some sort of logical override to prevent severe losses of capital. We've got limitations on our threshold for pain. If our models aren't able to keep risks within a certain range, then we'll step in. Lately, we've been overriding the models in our core alpha strategy to try to stay out of the markets.

IU.com: How defensive are you in those types of composite portfolios?

Kreinces: Right now, we're about 85% long in our core alpha model, which equal-weights the other three strategies into a single, blended portfolio. The effort to fight the current rally reflects the fact that we were down in the mid-single digits in the first quarter in the core alpha strategy. That's a big drawdown for us. So as markets started rallying, we've participated in a very conservative fashion. The core alpha strategy is down slightly for the year. So we've eaten away at the drawdown, which is giving us a progressively bigger risk appetite.

David Kreinces is a portfolio manager with ETF Portfolio Management. Before founding the Newbury Park, Calif.-based firm in 2007, he was a portfolio manager in Merrill Lynch's global private client group, specializing in absolute return strategies using exchange-traded funds.

Kreinces is one of a growing number of independent portfolio advisers offering all-ETF portfolios that implement hedging strategies.To find out more about his unique quantitative-based methodology, IndexUniverse.com's Managing Editor Murray Coleman recently caught up with him at ETF Portfolio Management's southern California headquarters.

IU.com: How do you implement ETFs in absolute return strategies?

Kreinces: Our strategies are built around quantitative, rules-based models. And they don't use leverage at all. That's an important point. By not using leverage, we feel like our ability to limit volatility and control portfolio risk is greatly enhanced. But this has been an unusual period. In the past 18 months, we've had record activity in terms of shifting positions. During this time, it has been rare for us to hold funds for more than a few weeks at a time. But this isn't designed as a short-term trading strategy.

IU.com: What's your fee structure for your various strategies?

Kreinces: Our core passive portfolios have no advisory fees. We offer three of these. One follows the basic recommendations for an all-ETF portfolio created by David Swensen, the manager of Yale University's endowment program. It basically follows the strategy described in his book, "Unconventional Success."

The second passive core portfolio is designed for novice investors and takes a more basic approach to diversification. A third passive portfolio takes a more diversified approach by not discriminating as much against emerging markets and commodities. Again, all three are passively managed buy-and-hold strategies using ETFs where our clients don't pay advisory fees.

IU.com: How do you make money then?

Kreinces: We make money because most clients, after seeing the results of our absolute return strategies, put at least a portion of their assets into those portfolios. After 2008, when the buy-and-hold strategy hit a pothole, about 90% of our client assets have moved into absolute return strategies.

IU.com: How much do you charge for those strategies?

Kreinces: Last year, we charged 50 basis points for our global growth model and 100 basis points for our long-short strategy and aggressive growth strategy. This year, they're all charging 200 basis points. That's because all of the strategies outperformed strongly in 2008. And we don't charge a performance fee.

IU.com: Can you provide a recent example of how you achieve positive returns in a down market?

Kreinces: Our global growth model in 2008 went into cash and stayed in cash for a large part of the year. When the model moved into equities, it was very selective about which ETFs it picked. Probably the broadly diversified ETFs we traded most often last year were the iShares MSCI Emerging Markets Index (NYSE: EEM), the iShares Russell 2000 Value Index (NYSE: IWN) and the iShares MidCap 400 Index (NYSE: IJH).

IU.com: What are you doing this year?

Kreinces: The global growth model is a long-only strategy. This year, it's long in large-cap growth. And what is driving that part of the market is technology. We use ETFs such as the PowerShares QQQ (Nasdaq: QQQQ) to capture large-growth with a tilt towards technology. We're also investing in emerging markets through EEM and the Vanguard Emerging Markets ETF (NYSE: VWO). But we continue to be very greatly invested in cash in the diversified global growth strategy.

IU.com: What are you doing in your aggressive growth strategy?

Kreinces: It's also a long-only absolute return strategy and rotates between sectors. Right now, it still has about a third of total assets in cash. In this model, we do have the ability to use more broad ETFs when the environment calls for it. That's the case now. We're using EEM with a heavy weighting on Brazil through the iShares MSCI Brazil Index (NYSE: EWZ). In this portfolio, we've also traded the Internet HOLDRS (NYSE: HHH). We don't hold them now, but our theme currently is to emphasize emerging markets and technology. We've traded SPDR Gold Shares (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV) in this model as well. But we don't hold either of those right now.

IU.com: What about your long-short portfolio?

Kreinces: It invests in concentrated countries and sectors as well as commodities. It also has the capacity to step back and go into broader ETFs. This model can go 100% long or 100% short. Right now, it's 100% long. We're not holding any individual commodity ETFs right now, preferring to gain that exposure through Brazil and other emerging markets that are strongly influenced by natural resources.

IU.com: What has made you turn so bullish in that strategy?

Kreinces: When the market is trending upward as strongly as it has been, we try to capture as much of that as possible. So our long-short model hasn't been in cash during the past five weeks. We're very much trying to listen to what the market is telling us. The nature of our long-short model—along with the other models—is that it doesn't try to outguess markets. We're clearly in an uptrend and that pattern hasn't broken enough to send us back to cash yet.

IU.com: You also have an overlay for your models based on your own views, don't you?

Kreinces: Yes, but that overlay is implemented only when markets are at extreme levels. Right now, our more subjective judgments are being used to override our objective, rules-based quantitative processes only to a very limited degree.

IU.com: Why is that?

Kreinces: Our goal is to follow our rules-based methodology as much as possible. But when the markets shock our models, we don't want to get whipsawed around—that's expensive. So part of our risk controls are to allow for some sort of logical override to prevent severe losses of capital. We've got limitations on our threshold for pain. If our models aren't able to keep risks within a certain range, then we'll step in. Lately, we've been overriding the models in our core alpha strategy to try to stay out of the markets.

IU.com: How defensive are you in those types of composite portfolios?

Kreinces: Right now, we're about 85% long in our core alpha model, which equal-weights the other three strategies into a single, blended portfolio. The effort to fight the current rally reflects the fact that we were down in the mid-single digits in the first quarter in the core alpha strategy. That's a big drawdown for us. So as markets started rallying, we've participated in a very conservative fashion. The core alpha strategy is down slightly for the year. So we've eaten away at the drawdown, which is giving us a progressively bigger risk appetite.

The fund, which aims to synthetically replicate the performance of hedge fund strategies, launched yesterday on NYSE Arca. Judging by early trading volume, the new fund is going to be a hit: QAI looks like it will trade more than 100,000 shares today, an impressive performance for just its second day on the market.

The idea of providing access to hedge fund-like returns through an ETF is hugely attractive. The best investors in the world---endowments like Harvard and Yale---hold enormous investments in hedge funds for a reason: They deliver returns with low correlations to the broader market. If QAI can make those returns available to all investors in a low-cost wrapper, it'll be big news.

As I said yesterday on CNBC, however, the proof will be in the pudding: Can QAI actually deliver on its promises?

It's important to understand that this ETF doesn't actually invest in hedge funds; rather, it uses factor-based analysis to determine the performance characteristics of hedge funds in general, and then builds a portfolio (using other ETFs) that it thinks will replicate that performance.

Over the past few days, a lot of people have told me that this idea sounds crazy. I disagree. Too many people have a near-mythical conception of hedge funds; they think they are run by high-paid geniuses who make either spectacular or spectacularly bad investments. The truth is more mundane: While some hedge funds ARE run by geniuses, most are run by normal guys who use pretty standard strategies to generate a certain kind of return. They do a reasonable job, and are paid absurdly well to do it.

The idea of synthetically replicating that performance at lower costs is well-established both in academia and the real world. Both Goldman Sachs, and IndexIQ itself, for example, have been running synthetic hedge fund mutual funds since last summer. Generally speaking, they've done pretty well: The Goldman Sachs fund is down about 15% since July 2008, while the IndexIQ fund is down about 12%; that compares to the S&P 500, which is down about 38%. That's a good relative performance. Most hedge funds are down over that span too, in line with the synthetic products.

The question now is whether these funds will be able to perform well as the market recovers. Although both funds have well-documented methodologies, they are nonetheless largely black box strategies; the concept behind the funds make sense, but you have to have faith that the quant-engine driving them is going to work.

One advantage of the new ETF is that you can watch the holdings on a daily basis and see for yourself if they make sense. As of yesterday's close, here's what QAI was holding:

If you drill down, the portfolio is fairly simple. The fund's positions include:

• 72.79% fixed income, including

            o 32.73% in broad-based bond indexes

            o 27.71% in short-term Treasuries            

            o 10.54% in junk bonds            

            o 1.81% in TIPS

• 13.33% in emerging market stocks, the only long equity position
• 9.47% in commodities and currencies
• 4.41% in various inverse funds

That's a fairly defensive portfolio. The question is, how will this portfolio perform if the market recovers? How will it adapt and change over time?

It's worth watching.

Jim Herrell considers himself a nontraditional index investor.

The chief investment officer at Partnervest Financial Group says his contrarian investing strategies take a more proactive approach to exchange-traded funds.

"We view volatility as an asset class unto itself that's negatively correlated with equity indexes," said Herrell.

The Santa Barbara, Calif.-based Partnervest manages portfolios for advisors across the country. It's part of a growing number of asset managers acting as outsourcers to independent planning firms.

Demand for such specialists is growing rapidly, according to industry statistics, as other aspects of financial planning—such as estate, health care and tax issues—are becoming more complex.

Partnervest was founded nearly seven years ago by ex-executives of a large asset manager based in Scottsdale, Ariz., that focused on serving high net worth clients and institutions in the health care industry. Herrell is a former longtime hedge fund manager.

Efficiency In An Inefficient World

"We believe markets are efficient, but traditional asset-class investing is inefficient," he said. "We're investing with the goal of achieving high absolute returns independent of the market's direction."

Before joining Partnervest last July, Herrell was a manager at Santa Barbara Quantitative Strategies for about five years. He was also a partner at Strome Investment Management, a global macro-hedge fund.

Herrell, age 42, started using ETFs with his hedging strategies in 2003. "Not only are they more flexible and transparent than mutual funds," he said, "but many ETFs have listed options."

That's important since some of the most sophisticated hedging approaches utilized by Partnervest rely heavily on options.

"Structured targeted-return strategies that used to be the purview of hedge funds and big institutions have been democratized by the rise of ETFs," said Herrell. "Now, almost any investor can access strategies similar to those used by Harvard and Yale and other large institutions in an all-ETF format."

An approach that simply invests in long positions with ETFs is just too risky in his view. "One bad year's worth of volatility can destroy several years' worth of accumulated returns," said Herrell. "No matter how you slice and dice it, traditional asset class investing provides way too much risk for the amount of return it can provide."

Partnervest's managers say they don't try to predict market movements. "The only predictive element in our strategy is that volatility is a constant," said Herrell.  "And our portfolios are built to take advantage of that uncertainty."

The firm employs a mix of strategies using ETFs. The simplest tries to maximize alpha. For example, the firm uses the SPDR S&P 500 (NYSE: SPY). Herrell says the ETF is added into the mix with the expectation that its underlying index will show long-term volatility of at least 20% a year.

In the firm's alpha strategy, that range is split in half to target 10% price movements in any given six-month period. "Instead of buying SPY, we structure an options call spread on the ETF at current prices," said Herrell.

The process involves taking advantage of gains made from initial strike prices on those option calls. (A strike price is simply the point at which an investor is going to start making profits. If SPY is selling for $85 per share, for example, and someone buys a call option on the ETF at that level, then an investor makes money on any price gains.)

"It's like leasing an ETF for a certain period," said Herrell.

While it still provides upside participation, using call spreads reduces downside risk, he says, "because you're risking fewer dollars since the cost of the options is much less than buying the ETF itself."

Herrell adds that even in a worst-case scenario, "the most you can lose is the cost of the spread" using such a strategy.

