Speakers at EMTA Summer Forum in London Generally Upbeat on Asset Class
EMTA’s 8th Annual Summer Forum was held in London on Wednesday, June 29, 2005. Hosted by Merrill Lynch, the Forum attracted 150 Emerging Markets traders, researchers, investors, salespeople and journalists. Speakers on both the Buy-Side and Sell-Side were generally optimistic in their outlook for Emerging Markets debt, and discussed topics ranging from US interest rates, the role of hedge funds and the likelihood of a change in Chinese exchange rate policy, to specific country analysis.
In introductory remarks, EMTA Co-Chair Mark Coombs (Ashmore Investment Management) reminded attendees of recent EMTA initiatives (including the Litigation and Job Opportunities areas on its website) and gave an update on the development of a new clearing facility in London. He also encouraged non-members attending the Forum to learn more about the benefits of EMTA membership.
Low Inflation Forecast by Most Panelists
Joyce Chang (JPMorgan) opened the Sell-Side panel discussion by projecting a slide that featured speaker forecasts of key economic variables for 2005. (Click Here to see the slide). Chang then invited her colleagues to debate the outlook for US rates. Marc Balston (Deutsche Bank) announced that he expects rate hikes to continue through early 2006, and anticipates Fed fund rates of 4% by year-end 2005 and 5% by year-end 2006. Evidence suggests, said Balston, that Emerging Markets spreads could remain stable even in times of US Treasury bond weakness. By contrast, Dresdner Kleinwort Wasserstein’s Arnab Das predicted that rate hikes would stop at 3.75%. "What we see is a world of slowing growth, low inflation and easy money," he declared, adding that prospects for emerging countries generally remain strong because of such factors as a weak dollar and strong oil prices. HSBC, according to research head Phil Poole, also subscribes to the "low-inflation world" scenario, based on deceleration of the US economy (below 2% growth in the second half of 2005), and the deflationary effects of outsourcing and inward migration. Finally, Larry Brainard (WestLB) concurred with the low-inflation scenario as well, adding that a "global savings glut" puts downward pressure on both interest rates and growth.
Effects of Hedge Funds Discussed
Chang steered the conversation towards the role of hedge funds in the market. Das compared hedge funds of the 1990s with their counterparts in 2005. "It is my impression that in the 1990s there was much more systemic risk for the market as a whole because the positions that a few hedge funds were carrying were so large, and their trading relationships with a few large broker-dealers were so concentrated," he explained. Several of those hedge funds have now closed, and today’s positions and trading relationships are more diversified, lessening the reasons for concern.
In Poole’s opinion, hedge funds probably increase market efficiency; their cross-asset investment approach is also likely to lead to increased correlations between asset classes. Balston commented that some local markets could experience "stress" as a result of hedge fund activity, but that this would not be widespread.
Views on Brazilian "Noise" and Mexican Pre-Election Period Diverge
Turning to Latin American politics, Chang polled her colleagues for their thoughts on the state of affairs in Brazil and Mexico. "The noise in Brazil will continue, but most of the dirty linen is out now in public," asserted Poole, adding that most politicians will increasingly perceive that further destabilization is not in their interest. Although the "damaged" administration will be less likely to enact reforms, and there may be more "pump-priming" in the run-up to the presidential election than previously expected, Brazilian economic fundamentals are much better now than they were in 2002, he commented. Brainard—more optimistic than Poole—does not foresee political turbulence having a material impact on economic policy. He suggested that the market has not given Brasilia full credit for its reduced dependence on dollar-linked debt, and invited investors to consider opportunistic purchases of Brazilian debt.
For Balston, the base case assumption is a stabilization in the Brazilian political situation, though he acknowledged this might take several months and "the reform process will be effectively dead until the next election." Das noted that the governing Workers’ Party (PT) has a unique opportunity to demonstrate that the left is capable of responsible economic policy, and it will thus do everything possible to assuage investor fears.
