Dubai's debt crisis may not sow lasting global contagion, but it may colour a 2010 investment landscape where asset managers will likely differentiate more between risks rather than embracing them indiscriminately.
The global market selloff after last Wednesday's Dubai bombshell on delaying debt payments from its state-owned conglomerates lasted only two days. World stocks have bounced back 2.5 per cent this week.
For all the ripples this aftershock of the credit crisis will create, the direct material impact of any debt rescheduling on international banks or governments outside the region pales in comparison to an event like last year's bankruptcy of Lehman Brothers, for example.
Of the $26-billion (U.S.) affected by the rescheduling, analysts reckon no more than 50 per cent is held by global banks, and individual lenders can absorb that sort of hit. Credit ratings firm Moody's said Tuesday it saw no reason to alter international bank ratings due to developments.
But while there's little rationale for direct contagion, the implications may seep through market psychology for many months to come.
The event was a reminder of the excessive leverage the world is still trying to shed and triggered what many investors, including giant U.S. bond fund Pimco, saw as a much-needed correction to 2009's surge in risky assets and emerging markets.
While many may see this as a good opportunity to re-enter the market, they will likely be more choosy on their return.
"Fundamentals will become more apparent again. It's the theme that will carry on in 2010. It's going to become much more discerning. We do appreciate next year will be turbulent for investors," said Rekha Sharma, global strategist at JP Morgan Asset Management.
Growth-sensitive emerging market assets were the main beneficiaries this year of the wholesale shift out of low-risk, low-yielding money market instruments that took place since March of this year.
But the liquidity and growth landscape is set to change next year as Western central banks seek to time their exits from super-cheap money policies flooding the world and as many emerging economies attempt to frustrate speculative flows with a variety of controls, taxes and state intervention.
As a result, country-specific risks are rising in the face of recent capital curbs by the likes of Brazil and Taiwan.
Reflecting these rising idiosyncratic risks, for example, Brazil has moved to the top of Swiss bank UBS's growth surprise rankings followed by China, Korea and Poland.
"We have, since October, been in a decidedly different phase of the recovery where differentiation increasingly matters. Recent events will only serve to intensify the market's scrutiny," Morgan Stanley said in a note to clients.
"If March-September was a beta trade - buy anything and it will go up - now it's all about picking your spots. The run-on risks have increased as the scrutiny on sovereign balance sheets has intensified."
Investors might also put a greater focus on differentiating between sovereign risks especially after the credit crisis effectively nationalized some private sector risks.
After the Dubai debt crisis, investors demanded higher compensation for holding debt of economies that are less fiscally robust and sold growth-sensitive currencies with weaker economic fundamentals, such as sterling and the New Zealand dollar.
For example, the 10-year Greek yield spread over safe-haven German debt widened to as much as 200 basis points after last week, compared with 100 basis points in August.
The cost of protecting debt of Greek and Irish debt against default also surged last week.
The Dubai event may also prompt a review on default risks of quasi-sovereigns and other corporates. Moody's highlighted this point Tuesday and said any Dubai World default could change long-held assumptions regarding implicit government supports.
Francesco Garzarelli, strategist at Goldman Sachs, said the developments in Dubai serve as a reminder that a sovereign's willingness to assume corporate default risk reflects rational political and economic considerations.
"Just as ... Abu Dhabi evidently could not find enough benefits to justify the fiscal costs of bailing out its neighbour, so too we continue to think that European sovereigns will fail to find justifications for future bailouts of either financial or non-financial corporates," he noted.