The firm also sells short-dated options. In terms of buying activity, Herrell sticks to purchasing only longer-dated options.

Self-Funding Approach 

"Even if the market doesn't go anywhere, the shorter-term options expire, and you'll make at least a little money," said Herrell. "The net result is that as time passes, this sort of time-decay pays for the upside participation. So it's a self-funding approach which limits your downside but participates in a market advance."

The other aspect of his portfolio strategy actually involves purchasing shares of ETFs outright. Currently, besides owning SPY, some of Partnervest's portfolios include: iShares Russell 2000 Index (NYSE Arca: IWM); iShares MSCI EAFE Index (NYSE: EFA); iShares MSCI Emerging Markets Index (NYSE: EEM) and iShares Dow Jones U.S. Real Estate (NYSE: IYR).

Owning actual shares of the ETFs is part of his Volatility Enhanced Global Appreciation strategy, or VEGA. In such a portfolio, Herrell will also sell call options on a portion of those ETFs to lock in returns.

"We're swapping a potential return for a fixed return," he said.

Partnervest has developed algorithms and built its own quantitative modeling system for constructing portfolios along those lines.

"It tells us how much of an ETF to buy and when to buy and sell options and at what prices," said Herrell. "Rather than guess, we have the model that dynamically adjusts to changing market conditions based on historical volatility patterns and returns."

-- This article was submitted by IU.com's Murray Coleman.

George Hoguet is a global investment senior strategist specializing in emerging markets at State Street Global Advisors. Prior to joining the firm in 1998, he worked in London and Boston with Baring Asset Management. Hoguet has also worked at the Frank Russell Co., where he consulted with large institutional investors.

IU: What do the major emerging market indexes show about volatility levels now?

Hoguet: Emerging markets have been and will continue to be much more volatile than developed markets. However, if you look at emerging markets in a portfolio, a modest allocation amount can help reduce overall risks since they're not perfectly correlated with developed markets.

IU: Do you think emerging markets noncorrelation qualities will return?

Hoguet: In the intermediate term—over the next five years or so—correlations are likely to increase. In the very long term, China will become less correlated, as will much of the rest of emerging markets. In about eight or nine years, China should surpass Japan as the second-largest economy in the world.

IU: Then for long-term-oriented investors, you're still bullish on emerging markets?

Hoguet: Investors should have a strategic allocation to emerging markets, which represent about 9% of the world's float-adjusted equity capitalization. Currently, emerging markets face substantial headwinds. But the MSCI Emerging Markets Index has significantly outperformed the MSCI World Index over the past seven years. And for the 18 years ending Aug. 30, 2008, the MSCI Emerging Markets Index had outperformed the S&P 500 by more than 76 basis points per year.

IU: Over longer periods, hasn't the U.S. in particular outperformed?

Hoguet: That's true if you go back to the turn of the 20^th century, because of the disruption of World War I and World War II. Also, the confiscation of assets by communist regimes meant that people lost everything and stock markets were closed in some countries. The point is, when you talk about the U.S. having above-average returns, that relates to the fact that in the 20^th century, we've never had a period where assets were confiscated on a large scale and markets were closed indefinitely.

IU: Then how do you measure the U.S. stock market versus the world?

Hoguet: There are a lot of methodology issues such as survivorship bias. Many companies have gone bankrupt. But what you can say is that the U.S. has been characterized by a relatively high degree of political, economic and social stability.

IU: As an investable theme, what does this mean?

Hoguet: The reason the U.S. represents roughly 45% of the world's market capitalization and emerging markets about 9% is precisely because of the political and economic risks involved in emerging markets. So the question with investing in emerging markets is whether that risk is being properly priced. And the question is over the long term, how much should emerging markets outperform developed markets?

IU: What are some of the short-term negatives?

Hoguet: Those would include the reality of a global recession. They'd also include increased financing costs and credit contraction in global markets. Investors are still deleveraging across the world and are much more risk-averse these days. Commodity prices are declining and, in some cases, countries are facing prospects for continued currency weakness. Then there's the contagion factor, which means a sell-off in one market could lead to a sell-off in other markets.

IU: Don't all markets face these same problems in varying degrees?

Hoguet: Yes, but it's a very broad dispersion. Some countries are much more dependent on commodities and natural resources, for example. China, with its large foreign exchange reserves, is in a better relative position than a country like Turkey. It runs a substantial current accounts deficit and its corporations are major borrowers on external markets. So if they can't obtain financing or if so, on unfavorable terms, they could face rollover risk. But those are just two examples. It can vary from country to country a lot.

IU: So you think correlations tightening between emerging and developed markets is a short-term occurrence?

Hoguet: I wouldn't put it that way. There are two trends at work. The first is a secular, long-term trend which is based on the fact that in general, investors are holding more diversified portfolios. That's reducing home biases, and emerging market companies are becoming more integrated into the world. The second factor is cyclical. We're seeing a deleveraging take place and a shock in the U.S. that led to a significant drop in the U.S. stock market last year. Investors have been lowering their risks and selling emerging markets. In the current environment, these two factors have led to increased correlations.

What I'm trying to suggest is that in the very long term, as China becomes the second-largest economy in the world, global business cycles won't be as synchronized. Right now, we've got a synchronized slowdown in markets across the world. That's forcing correlations to become much tighter.

IU: This year, what trends do you see?

Hoguet: The returns are extremely tied to progress in the world economies. For emerging markets to rally on a sustained basis, investors need to see significant progress towards normalization in credit markets. Right now, we're still on a downward path, as growth continues to disappoint. Investors will have to also see a reduction in volatility.

IU: How can individual investors monitor those factors?

Hoguet: What they should look at is volatility in developed equity markets, which likely will have to fall before anything happens in emerging markets. The consensus is that the U.S. economy will start to recover by the third quarter of 2009. But risks are to the downside. And there's a question mark to the path this year of the Chinese economy.

IU: What challenges does China face in coming quarters?

Hoguet: The question is how much growth will slow in China and how much its exports to the U.S. and the rest of the world will be offset by domestic demand. Chinese GDP growth below 6% would signal a sharp enough slowdown to further reduce the world's rate of growth. My feeling is that by the end of the year, emerging markets are likely to finish higher. My reasoning is that credit markets will have stabilized and improved enough to support growth and that the world economy will no longer be on a downward path.

Bogle: Play Through The Recession

Vanguard founder John Bogle is the subject of a Q&A with the Associated Press. Nothing really new here except that the story's headline plays up the fact that the indexing pioneer seems to think that the recession could last 18 months to two years before things get better.

But the gist of the icon's comments is basically to play through the downturn, no matter how long it lasts. Bogle actually makes a pretty good argument for using such downdrafts to buy shares of the indexes you like at lower costs. Smart investors can wind up benefitting in the long run from such periods if they remain disciplined and focused, according to Bogle.

Have you ever read anything you didn't like from this guy? Check out the article here.

PIMCO A Key Player In Bailout Plan For Automakers?

General Motors may ask unsecured debt holders Franklin Resources Inc. and PIMCO Advisors LP to accept as much as two-thirds less than the face value of their bonds as the automaker cuts debt in a bid to win U.S. government aid, according to Bloomberg News.

Although not directly related, such a hit could push back PIMCO's plans to enter the exchange-traded funds marketplace. It has already altered its first bond ETF from a portfolio tied to an intermediate index to short-term Treasuries.

Speaking on CNBC television, PIMCO's Co-Chief Executive Mohamed El-Erian said Monday that the Fed move "to stabilize the mortgage market last week ... was an important step in that direction," according to a separate Reuters report.

As Congressional hearings resume today on the big three automakers' request for a bailout, PIMCO could end up playing a bigger role than many would've first thought. The Bloomberg report explains that other fund companies with stakes in GM also might have to sign off on its final proposal to lawmakers. You can see the story here.

Top Traded ETFs In November

Richard Widows of TheStreet.com has compiled a list of the 20 ETFs with the highest average daily dollar volume of trading activity in the past month. No surprises here with SPY and QQQ on top. But the ProShares Ultra Short S&P 500 (SDS) moved up a spot to No. 3 from the previous month, knocking the iShares Russell 2000 (IWM) down to No. 4 in November.

Another big mover was the iShares MSCI Emerging Markets Index (EEM), which gained four spots from No. 11 the prior month. The Financial Select Sector SPDR (XLF) and the Energy Select Sector SPDR (XLE) also slipped downward in November. You can see the full results here.

The picture was relatively bright for the performance of the ten-largest exchange-traded funds in November. After the two-month market rout of September and October, even among volatile conditions, seven of the 10 largest ETFs had positive performance in November, according to Morningstar data through Nov. 26. At end of day Friday, the S&P had posted its best week since 1974, so the numbers should improve even a little more once the last day of the month is added, at least for the majority of equit yportfolios among the Top Ten.

Leading the way among equity ETFs was the iShares MSCI Emerging Markets Index (NYSE Arca: EEM), up 12.70% for the month.The Thanksgiving week was also kind to EEM, when the ETF surged 10.24%, through Wednesday the 26th. 

The best performer overall was the SPDR Gold Shares (NYSE Arca: GLD) up 14% for the month as market volatility continued to favor the long-time safe haven asset class.

EEM and GLD were the only ones among theTop Ten ETFs with double-digit performance for the month—at least, double-digit positive performance.

Amid the continued financial stock meltdown, the Financial Select Sector SPDR (NYSE Arca: XLF) was down 11.11% for the month. The situation did improve in the last week of November, however, as Citigroup's agreeing to a bailout plan by the government allowed XLF to gain 18.17% through the first three days of the week.

The only other funds among the Top Ten innegative performance territory for the month were the PowerShares QQQ (NASDAQ: QQQQ) and the iShares Russell 2000 Growth Index, down 0.66% and 1.02%, respectively. IWO, along with XLF, had large one-week gains in the Thanksgiving week. IWO surged 13.08%, only surpassed by XLF's gain of 18.17%.

Even with a healthy helping of positive performance in November, the Top Ten were still showing woeful year-to-date performance.

Here are the year-to-date numbers, through Nov. 26, as well as the rest of the performance picture for the Top Ten ETFs, which controlled more than $200 billion of the industry's $488 billion at the end of October, according to the National Stock Exchange:

Source: National Stock Exchange

Editor's Note: The following is a roundup of articles about ETFs, index funds and indexes by sources other than IndexUniverse.com. Comments and suggestions are welcome through email at: <!-- var prefix = 'ma' + 'il' + 'to'; var path = 'hr' + 'ef' + '='; var addy31849 = 'mcoleman' + '@'; addy31849 = addy31849 + 'indexuniverse' + '.' + 'com'; var addy_text31849 = 'mcoleman' + '@' + 'indexuniverse' + '.' + 'com'; document.write( '' ); document.write( addy_text31849 ); document.write( '' ); //-->mcoleman@indexuniverse.com <!-- document.write( '' ); //-->or <!-- var prefix = 'ma' + 'il' + 'to'; var path = 'hr' + 'ef' + '='; var addy27500 = 'mhougan' + '@'; addy27500 = addy27500 + 'indexuniverse' + '.' + 'com'; var addy_text27500 = 'mhougan' + '@' + 'indexuniverse' + '.' + 'com'; document.write( '' ); document.write( addy_text27500 ); document.write( '' ); //-->mhougan@indexuniverse.com.

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Bad Bets: Illiquid ETFs

Ian Salisbury of Dow Jones Newswires is one of the best fund reporters in the business. In his latest piece appearing in the Wall Street Journal, he takes a survey of 300 recent trades in 10 lightly traded ETFs.

Salisbury writes that it wasn't unusual to find prices off by 5%. In some cases, those spreads were more than 10%. Here's the story's lead: "Exchange-traded funds promise to let investors trade baskets of stocks at predictable prices throughout the day. But some thinly traded ETFs have been falling short of that goal."