As for Mexico, Poole expected political noise in the period preceding that country’s presidential election to have "fairly muted" market impact until the second quarter of 2006, when the peso will likely weaken. Brainard and Balston shared the view that Mexico would be a market underperformer. Das proclaimed the decision by the Mexican government to permit presidential candidate Andrés Manuel López Obredor to participate in the upcoming election a "critical event in the maturation of its political system, and the convergence of its political system—like its economic system—with that of the United States." Chang noted that she is less pessimistic than her panelists about potential returns on Mexican debt, and would recommend opportunistic purchases.
Speaker Predictions for Chinese FX Regime Vary
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anelist opinions diverged on the likelihood of a Chinese revaluation in 2005. Brainard said he was "unconvinced" by the arguments that a depreciation of the Chinese currency was critical. Balston assessed the probability of a modest revaluation and a move to a managed basket regime as being "just over 50%." He was unconcerned that a revaluation would lead to a Chinese economic slowdown and a subsequent drop in commodity pricing, and stated that "in terms of economics this is much of a non-event." US officials have realized that the strategy of aggressively and publicly pressing Chinese officials has backfired, and a new softened tone might pave the way to an adjustment, according to Balston.
Das foresaw no change this year and the possibility of a "small fudged change" in 2006 (to a trade-weighted basket that would leave the real effective exchange rate of the renminbi unchanged). Poole agreed that no action was likely until 2006 when a trade-weighted basket is likely to be adopted. "The argument for a revaluation is really a US-China bilateral argument…and from our view the argument for a sizable revaluation is somewhat weak," he stated. Chang concluded the Chinese revaluation debate with her own comments that a modest revaluation was likely in a "window of opportunity of the next month or two," with the likelihood of a change subsequently decreasing. [NB: Almost one month later, Beijing reduced the value of the yuan by 2.1% and pegged the currency to a trade-weighted basket.]
Russian Unanimous Panel Recommendation
At the close of the panel the speakers offered specific trade recommendations. Russian debt was a unanimous pick of the Sell-Side panelists. Das summarized several panelist views by explaining "we are not particularly bullish about the underlying reform process—there is no underlying reform process—it’s really about the twin surpluses resulting from the high prices of energy." Poole suggested that the benchmark for Russia had shifted from Mexico to China, and Das added that investors will be crowded into Russian corporate debt as the country’s sovereign debt is paid down. Three speakers also recommended Turkish lira trades, while Ecuador was mentioned twice as an asset to avoid.
Balston was upbeat about Venezuela’s prospects. He spoke positively about the "crowded" Brazilian real trade, as well as short-dated NDFs on Chinese currency, and warned investors against Philippine purchases due to political risk. Das highlighted the appeal of local market investments, declaring that "sovereign debt is not quite a dinosaur but it’s definitely not going to be growing."
Poole anticipated outperformance from Kazakhstan external debt and Indonesian, Polish and Russian local instruments, while cautioning that the South African rand and Mexico were likely underperformers. For Brainard, Bank of Moscow and Gazprom Bank corporate issues offer high returns, and Nigeria appears likely to make progress on its arrears with the Paris Club. Brainard expects an eventual Brady bond swap or buyback, "but it will happen on Nigerian time." He also confessed to not being a believer in the Ukrainian economic team.
As for moderator Chang, she urged investors to consider oil exporters and Argentine peso inflation-linked bonds, and described herself as a bear on Indonesian prospects.
Investor Speakers Share Generally Bullish View on the Market
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oderator Tulio Vera of Merrill Lynch initiated the investor panelist discussion by requesting opinions on whether Emerging Markets debt could trade at tighter spreads vis-à-vis the US corporate bond market—on a sustained basis—than it has in the past. Christian Kopf (DWS) asserted that there is no justification for a sustained spread differential between similarly-rated EM sovereign debt and US corporate debt. While some analysts have argued in favor of a spread differential because of a greater severity of loss in an EM sovereign default, Kopf disagreed. "It turns out that recovery rates on Emerging Markets names have been substantially higher than a lot of corporate recovery rates," he stated.
Turning to interest rates, BlueBay Asset Management’s Simon Treacher confirmed that he is "in the 3.5% camp on rates." Citing recent, and expected, moves in Europe, Treacher declared that interest rates around the globe are about to turn "dramatically to the downside." He predicted that "a low-inflation world could last for twenty years," and advised attendees to "get used to spreads now—they are going to halve!"
