While many investors are concerned about a possbile May-June style correction led by an emerging market sell off, Michala Mercsen, Global Chief Economist at SG Asset Management, suggests that although 2007 could see tighter liquidity conditions, it would not be to such an extent that it will prove negative for the markets.  

Excerpts from CNBC-TV18's exclusive interview with Michala Mercsen:

Q: How are you feeling about emerging markets right now? Are the signs positive and bullish or are they fraught with a lot of apprehension?

A: We continue to maintain a very positive view on the emerging markets and I would say on the equity markets at the global level as well. We do have elements of prudence built into our strategy since there are a number of risks out there to the global economy, but we feel that these risks are not particular to emerging markets.

Q: What do you see as the key risk for an emerging market like ours for example?

A: If we look in aggregate there are three major risks to the global financial market place today. Top of the list is of course that we could have a new shock to energy prices, this is an important risk to keep in mind or a new geopolitical event or both combined.

The second risk that we have to keep in mind is really that after a synchronized global housing market boom that we could have a synchronized global housing market slump and of course we have already seen house prices come down significantly in the US. So this is something that we need to be aware of at the global level.

The third factor that we have to be focused on for all of the financial markets is the question of liquidity. Markets will benefit tremendously from a lot of liquidity and this has come from different sources. It has come from the accumulation of foreign exchange reserves in Asia, it has come from a large flow of petro dollars. It has also come from the yen carry trade.

We don’t see a sharp unwinding of any of those three factors but there is of course a risk that these factors will start to gradually reverse over the course of 2007 and that in the event the markets become frightened about liquidity situation just as we saw happen back in May, we could see a correction on such a move.

Q: Is that your expectation in 2007 that we will see liquidity being slightly more subdued or moderate than we saw from 2005 on to the first half of 2006 from these quarters that you spoke about?

A: I would say that at the margin, we do expect to see tighter liquidity conditions but not to such an extent that it is going to prove negative for the markets. So I would say overall yes somewhat gradual tightening in liquidity conditions relative to 2006. But one thing to keep in mind is when liquidity starts to dry up the key thing that people will start to look at is fundamentals and as we look across the fundamentals of the global equity markets to our mind these still look healthy.

If we just zoom in on the case in India, the profit margin is still looking quite healthy in India especially if we take account of the recent easing of energy costs. This is an important factor for the Indian markets. If we look at topline sales atleast from a dynamic point of view, if we look at the sources of economic growth, these remain quite healthy. There are some risks that we need to monitor closely but our overall scenario is for a very favourable development in 2007.

Q: How do you see things shaping up for the commodity universe and the impact of what is happening with crude prices for example on the petro dollar inflow that you just mentioned?

A: We did a kind of rough rule of thumb calculation just to see what it would mean for lower oil prices next year. Our forecast on a USD 60 per barrel average for brands would mean a 10% reduction in OPEC revenues according to our estimates. So there is a removal of USD 60 billion in terms of liquidity from the markets but on the other hand we have to keep in mind that lower oil prices is also a positive for economic growth. So I think it is going to be favourable that oil prices will come off the very high levels.

One thing to keep in mind however is that there is a big difference between supply driven shock or demand driven shock on the oil price. If we have a situation where oil is going up because demand is stronger because of stronger growth in the rest of the world it is not at all the same scenario if we have oil going up because of geopolitical risks and concerns on the supply side so we must distinguish between those two scenarios. So our overall outlook for oil is that, as I said, USD 60 per barrel and also on commodity prices, we do feel that commodity prices are looking a bit toppish.

On the other hand fundamentals are still in place for strong demand especially coming out of China, they are also coming out of the other emerging countries in the region.

So I would say that I am a little bit concerned about commodities, I am a little bit concerned about the massive investment inflows, non-fundamental investors who have been piling into this asset class but I do not see much scope for a very sharp correction as long as global growth and growth in Asia continues to be solid.

Q: How do you see the US economic situation panning out in 2007 and do you think given your prognosis on what will happen there, the emerging markets as an equity asset class will continue to be the favoured asset class in 2007?

A: I think that equity should continue to be the favoured asset class but let me start by just tracking back on your question on the US economy and saying a few words about that. Our central scenario for the US economy is that of a soft landing and this builds really on the fact that despite the fact that the housing market has essentially entered what we can describe as a recession, we believe that the US economy overall has a member of buffers, which will help it through this more difficult patch.

The first buffer we already talked about is lower energy prices. One should keep in mind that if energy prices evolve the way we expect, this will add about 0.4% of GDP to the US consumer relative to the peak end prices.

Second point to keep in mind is that interest rates in the US remain moderate despite Fed tightening, especially at the long end to the curve, will be helpful to those people who have to lock in adjustable rate mortgages over the coming year.

So long bond-yields will still remain at moderate levels. And the most important thing and this is really the key factor to watch in the US, is the fact that US Corporation still shows appetite to hire and to invest.

If this were to falter that would be very negative for the US economic outlook but at the current juncture, we do not see any signs of US companies who are no longer willing to either hire or invest.

So overall I would say that with these buffers in mind we really have a moderate slowdown for the US consumer and in such an environment we believe that the rest of the world will be able to show resilience and this I think is a key point for Asia today-which is that we see growing resilience in the region towards the US consumer. The region has become less and less dependent on the US consumer alone and more dependent as well on the strength of the regional dynamics.