At least online, no accompanying chart or graphics detail which 10 ETFs he's comparing. And later, Salisbury writes: "The 10 ETFs selected weren't randomly chosen but represent a sampling of funds that embody this trend. Investors that stick to more established, heavily traded ETFs can expect better results."

You can read the full report here.

Exchanges Slow As Hedge Funds Decline

Whether you're an options fan or not, you might enjoy this original piece of reporting by Bloomberg's Jeff Kearns.

He takes the initiative to crunch some numbers on his own, resulting in a unique perspective of how options exchanges are showing big slowdowns as lots of money sits in cash and other safe havens.

Kearns also ties slowdowns in activity to stats from Hedge Fund Research. That data shows trading at the exchanges dropped as hedge funds were suffering their worst back- to-back monthly declines in September and October. You can catch the story here.

Preferred Stock ETFs

While markets continue to fall, one area that advisors have been talking about lately is preferred stocks. Advisor and newsletter writer Don Dion takes a look at a pair of ETFs focusing on this part of the market—the iShares S&P U.S. Preferred Stock Index Fund (NYSE: PFF) and the PowerShares Financial Preferred (AMEX: PGF).

Not only are both beating the broader market by double-digits this year, each sport yields of better-than 10%, observes Dion. One question looms here, though. Why no mention of PowerShares Preferred (AMEX: PGX)?

You can read his comparison of the two ETFs here.

Plotting ETF Volume Vs. Index Volume

On Barry Ritholtz's The Big Picture blog, there's an interesting short piece with a chart comparing trading activity of ETFs compared to the underlying index.

The author, Michael Panzner, writes: "As the market has sold off since January, exchange-traded fund volumes have outpaced those of the underlying indexes, suggesting that ETFs are increasingly becoming the hedging and speculative mechanisms of choice in the U.S. equity market."

You can read it here.

Emerging Markets Indexes Tumble

Russia's Micex Index fell almost 9% and the MSCI Emerging Markets Index dropped 4.6% on Thursday on fears that slumping oil prices will cripple developing economies around the world, according to Bloomberg News.

As oil slid to $52 a barrel, Russia moved to cut corporate taxes. (Russian indexes have lost the most of any major markets this year). You can read more about yesterday's turmoil in emerging markets here.

Drink Your Coffee First

If you haven't had your morning cup of coffee, this next one probably isn't a good idea to take a gander at just yet.

It's a piece on Seeking Alpha full of doom and gloom preparing investors for Friday's market action. But more than David Fry's analysis, the bottom of the article includes some interesting market data of various indexes.

Drink up! Here you go.

REITs Take Fall

Shocks in commercial REIT markets are rippling through exchange-traded funds, notes David Gaffen in the Wall Street Journal's Marketbeat blog.

Gaffen points to widening spreads in credit default swaps on commercial real estate investment trusts. Such swaps serve as private insurance contracts to protect against corporate bankruptcies or other severe financial problems.

Impacted have been funds such as the SPDR Dow Jones Wilshire REIT ETF (NYSE: RWR). You can read the story here.

Lee Kranefuss, chief executive officer of BGI's iShares business, recently took time to discuss with IndexUniverse's Murray Coleman the future of exchange-traded funds and recent developments relating to the industry's dominant product line.

IU:  Barclays recently renamed the Lehman-based bond indexes to the Barclays Capital moniker. Will the iShares Lehman ETFs change?

Kranefuss:  Barclays Capital completed its acquisition of Lehman Brothers' North American Investment Banking and Capital Markets businesses. As part of the transaction, Lehman Brothers' indices have become part of Barclays Capital. The Lehman indexes are now Barclays Capital indexes. iShares will be renaming those ETFs. It's our practice to include the index provider in the name of the funds; we think that transparency is important for investors. People ought to know which index a fund is following.

IU: BGI's market share as a percentage of assets under management has dropped in 2008 by more than 5% through October. At the same time, State Street Global Advisors and Vanguard have recorded more than 1% gains. What do you attribute this to?

Kranefuss: You've really got to look at these pieces of data over time. SSgA's ETF assets, for instance, are concentrated in a couple of large funds that have huge swings in assets due to a large institutional base and general market sentiment.

Eight out of every $10 dollars in ETFs have flowed into iShares for several years. We built the industry, and that obviously invited competition. One wouldn't expect that sort of concentrated asset gathering to continue. In the long run, we're still the leading ETF provider by far in the U.S. and globally. And competition is a good thing for a new product category. ETFs are a relatively new product to a lot of people. So more assets coming into the industry is good for BGI and everyone else. It validates what we're doing with ETFs and keeps us on our toes.

IU: BGI has 24 ETFs in registration that haven't come out yet. Do you expect most of those to still launch?

Kranefuss:  While I'm very limited in what I can say about funds in registration, we are committed to building out the product line in the U.S. which currently has 178 ETPs. We expect that to include equities and especially fixed income, which only represents about 20% of our lineup right now. We've got lots of room for many new products, particularly in areas of the market that are traditionally more difficult for retail investors to access. ETFs are a huge democratizing force in the marketplace.

IU: The longer-term picture is that bid/ask spreads keep widening for ETFs. Do you see this as a systemic problem?

Kranefuss: The current widening of bid/ask spreads is reflective on the volatile markets. Typically, correlations between the spread for the ETF and the spread of the underlying securities widen by the illiquidity of the underlying markets. So dealers have to make wider spreads on the ETF. That having been said, there are times when an ETF's spread can actually be tighter than on the underlying securities. For example, a few weeks ago the spread on the iShares iBoxx High Yield Corporate Bond Index Fund (NYSE: HGY) was 26 basis points. At the same time, the spread on the underlying basket of bonds was trading at 56 basis points. The spreads on the ETF was much tighter than if investors bought the underlying bonds as individual issues.

IU: You recently launched asset allocation funds. Who is the market for these and how will advisors use them in a portfolio?

Kranefuss: One of our key target markets is advisors. There are some segments of their business that would benefit from an ETF that offers a premixed diversified portfolio targeted to a particular date such as a child's entering college or to a specific risk level. There are numerous other types of examples. These are another set of tools to build out a diversified portfolio. Life cycle funds are gaining increased interest in 401(k) plans and we think that the iShares asset allocation funds are an excellent option for small 401(k) plans that are often advised by financial advisors. Currently ETFs have small penetration into the 401(k) market, so we'll see how the new funds take off.

IU: Are there any plans to lower the expense ratio on the iShares MSCI Emerging Markets Index (NYSE: EEM)?

Kranefuss:  Through time we've lowered expense ratios as warranted. We're always looking for opportunities. Right now, we feel that all of our products are well-priced. You can see by how asset flows are going into funds. Emerging markets are complicated and not easy to operate a fund against in terms of benchmarking. So people have done an assessment and found that EEM is fairly priced. And EEM is a bit more institutional driven. It has been one of our fastest growing funds, even in the current environment.

IU: What do you see as the big trends for ETFs going to be in 2009?

Kranefuss: One big trend is going to be a shakeout in the industry. There are a lot of people who entered the business a year or two ago who don't have sustainable business models. People want to invest with experienced, stable, long-term focused managers.

Another trend will continue to be the growth of ETFs. Mutual funds are losing assets. As people continue to learn the advantages of ETFs - transparency, relatively low costs, and tax-efficiency - they're going to keep moving to ETFs. And as people face end-of-year capital gains possibilities, those advantages are going to become even more apparent.

Lee Kranefuss, chief executive officer of BGI's iShares business, recently took time to discuss with IndexUniverse's Murray Coleman the future of exchange-traded funds and recent developments relating to the industry's dominant product line.

IU:  Barclays recently renamed the Lehman-based bond indexes to the Barclays Capital moniker. Will the iShares Lehman ETFs change?

Kranefuss:  Barclays Capital completed its acquisition of Lehman Brothers' North American Investment Banking and Capital Markets businesses. As part of the transaction, Lehman Brothers' indices have become part of Barclays Capital. The Lehman indexes are now Barclays Capital indexes. iShares will be renaming those ETFs. It's our practice to include the index provider in the name of the funds; we think that transparency is important for investors. People ought to know which index a fund is following.

IU: BGI's market share as a percentage of assets under management has dropped in 2008 by more than 5% through October. At the same time, State Street Global Advisors and Vanguard have recorded more than 1% gains. What do you attribute this to?

Kranefuss: You've really got to look at these pieces of data over time. SSgA's ETF assets, for instance, are concentrated in a couple of large funds that have huge swings in assets due to a large institutional base and general market sentiment.

Eight out of every $10 dollars in ETFs have flowed into iShares for several years. We built the industry, and that obviously invited competition. One wouldn't expect that sort of concentrated asset gathering to continue. In the long run, we're still the leading ETF provider by far in the U.S. and globally. And competition is a good thing for a new product category. ETFs are a relatively new product to a lot of people. So more assets coming into the industry is good for BGI and everyone else. It validates what we're doing with ETFs and keeps us on our toes.

IU: BGI has 24 ETFs in registration that haven't come out yet. Do you expect most of those to still launch?

Kranefuss:  While I'm very limited in what I can say about funds in registration, we are committed to building out the product line in the U.S. which currently has 178 ETPs. We expect that to include equities and especially fixed income, which only represents about 20% of our lineup right now. We've got lots of room for many new products, particularly in areas of the market that are traditionally more difficult for retail investors to access. ETFs are a huge democratizing force in the marketplace.

IU: The longer-term picture is that bid/ask spreads keep widening for ETFs. Do you see this as a systemic problem?

Kranefuss: The current widening of bid/ask spreads is reflective on the volatile markets. Typically, correlations between the spread for the ETF and the spread of the underlying securities widen by the illiquidity of the underlying markets. So dealers have to make wider spreads on the ETF. That having been said, there are times when an ETF's spread can actually be tighter than on the underlying securities. For example, a few weeks ago the spread on the iShares iBoxx High Yield Corporate Bond Index Fund (NYSE: HGY) was 26 basis points. At the same time, the spread on the underlying basket of bonds was trading at 56 basis points. The spreads on the ETF was much tighter than if investors bought the underlying bonds as individual issues.

IU: You recently launched asset allocation funds. Who is the market for these and how will advisors use them in a portfolio?

Kranefuss: One of our key target markets is advisors. There are some segments of their business that would benefit from an ETF that offers a premixed diversified portfolio targeted to a particular date such as a child's entering college or to a specific risk level. There are numerous other types of examples. These are another set of tools to build out a diversified portfolio. Life cycle funds are gaining increased interest in 401(k) plans and we think that the iShares asset allocation funds are an excellent option for small 401(k) plans that are often advised by financial advisors. Currently ETFs have small penetration into the 401(k) market, so we'll see how the new funds take off.

IU: Are there any plans to lower the expense ratio on the iShares MSCI Emerging Markets Index (NYSE: EEM)?

Kranefuss:  Through time we've lowered expense ratios as warranted. We're always looking for opportunities. Right now, we feel that all of our products are well-priced. You can see by how asset flows are going into funds. Emerging markets are complicated and not easy to operate a fund against in terms of benchmarking. So people have done an assessment and found that EEM is fairly priced. And EEM is a bit more institutional driven. It has been one of our fastest growing funds, even in the current environment.

IU: What do you see as the big trends for ETFs going to be in 2009?

Kranefuss: One big trend is going to be a shakeout in the industry. There are a lot of people who entered the business a year or two ago who don't have sustainable business models. People want to invest with experienced, stable, long-term focused managers.

Another trend will continue to be the growth of ETFs. Mutual funds are losing assets. As people continue to learn the advantages of ETFs - transparency, relatively low costs, and tax-efficiency - they're going to keep moving to ETFs. And as people face end-of-year capital gains possibilities, those advantages are going to become even more apparent.

Lee Kranefuss, chief executive officer of BGI's iShares business, recently took time to discuss with IndexUniverse's Murray Coleman the future of exchange-traded funds and recent developments relating to the industry's dominant product line.

