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Friday, November 27, 2009

Dubai debt fears tear into investor confidence

Friday, Nov 27, 2009

Investor confidence took a severe battering yesterday as worries about the potential fallout from a possible debt default in Dubai added to a growing sense of foreboding about the backdrop for financial markets.

"The state of play in global risk assets is looking more precarious by the day," said Lena Komileva, head of G7 market economics at Tullett Prebon. "The market is belatedly downgrading emerging and financial credit risk valuations."

With thin trading conditions due to the closure of Wall Street exacerbating price moves, equities in both Europe and emerging markets tumbled, credit spreads widened and commodities suffered broad losses.

A flight to safety helped the dollar pull away from recent lows and pushed up benchmark government bond prices. Gold touched another record peak, within sight of $1,200 an ounce.

The fears over Dubai served to heighten growing unease about sovereign debt amid a deteriorating environment in Greece and other peripheral European countries and after a ratings downgrade for Mexico.

Standard & Poor's yesterday put the credit ratings of four Dubai banks on negative outlook.

Adding to investors' disquiet yesterday was a warning from the Bundesbank that German banks faced further write-offs in 2010 - which came hard on the heels of a rescue for ailing lender WestLB.

"The market is far away from the days where asset pricing reflected any real potential for a large financial-centered shock," said Sacha Tihanyi, strategist at Scotia Capital.

"As we've learned from the crisis, financial distress in one part of the world risks contagion in others and the impact of a Dubai default could have serious repercussions."

But Benoit Anne, emerging markets debt strategist at BoA-Merrill Lynch, while noting the widespread contagion from the events in Dubai across EM credit, interest rate and foreign exchange markets, suggested the risks might be limited to the short term.

"The initial market reaction across EM may appear excessive, and to some extent also the result of the poor liquidity owing to the US holidays," he said.

"In a best-case scenario where the developments in the Gulf have no protracted impact on global risk appetite, the temporary weakness may produce some opportunity in a number of assets."

But the risk sell-off yesterday was severe. European equities suffered steep losses, with the FTSE Eurofirst 300 sliding 3.2 per cent - its worst one-day drop for seven months - and the Xetra Dax index in Frankfurt down 3.3 per cent. Greek stocks fell more than 6 per cent.

In Tokyo, the Nikkei 225 Average in Tokyo eased 0.6 per cent to a fresh four-month low as exporters were undermined by a hefty rise in the yen.

Emerging market stocks, unsurprisingly, also came under heavy pressure. The Russian Micex index shed 3.3 per cent, India lost 2 per cent and Brazil was down 2.3 per cent by late afternoon in New York.

In the credit markets, the cost of insuring against default by Dubai rocketed, with its five-year credit default swaps quoted as high as 550 basis points, against 300bp before the Dubai World restructuring was announced.

Greek and Irish CDS spreads also widened, as did those of eastern European nations such as Latvia.

In Europe, the Markit iTraxx Crossover index of mostly junk-rated credits widened 24bp to 536bp. Commodity prices suffered a broad retreat, with the US oil price falling $1.73 and threatening to slide through the $76 a barrel mark, while copper retreated from a 14-month high above $7,000 a tonne.

Gold touched a record $1,194.90 after Sri Lanka on Wednesday bought 10 tonnes of bullion from the IMF.

But gold eased back as rising risk aversion helped the dollar bounce off a 15-month low against the euro and a 14-year low against the yen in the currency market s .

Benchmark European government bonds attracted buying by nervous investors, with the 10-year Bund yield down 9bp at 3.17 per cent and the 10-year gilt yield down 10bp at 3.53 per cent.

. Copyright Financial Times Limited 2009. All Rights Reserved.

By Dave Shellock