Both Treacher and John Cleary (Standard Asset Management) expressed little concern over a potential inverted US treasury curve. Cleary remarked that, as a result of the widespread adoption of explicit and implicit inflation-targeting regimes by central banks, interest rates are likely to stay at low levels. This provides a favorable environment for Emerging Markets debt, although Cleary stressed that EM spreads are not necessarily correlated with global interest rates, adding that "the last time spreads were at this level, US rates were more than double what they are now." Of greater concern to him was the potential exit from the market of those investors who entered the market at the tighter range of spreads, often due to credit upgrades.
Some Emerging Countries Remain Vulnerable to a Change in Liquidity
Have emerging countries shielded themselves from a change in liquidity conditions? Cleary voiced skepticism that emerging sovereigns could genuinely defend themselves from a downturn in global liquidity, although he acknowledged improved fundamentals, such as increased central bank reserves and the widespread adoption of floating-rate foreign exchange regimes in lieu of fixed-rate regimes.
Kopf noted that some emerging countries are protected from a downturn in liquidity by a stockpiling of FX reserves, while others remain vulnerable. He recommended that emerging countries should "buy protection" by locking in low rates for longer tenors, and later emphasized that he also did not expect global liquidity to decrease "any time soon."
Rob Drijkoningen (ING Investment Management) pointed out that liquidity is problematic if an issuer has a homogenous investor base; this helps to explain why sovereigns are increasingly focusing on obtaining funds in the local debt markets. He reasoned that pre-funding and an increasing move away from hard currency-denominated debt are reducing EM vulnerability to any change in liquidity.
Hedge Funds Redux
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uy-Side speakers largely agreed with their Sell-Side counterparts that the effect of hedge funds on the marketplace has been somewhat overstated. Treacher reminded the audience that there are different types of hedge funds, and that his own firm’s hedge fund takes long positions only. Crossover hedge funds are not themselves to blame for their fickle allegiance to the asset class; rather the blame for any hedge fund-related volatility should be placed on the investment banks that give them large allocations of new issues.
Kopf stated that the activities of hedge funds have little effect on the way he manages his portfolio. He echoed Treacher’s comments that the distinction between long-only hedge funds and real money accounts has decreased over time, and that currently there are only a few assets that hedge funds would consider shorting. According to Drijkoningen, hedge funds might be contributing to increasing correlations in local markets.
Local Markets the "Big Trade"
Vera steered the conversation towards local market investments, and invited panelists to discuss the role they expect local markets to play in their portfolios in the future. After a decade of 12-13% returns, Kopf proclaimed, it is mathematically impossible for external debt to continue to outperform. Both corporate bonds and local markets offer possible alternatives, with Kopf labeling the latter "the big trade" because of independent central banks, reduced inflation, and the "captive demand" from local pension funds. Kopf called the new JPMorgan local bond market index a "killer product" because his own analysis showed it has a negative correlation with bunds.
Cleary and Drijkoningen concurred that local market investing would play a bigger role in the future. Local market instruments in investment-grade countries are especially appealing, according to Cleary, who highlighted the diversification benefits of local debt issues. However, he cautioned that managing a local markets portfolio was not the same as managing external debt. "Maybe your duration is shorter, maybe your decisions are a lot more tactical," he explained.
Treacher noted that the JPMorgan local markets index puts pressure on sovereigns like Brazil to issue additional local debt. He predicted that in ten years, African countries would comprise a much larger percentage of such local debt indices.
Russia the "Easy Trade"; Investment Grade Not Likely for Brazil or Turkey
Concluding with a question on fundamentals, Vera asked panelists to briefly analyze the prospects for several countries over the next 3-5 years. Neither Kopf nor Cleary foresaw either Brazil or Turkey achieving investment grade ratings by 2010, although Treacher speculated that it was possible in Brazil’s case. Panelists largely agreed that Mexico would continue to be an interesting investment from a local market perspective.
Russia is not an improving credit, but its ability and willingness to pay mean that spreads are still too wide on Russian debt, according to Kopf. Treacher concurred, calling Russia "the easiest trade of the past few years." Drijkoningen added that eventually policymakers in Moscow would realize the need to enact additional reforms.