IU:  Barclays recently renamed the Lehman-based bond indexes to the Barclays Capital moniker. Will the iShares Lehman ETFs change?

Kranefuss:  Barclays Capital completed its acquisition of Lehman Brothers' North American Investment Banking and Capital Markets businesses. As part of the transaction, Lehman Brothers' indices have become part of Barclays Capital. The Lehman indexes are now Barclays Capital indexes. iShares will be renaming those ETFs. It's our practice to include the index provider in the name of the funds; we think that transparency is important for investors. People ought to know which index a fund is following.

IU: BGI's market share as a percentage of assets under management has dropped in 2008 by more than 5% through October. At the same time, State Street Global Advisors and Vanguard have recorded more than 1% gains. What do you attribute this to?

Kranefuss: You've really got to look at these pieces of data over time. SSgA's ETF assets, for instance, are concentrated in a couple of large funds that have huge swings in assets due to a large institutional base and general market sentiment.

Eight out of every $10 dollars in ETFs have flowed into iShares for several years. We built the industry, and that obviously invited competition. One wouldn't expect that sort of concentrated asset gathering to continue. In the long run, we're still the leading ETF provider by far in the U.S. and globally. And competition is a good thing for a new product category. ETFs are a relatively new product to a lot of people. So more assets coming into the industry is good for BGI and everyone else. It validates what we're doing with ETFs and keeps us on our toes.

IU: BGI has 24 ETFs in registration that haven't come out yet. Do you expect most of those to still launch?

Kranefuss:  While I'm very limited in what I can say about funds in registration, we are committed to building out the product line in the U.S. which currently has 178 ETPs. We expect that to include equities and especially fixed income, which only represents about 20% of our lineup right now. We've got lots of room for many new products, particularly in areas of the market that are traditionally more difficult for retail investors to access. ETFs are a huge democratizing force in the marketplace.

IU: The longer-term picture is that bid/ask spreads keep widening for ETFs. Do you see this as a systemic problem?

Kranefuss: The current widening of bid/ask spreads is reflective on the volatile markets. Typically, correlations between the spread for the ETF and the spread of the underlying securities widen by the illiquidity of the underlying markets. So dealers have to make wider spreads on the ETF. That having been said, there are times when an ETF's spread can actually be tighter than on the underlying securities. For example, a few weeks ago the spread on the iShares iBoxx High Yield Corporate Bond Index Fund (NYSE: HGY) was 26 basis points. At the same time, the spread on the underlying basket of bonds was trading at 56 basis points. The spreads on the ETF was much tighter than if investors bought the underlying bonds as individual issues.

IU: You recently launched asset allocation funds. Who is the market for these and how will advisors use them in a portfolio?

Kranefuss: One of our key target markets is advisors. There are some segments of their business that would benefit from an ETF that offers a premixed diversified portfolio targeted to a particular date such as a child's entering college or to a specific risk level. There are numerous other types of examples. These are another set of tools to build out a diversified portfolio. Life cycle funds are gaining increased interest in 401(k) plans and we think that the iShares asset allocation funds are an excellent option for small 401(k) plans that are often advised by financial advisors. Currently ETFs have small penetration into the 401(k) market, so we'll see how the new funds take off.

IU: Are there any plans to lower the expense ratio on the iShares MSCI Emerging Markets Index (NYSE: EEM)?

Kranefuss:  Through time we've lowered expense ratios as warranted. We're always looking for opportunities. Right now, we feel that all of our products are well-priced. You can see by how asset flows are going into funds. Emerging markets are complicated and not easy to operate a fund against in terms of benchmarking. So people have done an assessment and found that EEM is fairly priced. And EEM is a bit more institutional driven. It has been one of our fastest growing funds, even in the current environment.

IU: What do you see as the big trends for ETFs going to be in 2009?

Kranefuss: One big trend is going to be a shakeout in the industry. There are a lot of people who entered the business a year or two ago who don't have sustainable business models. People want to invest with experienced, stable, long-term focused managers.

Another trend will continue to be the growth of ETFs. Mutual funds are losing assets. As people continue to learn the advantages of ETFs - transparency, relatively low costs, and tax-efficiency - they're going to keep moving to ETFs. And as people face end-of-year capital gains possibilities, those advantages are going to become even more apparent.

The Dow, however, dipped under its October 27 low of 8,176 while the S&P 500 Index was far below its 848.92 low last month.

The CBOE Volatility Index - which measures options traders’ sentiment on the S&P 500 Index - plunged 10% to 59.83. That’s still a highly elevated level with the VIX in record territory since Lehman’s collapse in mid-September. In 2008, the VIX has surged 113% and has…

``We do expect the Indian business cycle to be the first to bottom in Asia. And, it should, in theory, be first to emerge,'' Sharmila Whelan, senior economist at CLSA, said ``The worst will be over by mid-2009 and by 2010 you should be able to see the next investment-led business cycle taking root.''

Ironically, the current global situation is also making India's measured pace of economic reform look wiser than before. At a time when Western countries are frantically nationalising banking assets, the Indian government's reluctance to sell more than 49% in its state-owned banks—which control some 70% of banking assets—now seems reassuring. In addition, India has not yet introduced full capital-account convertibility, which protects its currency, while its careful control of foreign borrowings by domestic companies limits dependence on the global financial system. Regulators have also periodically introduced curbs to slow the formation of potential asset bubbles, such as higher provisioning and prudential requirements on real-estate lending.
The Economist

“For India we have marked our forecast down to 6.3% of 2009 calendar year. That is considerably below what we consider to be India’s potential growth,” IMF deputy director for Asia Pacific region, Kalpana Kochhar said. “There is a specific meaning to “potential” - it is the rate at which you can grow without causing inflation. And for India we estimate that to be 7.5% to 8%. Our forecast of 6.3% would put it quite a bit below the potential,”.

"The outlook for the manufacturing sector appears to be bleaker in the backdrop of tough local and global economic conditions," said ABN AMRO Bank N.V. senior economist Gaurav Kapur.

Output, total new orders and new export orders all contracted at the fastest rates in the survey history in October. With the exception of India, which again bucked the global trend, all of the national manufacturing surveys posted declines in output and new orders. The impact of the downshift in global market conditions also had a far-reaching effect on international trade volumes. Although new export orders fell at a slower rate than total new business, all of the national manufacturing sectors covered by the survey (including India) saw a reduction in new export orders.

"October manufacturing PMI data reinforce the stark retrenchment that the sector is currently facing, with production, total new business and new export orders all falling at record rates. The latest Output Index reading is consistent with a fall in global IP of almost 8%. The only positive from the surveys was a decline in input prices for the first time since August 2003."
David Hensley, Director of Global Economics Coordination at JPMorgan

``The global financial and economic headwinds adversely affected foreign demand for Indian manufactured goods,'' said Gaurav Kapur, an economist at ABN Amro Bank in Mumbai. ``The growth of total incoming new work to the Indian manufacturing economy lost considerable momentum.''

``We do expect the Indian business cycle to be the first to bottom in Asia. And, it should, in theory, be first to emerge,'' Sharmila Whelan, senior economist at CLSA, said ``The worst will be over by mid-2009 and by 2010 you should be able to see the next investment-led business cycle taking root.''

“For India we have marked our forecast down to 6.3% of 2009 calendar year. That is considerably below what we consider to be India’s potential growth,” IMF deputy director for Asia Pacific region, Kalpana Kochhar said. “There is a specific meaning to “potential” - it is the rate at which you can grow without causing inflation. And for India we estimate that to be 7.5% to 8%. Our forecast of 6.3% would put it quite a bit below the potential,”.

"The outlook for the manufacturing sector appears to be bleaker in the backdrop of tough local and global economic conditions," said ABN AMRO Bank N.V. senior economist Gaurav Kapur.

Output, total new orders and new export orders all contracted at the fastest rates in the survey history in October. With the exception of India, which again bucked the global trend, all of the national manufacturing surveys posted declines in output and new orders. The impact of the downshift in global market conditions also had a far-reaching effect on international trade volumes. Although new export orders fell at a slower rate than total new business, all of the national manufacturing sectors covered by the survey (including India) saw a reduction in new export orders.

"October manufacturing PMI data reinforce the stark retrenchment that the sector is currently facing, with production, total new business and new export orders all falling at record rates. The latest Output Index reading is consistent with a fall in global IP of almost 8%. The only positive from the surveys was a decline in input prices for the first time since August 2003."
David Hensley, Director of Global Economics Coordination at JPMorgan

``The global financial and economic headwinds adversely affected foreign demand for Indian manufactured goods,'' said Gaurav Kapur, an economist at ABN Amro Bank in Mumbai. ``The growth of total incoming new work to the Indian manufacturing economy lost considerable momentum.''

This from Sovereign Society:

It’s highly likely that an entire generation of investors will never return to stocks again following the worst drubbing for equities in a single month since the spring of 1932.

It’s also likely that many retirees will never buy another stock or mutual fund. And younger investors will probably shun stocks altogether because of the enormous losses suffered by benchmarks over the last 12 months -…

This from Sovereign Society:

It’s highly likely that an entire generation of investors will never return to stocks again following the worst drubbing for equities in a single month since the spring of 1932.

It’s also likely that many retirees will never buy another stock or mutual fund. And younger investors will probably shun stocks altogether because of the enormous losses suffered by benchmarks over the last 12 months -…

This from Sovereign Society:

It’s highly likely that an entire generation of investors will never return to stocks again following the worst drubbing for equities in a single month since the spring of 1932.

It’s also likely that many retirees will never buy another stock or mutual fund. And younger investors will probably shun stocks altogether because of the enormous losses suffered by benchmarks over the last 12 months -…

Many factors impact the size of the spread on ETFs, including:

• The assets held by the ETF—the more the better
• The volume of trading in the ETF itself—the more the better
• The liquidity of the stocks or bonds the ETF holds—the more liquid the better
• Market conditions-the less volatility the better

There's been a lot of talk recently about ETF spreads rising during the current volatile markets, and that looks very much to be true.

The table below looks at the average bid/ask spread for every ETF and ETN on the market, measured on a tick-by-tick basis throughout the trading day. It looks at two distinct periods—October 2007 and October 2008 (through yesterday). As it shows, the average spread for ETFs has risen sharply over the past year.

For reference, I consider any ETF with an average spread of a nickel ($0.05/share) or less to be trading well, and anything with an average spread of less than a dime ($0.10/share) to be acceptable. Once you get beyond that, spreads become a very serious issue.

In October 2007, 50% of all ETFs had an average spread of $0.05/share or less; this October, that number is down to just 16%. Similarly, a whopping 82% of all ETFs had "acceptable" spreads of $0.10/share or less in October of 2007; right now, that number is just 33%.

Another way to look at this is to examine the "spread percentage." This is probably a more accurate measure of trading costs than absolute dollar spread. The spread percentage divides the dollar spread into the share price; if an ETF costs $100/share and has a spread of $0.10/share, its spread percentage is 0.10%; if another ETF costs just $10/share and has the same per-share spread of $0.10/share, its spread percentage is 1.0%.

The table below looks at the percentage of ETFs trading different spread deciles over the past year.

Back in October 2007, 60% of all ETFs had either 0% or 0.10% spreads; in October 2008, that number is just 16%. More importantly, today, more than 62% of all ETFs had spreads wider than 0.50%, at which point, trading is prohibitively expensive.

You have to take these numbers with a grain of salt, as they can be impacted by illiquidity. If there is no market in a particular ETF, the bid and or the ask can become stale, and spreads can widen artificially. However, the trends are so large that the point is unavoidable: spreads are widening significantly in many ETFs, and that could cost investors money.

Of course, there are still plenty of ETFs that are trading beautifully. Most of the truly large, liquid ETFs continue to trade at extremely tight spreads. By my count, 31 ETFs had an average bid/ask spread in the month of October of just one penny ($0.01)—the lowest possible result. This included giant funds like the S&P 500 SPDR (AMEX: SPY) and the iShares MSCI EAFE Index Fund (NYSEArca: EFA). (A full list is posted at the end of this blog.)

But many more ETFs had spreads of $0.25/share or more.

What does all this mean for investors? It means you have to choose carefully in this market. If you are looking at ETFs with relatively low levels of assets or relatively light trading volume, check to see what the average trading spread looks like and use limit orders when entering your trades. The Arcavision data is not available to retail investors, but IndexUniverse.com has average monthly spreads data available for all ETFs for free at www.indexuniverse.com/data. If you're buying an ETF with a wide spread, factor that cost into your decision-making process.

Weaker price gains and a shortage of money in the banking system have allowed the central bank to shift its focus from fighting inflation to stimulating an already slowing economy. The Reserve Bank of India on Thursday lowered the amount of deposits that lenders need to set aside for the second time in a week to ease the worst cash shortage in the economy since 2000. The central bank reduced its cash reserve ratio to 6.5 percent from 7.5 percent, a move which will add 400 billion rupees ($8.2 billion) to the financial system. India also accelerated loan payments to banks and doubled the overseas investment limit in corporate bonds to shore up the rupee from near a record low. Until the reduction in the cash reserve ratio which started just over a week ago now the Reserve Bank had increased its repurchase rate by 3 percentage points to 9 percent since 2004 and the cash reserve ratio by 4 percentage points since December 2006. The central bank's next monetary policy statement is due to be released in Mumbai on Oct. 24.

India thus joined Brazil and Russia in injecting funds into commercial banks to tackle the global credit crunch, this is viewed to be a less riskier route at this point than intrioducing interest rate-cuts, and it is hoped it may also prove to be a more effective way of getting liquidity quickly through to the corporate sector.

India has injected one trillion rupees ($21 billion) through reserve requirement cuts since Oct. 11 as call money rates surged and mutual funds sought government help to meet the highest redemptions by investors this year. The central bank's moves to inject liquidity helped push down India's call rates to 7 percent today from an 18-month high of 16 percent hit on Oct. 10.

Finance Minister Palaniappan Chidambaram also increased interest rates on deposits by non-resident Indians and doubled the overseas investment limit in corporate bonds to $6 billion to shore up the rupee from near a record low.

The extra yield investors demand to own developing nations' bonds instead of U.S. Treasuries fell 17 basis points to 6.06 percentage points, according to JPMorgan Chase & Co.'s EMBI+ index. The yield on bonds rises, as the value of the underlying bond falls.

Oil and Commodities Continue To Fall

Oil prices recovered some ground Friday, rallying above $71 a barrel on speculation that OPEC could slash output in an effort to stop crude's downward spiral. But pump prices kept falling and appeared poised to drop below $3 a gallon nationally — a level not seen in eight months. Light, sweet crude for November delivery rose $2 to settle at $71.85 a barrel on the New York Mercantile Exchange after earlier rising as high as $74.30. On Thursday, prices lost $4.69 to settle at $69.85 a barrel. Despite Friday's modest rally, oil is still down $75 — or 51 percent — since catapulting to a record high of $147.27 on July 11.




Commodity prices fell during a volatile week, with the Reuters/Jeffries CRB Index of 19 raw materials from coffee to silver, dropping 3.6 per cent amid concerns that the global economy was heading into recession. The abrupt falls in commodities - the RJ-CRB index hit its lowest level in four years - engulfed gold , which ended yesterday at a one-month low of $775 a troy ounce,



Steel prices as also falling rapidly, as industrial and construction demand drops sharply. Tata Steel Ltd., India's biggest steelmaker, has announced itwon't raise prices for six months or cut output if the government imposes an import tax and scraps levies on exports of the metal.

Companies are seeking 15 percent import duty and scraping of the export levy as demand weakens, Minister Ram Vilas Paswan told reporters after meeting executives in New Delhi today. They also want excise tax to be lowered to 8 percent from 14.4 percent.

Slowing demand from manufacturers and builders is driving down steel prices and forcing producers including ArcelorMittal, and Corus, the U.K. unit of Tata, to consider output cuts. Global steel production and consumption may slump 5 percent in 2009, Research & Consulting Group AG said Oct 9.

Foreign Exchange Reserves


India's foreign exchange reserves fell $9.94 billion during the week ending October 10, 2008 to $274 billion mainly because the Reserve Bank of India continued to sell dollars to try to contain the steep depreciation of the rupee.Forex reserves fell by another $9.93 billion (to $274 billion) during the tumultous week ended October 10, 2008 following the $7.8 billion fall of the previous week. .

India — the fourth largest holder of foreign exchange reserves in Asia after China, Japan and Taiwan — has seen reserves sliding since the start of this fiscal year. Since hitting a peak of $316.17 billion during the week ending May 23 this year, reserves have dropped by $42.17 billion. , forcing policymakers to unveil measures such as higher investment limit for foreign institutional investors (FIIs) in corporate debt and allowing banks to offer higher rates on NRI deposits to boost inflows. The situation now stands in stark contrast to the same period a year ago, when reserves rose by $57 billion.


The revaluation of the foreign currency assets also contributed to the steepest-ever weekly fall. In the previous week foreign exchange reserves had declined by $7.8 billion, which was also a weekly record. Overall, reserves have fallen by nearly $18 billion in a fortnight.


In rupee terms, India's foreign exchange reserves, however, rose by Rs 2,258 crore during the week ending October 10 to Rs 13,33,424 crore. In the financial year, the increase is to the tune of Rs 95,459 crore. India's merchandise exports, which were estimated at $250 billion in 2007-08 are, for the time being, well covered.

In recent months, foreign institutional investors (FIIs), which are facing financial pressures at home , have been selling in the Indian markets and repatriating money. In calendar 2008 so far, FIIs have been net sellers of $10.83 billion in the equity market. FII sales have put pressure on the rupee, which has dropped 22.96 per cent against the dollar since January. This has prompted RBI to intervene heavily in the forex markets.





Stocks Fall

Indian stocks fell, with the benchmark Sensitive Index declining to its lowest in more than two years on speculation that overseas funds faced with redemptions are selling the nation's equities. Reliance Industries Ltd. tumbled 6.2 percent to its lowest since March 16, 2007. Infosys Technologies Ltd., the software developer that gets more than half its revenue from the U.S., fell 4.8 percent to its lowest in three years.

The Bombay Stock Exchange's Sensitive Index, or Sensex, fell 606.14, or 5.7 percent, to 9,975.35, its lowest since June 20, 2006. The benchmark posted its fourth weekly decline, falling 5.3 percent. All 30 stocks in the index dropped. The S&P CNX Nifty Index on the National Stock Exchange dropped 194.95, or 6 percent, to 3,074.35. The BSE 200 Index lost 5.1 percent to 1,201.95.

India's MCSI Core Stock Index was down 4.45% on the day on Friday, after falling 26.7% so far this month, and 63.44% so far this year. But India is far from alone here, since the MSCI Emerging Markets Index plunged by 28 percent this month, with Russia's Micex Index alone falling 42 percent.





Overseas investors sold a net 8.41 billion rupees ($172 million) of Indian equities on Oct. 15, increasing the outflow this year from stocks to a record $11.1 billion, according to India's stock market regulator.


The Rupee


India's rupee fell to a six-year low as the benchmark equity index slid below 10,000 for the first time since June 2006, stoking concern capital outflows will quicken. The currency completed a 10th weekly loss. The rupee in part dropped on concern measures taken by global central banks and governments won't be enough to stave off the credit crisis.

The currency fell back0.8 percent this week to 48.8825 a dollar at the 5 p.m. close in Mumbai. That is the lowest since June 2002. The currency's 10-week losing streak is the longest since December 2005. The rupee has fallen 19.4 percent this year, the most since a balance-of-payments crisis in 1991 forced the nation to pawn its gold with the International Monetary Fund to pay for imports. It is poised for the first annual loss since 2005 as overseas investors pulled out almost two-thirds of the record $17.2 billion they invested in Indian equities in 2007.



Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Weaker price gains and a shortage of money in the banking system have allowed the central bank to shift its focus from fighting inflation to stimulating an already slowing economy. The Reserve Bank of India on Thursday lowered the amount of deposits that lenders need to set aside for the second time in a week to ease the worst cash shortage in the economy since 2000. The central bank reduced its cash reserve ratio to 6.5 percent from 7.5 percent, a move which will add 400 billion rupees ($8.2 billion) to the financial system. India also accelerated loan payments to banks and doubled the overseas investment limit in corporate bonds to shore up the rupee from near a record low. Until the reduction in the cash reserve ratio which started just over a week ago now the Reserve Bank had increased its repurchase rate by 3 percentage points to 9 percent since 2004 and the cash reserve ratio by 4 percentage points since December 2006. The central bank's next monetary policy statement is due to be released in Mumbai on Oct. 24.

India thus joined Brazil and Russia in injecting funds into commercial banks to tackle the global credit crunch, this is viewed to be a less riskier route at this point than intrioducing interest rate-cuts, and it is hoped it may also prove to be a more effective way of getting liquidity quickly through to the corporate sector.

India has injected one trillion rupees ($21 billion) through reserve requirement cuts since Oct. 11 as call money rates surged and mutual funds sought government help to meet the highest redemptions by investors this year. The central bank's moves to inject liquidity helped push down India's call rates to 7 percent today from an 18-month high of 16 percent hit on Oct. 10.

Finance Minister Palaniappan Chidambaram also increased interest rates on deposits by non-resident Indians and doubled the overseas investment limit in corporate bonds to $6 billion to shore up the rupee from near a record low.

The extra yield investors demand to own developing nations' bonds instead of U.S. Treasuries fell 17 basis points to 6.06 percentage points, according to JPMorgan Chase & Co.'s EMBI+ index. The yield on bonds rises, as the value of the underlying bond falls.

Oil and Commodities Continue To Fall

Oil prices recovered some ground Friday, rallying above $71 a barrel on speculation that OPEC could slash output in an effort to stop crude's downward spiral. But pump prices kept falling and appeared poised to drop below $3 a gallon nationally — a level not seen in eight months. Light, sweet crude for November delivery rose $2 to settle at $71.85 a barrel on the New York Mercantile Exchange after earlier rising as high as $74.30. On Thursday, prices lost $4.69 to settle at $69.85 a barrel. Despite Friday's modest rally, oil is still down $75 — or 51 percent — since catapulting to a record high of $147.27 on July 11.




Commodity prices fell during a volatile week, with the Reuters/Jeffries CRB Index of 19 raw materials from coffee to silver, dropping 3.6 per cent amid concerns that the global economy was heading into recession. The abrupt falls in commodities - the RJ-CRB index hit its lowest level in four years - engulfed gold , which ended yesterday at a one-month low of $775 a troy ounce,



Steel prices as also falling rapidly, as industrial and construction demand drops sharply. Tata Steel Ltd., India's biggest steelmaker, has announced itwon't raise prices for six months or cut output if the government imposes an import tax and scraps levies on exports of the metal.

Companies are seeking 15 percent import duty and scraping of the export levy as demand weakens, Minister Ram Vilas Paswan told reporters after meeting executives in New Delhi today. They also want excise tax to be lowered to 8 percent from 14.4 percent.

Slowing demand from manufacturers and builders is driving down steel prices and forcing producers including ArcelorMittal, and Corus, the U.K. unit of Tata, to consider output cuts. Global steel production and consumption may slump 5 percent in 2009, Research & Consulting Group AG said Oct 9.

Foreign Exchange Reserves


India's foreign exchange reserves fell $9.94 billion during the week ending October 10, 2008 to $274 billion mainly because the Reserve Bank of India continued to sell dollars to try to contain the steep depreciation of the rupee.Forex reserves fell by another $9.93 billion (to $274 billion) during the tumultous week ended October 10, 2008 following the $7.8 billion fall of the previous week. .

India — the fourth largest holder of foreign exchange reserves in Asia after China, Japan and Taiwan — has seen reserves sliding since the start of this fiscal year. Since hitting a peak of $316.17 billion during the week ending May 23 this year, reserves have dropped by $42.17 billion. , forcing policymakers to unveil measures such as higher investment limit for foreign institutional investors (FIIs) in corporate debt and allowing banks to offer higher rates on NRI deposits to boost inflows. The situation now stands in stark contrast to the same period a year ago, when reserves rose by $57 billion.


The revaluation of the foreign currency assets also contributed to the steepest-ever weekly fall. In the previous week foreign exchange reserves had declined by $7.8 billion, which was also a weekly record. Overall, reserves have fallen by nearly $18 billion in a fortnight.


In rupee terms, India's foreign exchange reserves, however, rose by Rs 2,258 crore during the week ending October 10 to Rs 13,33,424 crore. In the financial year, the increase is to the tune of Rs 95,459 crore. India's merchandise exports, which were estimated at $250 billion in 2007-08 are, for the time being, well covered.

In recent months, foreign institutional investors (FIIs), which are facing financial pressures at home , have been selling in the Indian markets and repatriating money. In calendar 2008 so far, FIIs have been net sellers of $10.83 billion in the equity market. FII sales have put pressure on the rupee, which has dropped 22.96 per cent against the dollar since January. This has prompted RBI to intervene heavily in the forex markets.





Stocks Fall

Indian stocks fell, with the benchmark Sensitive Index declining to its lowest in more than two years on speculation that overseas funds faced with redemptions are selling the nation's equities. Reliance Industries Ltd. tumbled 6.2 percent to its lowest since March 16, 2007. Infosys Technologies Ltd., the software developer that gets more than half its revenue from the U.S., fell 4.8 percent to its lowest in three years.

The Bombay Stock Exchange's Sensitive Index, or Sensex, fell 606.14, or 5.7 percent, to 9,975.35, its lowest since June 20, 2006. The benchmark posted its fourth weekly decline, falling 5.3 percent. All 30 stocks in the index dropped. The S&P CNX Nifty Index on the National Stock Exchange dropped 194.95, or 6 percent, to 3,074.35. The BSE 200 Index lost 5.1 percent to 1,201.95.

India's MCSI Core Stock Index was down 4.45% on the day on Friday, after falling 26.7% so far this month, and 63.44% so far this year. But India is far from alone here, since the MSCI Emerging Markets Index plunged by 28 percent this month, with Russia's Micex Index alone falling 42 percent.





Overseas investors sold a net 8.41 billion rupees ($172 million) of Indian equities on Oct. 15, increasing the outflow this year from stocks to a record $11.1 billion, according to India's stock market regulator.


The Rupee


India's rupee fell to a six-year low as the benchmark equity index slid below 10,000 for the first time since June 2006, stoking concern capital outflows will quicken. The currency completed a 10th weekly loss. The rupee in part dropped on concern measures taken by global central banks and governments won't be enough to stave off the credit crisis.

The currency fell back0.8 percent this week to 48.8825 a dollar at the 5 p.m. close in Mumbai. That is the lowest since June 2002. The currency's 10-week losing streak is the longest since December 2005. The rupee has fallen 19.4 percent this year, the most since a balance-of-payments crisis in 1991 forced the nation to pawn its gold with the International Monetary Fund to pay for imports. It is poised for the first annual loss since 2005 as overseas investors pulled out almost two-thirds of the record $17.2 billion they invested in Indian equities in 2007.



Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Investors remained wary of emerging-market debt as evidence mounted that most of the major major economies - the U.S., the UK, Japan and the Eurozone - are sliding into recession. This realisation has triggered a major exit from commodities, which are a significant source of export revenue for a large number of developing nations. In particular bonds extended losses on the perception that the $700 billion U.S. bank bailout would not work miracles and thus many developed economies will be struggling to digest the impact of the credit blow-out for some time to come.


Until credibility is restored, we will not see people investing in the numbers that emerging economies like India and Brazil badly need to see. But at the same time, we might ask ourselves, at theis moment in time if they don't invest in India and Brazil, then where are they going to invest? The problem is that in the present global environment people are not simply not willing to take assume what is perceived as "risky" without being paid a large - and from the emerging economy point of view - damaging premium. Of course, the situation is also confused since people are no longer clear what constitutes "risky" and what doesn't - the German government, for example, yesterday found itself forced to offer a blanket guarantee of all domestic bank deposits to head off any risk of flight from German bank accounts.

One result of all this nervousness is that the cost of protecting developing nations' bonds against default has been steadily rising. Five-year credit-default swaps based on Argentina's debt climbed 44 basis points to 12.55 percentage points last week, the highest since at least June 2005. That means it costs $1.255 million to protect $10 million of the country's debt from default. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.


Emerging Market Stocks

Emerging-market stocks also fell substantially last week, experiencing their the biggest weekly decline in seven years, led by the banks and energy companies. The MSCI Emerging Markets Index dropped 2.3 percent on Friday to 741.73, following a 3.4 percent decline on Thursday. The index lost 10 percent on theweek, the most since the September 2001 terrorist attacks.


Turkey's benchmark index fell the most in three weeks, losing 4.2 percent to 34,553 in the first trading day since Sept. 29. Russia's Micex Index slumped 5.3 percent, extending its annual loss to 51 percent. India's Sensex index slid 4.1 percent to 12,526.32. Reliance Industries Ltd., India's biggest company by market value, slumped 7.6 percent, to its lowest in a year.

Inflation Falls

But while India's financial system has been taking a beating, Indian inflation, almost un-noticed -slipped back to a 13-week low in late September, giving the central bank some breathing space to keep interest rates unchanged and lossen the liquidity strings when it next meets at the end of this month. Wholesale prices rose 11.99 percent in the week to Sept. 20 from a year earlier after gaining 12.14 percent in the previous week, the commerce ministry said in a statement in New Delhi on Thursday.



Reserve Bank of India Governor Duvvuri Subbarao is under pressure to boost money supply as a local stock sell-off triggered by the global credit crunch has drained funds from the banking system, increasing borrowing costs. Subbarao will undoubtedly seek to steer a middle course, since, given that inflation is still double the central bank's target he will not want to seem to be "soft", while on the other hand he will want to be prudent and will try to head off an excessively rapid credit tightening on the back of the global crunch. In addition, the peak of global inflation has now undoubtedly past, and we are now likely to see growing deflationary (rather than inflationary) headwinds as capacity levels exceed demand across the whole global economy and commodity prices tumble, as Claus Vistesen explains in this excellent and timely post.

The Indian central bank had been busy tightening, and had raised the cash reserve ratio, or the proportion of deposits that lenders maintain with it as reserves, by 400 basis points to 9 percent during the period between December 2006 and July 2008 in an ongoing battle to contain inflation. The bank will make the outcome of its next meeting in Mumbai known on Oct. 24, but we can be pretty sure that the "bias" will now have shifted towards loosening liquidity conditions rather than tightening them, as the priorities have changed, and the big priority now is to avoid any systemic bank problems, to keep the cost of borrowing for Indian companies down, and to prevent consumer credit slowing too dramatically.

The Indian banking system has been under increasing strain in recent days, and one symptom of this is that the rate at which Indian banks lend to each other reached an 18-month high of 17.5 percent on Oct. 1. Indian banks borrowed an average 413 billion rupees a day from the central bank in September, almost twice the amount in August, further indicating a shortage of funds in the banking system.


Commodities Down

Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, tumbled 9.9 percent last week, the most since at least 1956.

Crude oil has lost 12 percent during the week, the most since 2004. The contract for November delivery traded at $94.47 a barrel, up 0.5 percent, as of 12:11 p.m. London time. Copper fell as much as 3.1 percent to $5,670 a ton on the London Metal Exchange, the lowest since February 2007 and was down 12% on the week.

Such downward movement in commodity prices has a double-edged impact on emerging economies. On the one hand inflation, which has in large part been driven up by rising commodity prices, will reduce significantly, but on the other hand many emerging economies are dependent on revenue from commodity sales to finance growth and development. Really this is a situation which will sort the "men" from the "boys", since those emerging economies which are really going to emerge will be in a position to switch the driving force of growth from commodity and agricultural dependence to industrialisation and domestic investment and consumer demand. It is my firm belief that India is now decidedly inside the group which is in the process of making this transition.


Stocks Down

Indian stocks fell during the week, with the benchmark Sensex stock index declining to its lowest in 18 months. The Bombay Stock Exchange's Sensitive Index, dropped 529.35, or 4.1 percent, to 12,526.32, its lowest since April 2, 2007. The index posted its second weekly decline, falling 4.4 percent. The S&P CNX Nifty Index on the National Stock Exchange fell 3.4 percent to 3,818.30. The BSE 200 Index declined 3.8 percent to 1,515.29. Nifty futures for October delivery fell 2.9 percent to 3,853.


Overseas investors bought a net 845 billion rupees ($18 million) of Indian stocks on Sept. 30, trimming their net outflow this year from equities to $9.1 billion, the nation's stock market regulator said.


Forex Reserves

India's foreign exchange reserves fell marginally by USD 153 million to USD 291.819billion for the week ended September 26 from USD 291.972 billion in the previous week. Reserves had jumped by USD 2.511 billion in the previous week. Foreign currency assets (FCA), during the week, dropped to USD 282.652 billion from USD 282.811 billion a week ago, according to data issued by the RBI on Friday.

Rupee

India's rupee slumped to the lowest since 2003, adding to speculation investors will take continue taking money out of the currency. The currency completed its eighth weekly loss, the longest drop since December 2005. The rupee was down 1 percent on the day to 47.085 per dollar, the lowest since June 2003, as of the 5 p.m. close in Mumbai on Friday. The currency lost 1.15 percent this week.

September Global Manufacturing PMI Shows Sharp Contraction

September seems to have been the ultimate "mensis horribilis" for industrial output internationally - and thus it is only natural to assume that Indian industry was also adversly affected - with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).


According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Manufacturing in China contracted for a second month in August, underscoring the risk of a slump in the world's fourth-biggest economy. The Purchasing Managers' Index was a seasonally adjusted 48.4, unchanged from July, the China Federation of Logistics and Purchasing said today in an e-mailed statement.




Brazil's industrial output fell a seasonally-adjusted 1.3 percent in August, the largest monthly drop this year, bolstering expectations the central bank will ease monetary tightening in response to slowing economic growth. On an annual basis, output rose 2 percent, the slowest pace since March, according to data from the national statistics agency in Rio de Janeiro.

And the situation seems to have deteriorated further in August, since the headline seasonally adjusted Banco Real Purchasing Managers’ Index (PMI) registered a 25-month low of 50.4, down from 51.1 in August.

So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth.

India's Industrial Output Weakens Too

India's industrial output growth bounced back again in July (the last month for which we have official data), reaching a five-month year on year expansion rate high of 7.1%. This follows a noted slowdown where output only rose by 5.4 percent gain in June, and 4.1% in May, according to data from the Central Statistical Organisation.


But if we come to look at the manufacturing PMI we will see that India's manufacturing output has also slowed somewhat, and expanded at its slowest pace in 14 months in September according to the ABN AMRO Bank purchasing managers' index. The PMI reading - which is based on a survey of 500 companies operating in India - fell to a seasonally adjusted 57.3 in September from 57.9 in August. This reading was the lowest since July 2007. Still 57.3 still suggests Indian industry continues to grow quite vigoursly, although the report did highlight the fact that the drop in the index was mainly the result of a decline in growth of new orders, and implied a deterioration in demand conditions, both locally as well as in export markets.


Current Account and Trade Deficit

The Rupee has also been dropping in reaction to India's deteriorating current account situation. The current account deficit rocketed to $10.7 billion in the three months from April to June, up from a $1.04 billion gap in the previous quarter,according to data from the Reserve Bank of India last week.

India's trade deficit almost doubled to a record in August as a surge in crude oil prices increased the import bill and overseas sales of goods slowed. The trade deficit widened to $13.9 billion from $7.2 billion a year earlier, according to data from the Ministry of Commerce and Industry. Imports grew 51 percent, the fastest gain in seven months, to $29.9 billion, while exports expanded 27 percent to $16 billion.

A near doubling of oil prices has boosted import costs, since India relies on overseas purchases for three-quarters of its energy needs. India paid an average $8 billion a month this year for oil imports, up from $5.5 billion in 2007, as crude oil costs surged to a record $147 a barrel on July 11. In India's case the 35 percent drop in oil prices we have seen since July has been partially offset by the decline in the rupee to a five-year low.

India's oil imports in August rose 77 percent to $10.9 billion as refiners paid more for crude oil purchased overseas. Non-oil imports gained 40 percent to $18.9 billion. Imports in the five months ended August 31 rose 38 percent to $130.3 billion from $94.6 billion a year ago. That took the trade deficit to $49.2 billion, compared with $34.5 billion in the same period a year earlier. Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.

India and Brazil Critical Weathervanes

What I have been arguing in this post is not that everything about India's economy is perfect - far from it, but neither is it the "perfect storm" disaster which current knee jerk reactions among international investors would seem to suggest. The problems which are hitting the Indian economy at the moment, from the rapid rise in inflation to the sudden withdrawal of sentiment have a common origin: the dynamics of the global economy, and it is to these we must now look if we are to be able to sort the wood from the trees about what happens next. Basically, when the dust settles, I think it will be apparent that there are few economies left sufficiently well standing (not Russia certainly, and probably not China, given the export dependence on the developed economies) and with sufficient energy to bounce back. Many may be sceptical that Brazil and India are going to lead the coming charge (this recession cannot, after all, last forever), but I ask you, if it isn't Brazil and India, who is it going to be?

JP Morgan Global Manufacturing PMI Methodology


The Global Report on Manufacturing is compiled by Markit Economics based on the results of surveys covering over 7,500 purchasing executives in 26 countries. Together these countries account for an estimated 83% of global manufacturing output. Questions are asked about real events and are not opinion based. Data are presented in the form of diffusion indices, where an index reading above 50.0 indicates an increase in the variable since the previous month and below 50.0 a decrease.

The countries included are listed below by size of global GDP share, and the figures in brackets are the % og global GDP in each case (World Bank Data).

United States (30.5), Eurozone (18.7), Japan (13.9), Germany (5.6), China (4.9),United Kingdom (4.5), France (4.0), Italy (3.2), Spain(1.9), Brazil (1.9),India (1.7), Australia (1.3), Netherlands (1.1), Russia (0.9), Switzerland (0.7), Turkey (0.7), Austria (0.6), Poland (0.5), Denmark (0.5), South Africa (0.4), Greece (0.4), Israel (0.3), Ireland (0.3), Singapore (0.3), Czech Republic (0.2), New Zealand (0.2), Hungary 0.2.

Investors distanced themselves from emerging-market debt as the evidence mounted that major economies - the U.S., the UK, Japan and the Eurozone - are sliding into recession and this triggered a major exit from commodities, which is a significant source of export revenue for a large number of developing nations. In particular bonds extended losses on the perception that the $700 billion U.S. bank bailout would not work miracles and thus many developed economies will be struggling to digest the impact of the credit blow-out for some time to come.


Until credibility is restored, we will not see people investing in the numbers that emerging economies like India and Brazil badly need to see. In the present environment people are not simply not willing to take assume what is perceived as "risky" without being paid a large - and from the emerging economy point of view - damaging premium. As a result the cost of protecting developing nations' bonds against default has been steadily rising. Five-year credit-default swaps based on Argentina's debt climbed 44 basis points to 12.55 percentage points last week, the highest since at least June 2005. That means it costs $1.255 million to protect $10 million of the country's debt from default. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.


Emerging Market Stocks

Emerging-market stocks had the biggest weekly decline in seven years last weeks, led by banks and energy companies. The MSCI Emerging Markets Index dropped 2.3 percent on Friday to 741.73, following a 3.4 percent decline on Thursday. The index lost 10 percent on theweek, the most since the September 2001 terrorist attacks.


Turkey's benchmark index fell the most in three weeks, losing 4.2 percent to 34,553 in the first trading day since Sept. 29. Russia's Micex Index slumped 5.3 percent, extending its annual loss to 51 percent. India's Sensex index slid 4.1 percent to 12,526.32. Reliance Industries Ltd., India's biggest company by market value, slumped 7.6 percent, to its lowest in a year.

Inflation Falls

But while India's financial system has been taking a beating, Indian inflation, almost un-noticed -slipped back to a 13-week low in late September, giving the central bank some breathing space to keep interest rates unchanged and lossen the liquidity strings when it next meets at the end of this month. Wholesale prices rose 11.99 percent in the week to Sept. 20 from a year earlier after gaining 12.14 percent in the previous week, the commerce ministry said in a statement in New Delhi on Thursday.



Reserve Bank of India Governor Duvvuri Subbarao is under pressure to boost money supply as a local stock sell-off triggered by the global credit crunch has drained funds from the banking system, increasing borrowing costs. Subbarao will undoubtedly seek to steer a middle course, since given that inflation is still double the central bank's target he will not want to seem to be "soft", while on the other hand he will want to be prudent and will try to head off an excessively rapid credit tightening on the backs of the global crunch. In addition, the peak of global inflation has now undoubtedly past, and we are now likely to see growing deflationary headwinds as capacity levels exceed demand across the whole global economy, as Claus Vistesen explains in this excellent and timely post.

The central bank has raised the cash reserve ratio, or the proportion of deposits that lenders maintain with it as reserves, by 400 basis points to 9 percent since December 2006 to contain inflation. The bank will make the outcome of its next meeting in Mumbai known on Oct. 24.

The rate at which Indian banks lend to each other climbed to an 18-month high of 17.5 percent on Oct. 1 as investors hoarded cash. Indian banks borrowed an average 413 billion rupees a day from the central bank in September, almost twice the amount in August, further indicating a shortage of funds in the banking system.

Essentially the wholesale price index fell because of a decline in the prices of farm products such as cereals, fruits and vegetables. The index of primary articles, that includes food items, dropped 0.2 percent, while the indices of manufactured and fuel were unchanged in the week to Sept. 20, today's report said.

Commodities Down

Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, tumbled 9.9 percent last week, the most since at least 1956.

Crude oil has lost 12 percent during the week, the most since 2004. The contract for November delivery traded at $94.47 a barrel, up 0.5 percent, as of 12:11 p.m. London time. Copper fell as much as 3.1 percent to $5,670 a ton on the London Metal Exchange, the lowest since February 2007 and was down 12% on the week.

Such downward movement in commodity prices have a double edged impact on emerging economies. On the one hand inflation, which has in large part been driven up by rising commodity prices, will reduce significantly, but on the other hand many emerging economies are dependent on revenue from commodity sales to finance growth and development.


Stocks Down

Indian stocks fell during the week, with the benchmark Sensex stock index declining to its lowest in 18 months. The Bombay Stock Exchange's Sensitive Index, dropped 529.35, or 4.1 percent, to 12,526.32, its lowest since April 2, 2007. The index posted its second weekly decline, falling 4.4 percent. The S&P CNX Nifty Index on the National Stock Exchange fell 3.4 percent to 3,818.30. The BSE 200 Index declined 3.8 percent to 1,515.29. Nifty futures for October delivery fell 2.9 percent to 3,853.


Overseas investors bought a net 845 billion rupees ($18 million) of Indian stocks on Sept. 30, trimming their net outflow this year from equities to $9.1 billion, the nation's stock market regulator said.


Forex Reserves

India's foreign exchange reserves fell marginally by USD 153 million to USD 291.819billion for the week ended September 26 from USD 291.972 billion in the previous week. Reserves had jumped by USD 2.511 billion in the previous week. Foreign currency assets (FCA), during the week, dropped to USD 282.652 billion from USD 282.811 billion a week ago, according to data issued by the RBI on Friday.

Rupee

India's rupee slumped to the lowest since 2003, adding to speculation investors will take continue taking money out of the currency. The currency completed its eighth weekly loss, the longest drop since December 2005. The rupee was down 1 percent on the day to 47.085 per dollar, the lowest since June 2003, as of the 5 p.m. close in Mumbai on Friday. The currency lost 1.15 percent this week.

September Global Manufacturing PMI Shows Sharp Contraction

September seems to have been the ultimate "mensis horribilis" for industrial output internationally, with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).


According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Manufacturing in China contracted for a second month in August, underscoring the risk of a slump in the world's fourth-biggest economy. The Purchasing Managers' Index was a seasonally adjusted 48.4, unchanged from July, the China Federation of Logistics and Purchasing said today in an e-mailed statement.




Brazil's industrial output fell a seasonally-adjusted 1.3 percent in August, the largest monthly drop this year, bolstering expectations the central bank will ease monetary tightening in response to slowing economic growth. On an annual basis, output rose 2 percent, the slowest pace since March, according to data from the national statistics agency in Rio de Janeiro.




So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth.




Current Account and Trade Deficit

The Rupee has also been dropping in reaction to India's deteriorating current account situation. The current account deficit increased to $10.7 billion in the second quarter of 2008 from a $1.04 billion gap in the previous quarter,according to data from the Reserve Bank of India last week.

India's trade deficit almost doubled to a record in August as a surge in crude oil prices increased the import bill and overseas sales of goods slowed. The trade deficit widened to $13.9 billion from $7.2 billion a year earlier, according to data from the Ministry of Commerce and Industry. Imports grew 51 percent, the fastest gain in seven months, to $29.9 billion, while exports expanded 27 percent to $16 billion.

A near doubling of oil prices has boosted import costs, since India relies on overseas purchases for three-quarters of its energy needs. India paid an average $8 billion a month this year for oil imports, up from $5.5 billion in 2007, as crude oil costs surged to a record $147 a barrel on July 11. In India, the 35 percent drop in oil prices since July has been partially offset by the decline in the rupee to a five-year low. India's oil imports in August rose 77 percent to $10.9 billion as refiners paid more for crude oil purchased overseas. Non-oil imports gained 40 percent to $18.9 billion. Imports in the five months ended August 31 rose 38 percent to $130.3 billion from $94.6 billion a year ago. That took the trade deficit to $49.2 billion, compared with $34.5 billion in the same period a year earlier.

Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.


Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.

India's current account deficit widened to a record in the three months to June as a surge in crude oil prices increased the nation's import bill. The shortfall, the amount by which imports exceed exports, remittances and other income from abroad, increased to $10.72 billion from a $1.04 billion gap in the previous quarter, the Reserve Bank of India said in a statement in Mumbai. Analysts expected a deficit of $11.52 billion.

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

India's financial system is evidently showing signs of strain as the impact of both local policy tightening and the global credit crunch steadily take hold. The rate at which Indian banks lend to each other climbed to an 18-month high of 15.125 percent on Sept. 19, following the failure of Lehman Brothers Holdings and the U.S. government takeover of American International Group. As a result the Indian finance ministry responded by allowing companies building roads, ports, utilities and other infrastructure projects to borrow more overseas - thus giving them access to cheaper funds - while the central bank announced measures to boost cash in India's financial system.

Indian banks have borrowed an average 642.8 billion rupees from the central bank in the last two weeks, more than five times the average 113 billion rupees in the previous fortnight, further indicating a shortage of funds in the banking system.

Foreign Exchange Reserves Rise Slightly

India’s foreign-exchange reserves rose by the most in five months in the week ended September 19, according to the latest data from the Reserve Bank of India. The rise has surprised many observers, but it should be borne in mind that it coincided with the rise in the dollar against a number of other currencies (and in particular the euro, which the RBI also holds in reserves) on the back of the euphoria about the possible bailout of the US financial system.

Total foreign-exchange reserves rose by $2.51 billion to $292 billion in the week ended Sept 19, while foreign-currency assets - which form the lions share of the reserves -climbed $2.5 billion to $282.8 billion during the week. As we can see from the chart (below) the value of foreign exchange reserves has stabilised since mid-August, so the rot, it would seem, has definitely stopped. I think it is significant that we saw a positive initial response across the key emerging markets to the proposed US bailout, and while we are now seeing considerable volatility as people become nervous about whether it will, finally, arrive.I think when the package is introduced the key emerging market economies will be the principal beneficiaries, as the so called "risk appetite" will bounce back, especially given that the aftermath of the package will be a lower growth period in the OECD economies as the cost of the bailout has to be assimilated.




Even given the recent decline, it is important to bear in mind that India's foreign-exchange reserves, including overseas currencies, gold and special drawing rights with the International Monetary Fund, have increased $56.1 billion in the past year.

Money Supply Continues To Grow

Meanwhile, money supply in India grew year on year by 21 % in the two weeks ended Sept. 12, same rate as in the previous fortnight, according to data from the RBI. M3 - which largely consists of currency in public circulation, bank deposits and money invested in other saving plans, stood at Rs 42,26,143 crore as on September 12.

M3 has been rising at an average rate of 21% since the current fiscal year began on April 1, and has been consistently above the central bank’s target of 16.5% to 17% for the fiscal year ending March. At the same time, total bank loans rose by Rs 32,914 crore in the two weeks ended Sept 12, the biggest fortnightly increase since March. Outstanding bank credit was up by 26.1% year on year and reached Rs 24, 91,248 crore. Food credit was up by Rs 847 crore to Rs 45,190 crore, while non-food credit increased by Rs 32,067 crore to Rs24,46,058 crore. Total bank deposits rose by 22.5%, or Rs 6, 25,282 crore, in the same period to Rs reach 34, 05,377 crore.


The Rupee Weakens Again


The rupee has declined almost 17 percent so far this year and is the second-worst performer among the ten most-active Asian currencies excluding the yen. This week it declined for the seventh consecutive week, the longest run in more than 2 1/2 years. The rupee was down 5.6 percent in September, and is thus headed for its worst month since the Asian financial crisis in 1997.

Foreign investors were net sellers of Indian stocks for a fifth straight month in September, and have offloaded $9 billion so far this year, according to data from the Securities & Exchange Board of India. They bought a record $17.2 billion in stocks last year. Indian stocks fell, with the benchmark posting its biggest weekly drop in six months, after talks on a U.S. credit market rescue plan stalled and Washington Mutual Inc. became the biggest bank failure in American history.



The Bombay Stock Exchange's Sensitive Index, or Sensex, fell 445, or 3.3 percent, to 13,102.18. The index had its biggest weekly drop since the week ended March 7. The S&P CNX Nifty Index on the National Stock Exchange slid 125.30, or 3.1 percent, to 3,985.25. The BSE 200 Index declined 3.2 percent to 1,590.58. Nifty futures for October delivery fell 3.9 percent to 3,995.

Standard & Poor's 500 Index futures slid 1.7 percent when negotiations on a $700 billion bailout plan for U.S. credit markets were thrown into doubt by a group of House Republicans who said the plan drawn up by Treasury Secretary Henry Paulson wouldn't work.

The decline in Indian stocks is more a reflection of global sentiment towards emerging market stocks and bonds than it is an indicator of any specific local issue. The MSCI Emerging Markets Index of stocks has been falling since last May - as can be seen in the chart below - and dropped 1.74% percent on Friday to 823.694, its lowest level since Sept. 15. The index is now down 13.6% so far this month, and 33.87% so far this year. But if you look carefully you can see that it peaked up again after 20th September, as speculation increased that there would be a major bailout of the US banking and insurance sector. This bounce back unwound towards the end of last week, as uncertainty grew about the arrival of the package.


A similar picture can be seen of the JPMorgan EMBI+ emerging bonds index (see below), which has been down significantly since the end of August. Since the US package seems now about to be approved for the US congress, as a result we should see sentiment improve significantly, and India may well be one of the principal beneficiaries of this change in sentiment. The coming weeks should clear all this up quite quickly.

I think it is important to bear in mind here that Russia's economy actually grew at an annual 7.5% in the second quarter, while manufacturing growth was nearer 5%. Which means that in a "newly industrialising country" the weight of industry in the economy is declining. This is obviously unsustainable, since however resource rich Russia maybe, you cannot live from oil alone, especially when your oil output has a ceiling. Basically the more living standards in Russia rise, the less important oil will become as a percentage of GDP, and the more dependent the Russian economy will become on other sectors. This is why the current consumer price and wage inflation levels are no mere trifle.

Obviously the Russian authorities have deperately needed to get a grip on the inflation problem, and this is just what the central bank has clearly failed to do, with the annual rate rising again to 15 percent in August, up from 14.7 percent in July. So one part of the present financial crisis is clearly an institutional crisis of confidence. With the benchmark interest rate at the central bank currently at 11%, Russia has negative interest rates of 4% which obviously make it very easy to fuel a lending driven consumer and construction boom, but very much more difficult to communicate to observers that you actually know what you are doing. So while the fx muscle that the central bank can put to work in the short term to stamp out the present will in all probability work, they are clearly not able to prevent such forest fires breaking out in the first place, and we should, of course, expect more. Brazil's central bank which currently has interest rates at 13.75% while inflation is just over 6% (ie 7.5% positive interest rates) is currently justifiably earning for itself a reputation as Latin America's new Bundesbank, a way in which it would never ocur to anyone to refer to the Russian equivalent. And the comparison I would make with Brazil is not meant idly, since Brazil is, of course, also an oil and resource rich emerging economy.



So it is clear that Russia has special problems, which set what is happening in Russia rather apart from what is currently happening in a lot of emerging market economies.

Rout On The Bourses

Both Russia's MICEX and RTS exchanges remained effectively closed first thing this morning following trading being suspended again yesterday (Wednesday) - they were in fact open for less than two hours - in order to prevent a further sell-off on top Monday's record-breaking falls. The ruble-denominated Micex Stock Exchange did resume some very limited trading at 11:00 this morning, but only limited operations were authorsied - the decision was effectively simply to allow participants to close repurchase deals still outstanding from Sept. 16 and Sept. 17.

Russian stocks have now plunged around 60 percent since their May peak, and while the Micex did initially gain 7.6 percent in initial trading yesterday, this gains were very rapidly erased and then turned negative, as the index plunged as much as 10 percent before a halt was called. Russia's dollar-denominated RTS index stood at 1,058 points when trading was halted, nearly 58 percent down from its peak of 2,498 points reached in May.

Emerging Market Woes

In part Russia's problems only reflect more general "risk aversion" issues which are facing all emerging market economies. Emerging-market stocks have fallen the most in 11 years this week, their currencies have been falling, and the cost of insuring emerging market bonds has rocketed as rising lending rates and tumbling commodities have prompted investors to sell riskier assets.

Every emerging stock market in MSCI indexes has been retreating this month, and the MSCI Emerging Markets Index fell 2 percent yesterday to 768.92 a time, its lowest level since October 2006. The index is now down 19.59% since the start of the month, and 29.27% over the past 3 months.



The Russian MSCI index, in comparison, is down 36.1% on the month, and 54.2% over the past three months.



Of course, to put the recent fall in perspective, this recent fall follows several years of rising stock values, and thus is to some extent cyclical, as can be seen from the 4 year MSCI index chart (below).




Falling Oil Prices


In the forefront of the fall in Russia share prices have been energy stocks, including Russian oil producers like OAO Gazprom and OAO Rosneft, who have declined substantially following the sharp drop in crude prices. Gazprom, the world's biggest natural-gas producer, lost 18 percent to 158.41 rubles in the latest turmoil, while Rosneft, Russia's largest oil company, sank 22 percent to 132.20 rubbles.

Oil prices were down again this morning, after bouncing back somewhat yesterday. Light, sweet crude for October delivery fell 97 cents to $96.19 a barrel in electronic trading on the New York Mercantile Exchange midafternoon in Singapore. Overnight, the contract rose $6.01 to settle at $97.16, after having dropped $10.03 the previous two trading sessions. But the trend is decidedly down, and crude has now fallen more than $50 — or over 35 percent — from its all-time trading record of $147.27 reached July 11.




Urals crude peaked at $140.80 a barrel on July 3, and has fallen about 36 percent to $90.01 since then. Still, the oil price averaged $108.65 a barrel so far this year, compared with $63.54 a barrel January 02 through Sept. 18 last year.


Foreign Exchange Reserves


Evidently the Russian economy is in no evident danger of short term default, and foreign exchange reserves, which stood at $560.3 billion on September 12 (according to data from the Russian central bank) - the third largest globally, after China and Japan - are evidently ample. In addition Russia has a $163 billion SWF (the National Welfare Fund), which is split into two parts, $130 billion in a reserve fund, and $33 billion in the National Wealth Fund (the SWF proper).




Nonetheless, the reserves have dropped quite sharply since early August, and are now down some $37 billion since their August 8 peak, and reserves declined by $13.3 billion to $560.30 billion in the week ended Sept. 12, after falling $8.9 billion in the previous week. About 47 percent of Russia's reserves are held in U.S. dollars, 42 percent in euros, 10 percent in pounds and 1 percent in yen, according to the most recent figures released by the central bank (June 30, 2007.

Part of this reduction in reserves is a result of central bank intervention in support of the ruble, since Russia operates a policy of trying to maintain the currency steady within a trading band set against a basket of euros and dollars. Evgeniy Nadorhsin, a senior economist at Trust Investment Bank in Moscow, estimates that the central bank sold approximately $3 billion in fx reserves last week.


So Where Do We Go Now?

This is very hard to say. Clearly we should expect the economy to slow substantially in the last quarter of 2008 and the first quarter of 2009, as credit conditions tighten for households, and the decline in oil prices restricts revenue flows. As just one indication of the worsening credit conditions we could note that Russian 5-year credit default swaps are trading with a spread of around 253-255 basis points, little changed this week but more than double the level seen before the start of the conflict with Georgia.


On the other hand Russia is hardly the Baltics, so we should not expect the economy to go into a nosedive. A lot depends on the view you take about the future of energy prices. Since my own view is that the global economy will slow down considerably - in addition to the reduction in growth rates we have seen so far this year -following the most recent bout of financial turmoil, and this will serve top bring oil prices down even further, but we should see a floor, at around $80 perhaps.

More importantly I am not expecting a long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009.

As we can see in the JP Morgan EMBI+ index (see below), bonds from these economies have taken one hell of a battering in September. Looked at the other way round, the extra yield investors demand to own developing nations' bonds instead of U.S. Treasuries has been going up, and today rose 2 basis points to 4.24 percentage points, the widest spread since September 2004, according to the EMBI+ index. So EM bonds have been taking a battering but they have taken a battering because of nervousness about the implications of a financial crisis in the developed economies, rather that as the result of any inherent problems in their own ones. That is what sets this crisis apart from the 1998 one, and that is what means that the financial markets in these economies will in all probablilty bounce back again quite substantially once all the nervousness dies down. Basically most of these markets are neither "oversold" nor are they "maxed out".

What is interesting about the above chart is the way in which things seem to have really taken a decisive turn for the worst in late August, and it is curious to note on the chart below that the Russian MSCI index also started to deteriorate further starting on or around 2 September (see chart below which is from May 2008 to date). So while the Georgia factor may have made people nervous, other, deeper, structural factors are obviously at work.

And while I am on deep structural factors, and the MSCI Emerging Markets index, I would like to conclude by pointing out that the decline since mid May has been pretty generalised, and in some sense is obviously cyclical. The point is that this fall will at some point hit bottom, after which time we should be ready to see a rebound, as investors move in and snap up what will obviously be seen as very attractive buying opportunities.