Brazilian Central Bank President Meirelles Addresses EMTA Annual Meeting
EMTA’s 2006 Annual Meeting was held on December 6, 2006 at the offices of Citigroup in the Tribeca section of Manhattan. Brazilian Central Bank President Henrique de Campos Meirelles delivered the meeting’s keynote address to an overflow crowd of 300 EM professionals.
Brazilian Central Bank President Meirelles Stresses Macroeconomic Improvements
Brazilian Central Bank Governor Meirelles’ presentation focused on the progress Brazil has made on the economic front in recent years. In particular, he underscored how his country has taken advantage of the global environment to set the stage for sustained economic growth. He also emphasized that an improved balance sheet and macroeconomic improvements have paid a “stability dividend.”
Meirelles began his formal remarks by reminding the audience of meetings he had with market participants shortly after the US Federal Reserve indicated it was likely to begin raising rates. During those meetings, Meirelles recalled, investors had expressed concern that Latin America would suffer a fate similar to its decline during Fed hikes a decade earlier. He had countered that conditions had changed substantially and that a repeat would be avoided.
“I think the main reason is the fact that many of the Latin American countries took advantage of favorable international conditions in recent years to improve their capacity to absorb shocks,” he asserted. Many Latin American countries now have sounder fiscal outlooks, public debt has been reduced, primary surpluses have increased and the move to flexible exchange rates allows for a less traumatic adjustment to changes in the international environment. In addition, monetary policy is more transparent and thus more predictable.
The Governor went on to describe how Brazil is a prime example of such a country. “Macroeconomic fundamentals have improved consistently in the last few years and that has contributed to the progressive reduction in perceived macroeconomic risk,” he noted. Meirelles then presented slides showing improvements in Brazil’s balance of payments, disinflation, and primary surplus. As a result of these improvements, spreads on Brazilian debt have fallen.
Meirelles stressed the Central Bank’s commitment to reduce inflation. In 2001 and 2002, actual inflation was above the Bank’s target zone, he acknowledged; however, over the past three years the Bank has succeeded in keeping inflation within its targets. Real interest rates have continued to decline since the adoption of the real. With inflation under control, real interest rates should continue to fall and thus encourage faster economic growth, Meirelles stated.
Structural changes in the economy, “overdue from the 1970s,” have resulted in an improved balance of trade, with the country showing a $38 billion surplus for the period of January to October 2006, up 4% compared with the same period in 2005. “It’s worth noting that—contrary to the popular view—Brazil has a healthy mix of export products,” the Governor added, specifying that 54% of exports are factory goods. Other accomplishments include the creation of 1.5 million formal-sector jobs in the first 10 months of 2006, and average real earnings growth of 4.1%. Increased investment in the oil sector has made Brazil self-sufficient in oil supply, Meirelles reminded attendees. Finally, reviewing GDP performance in 2006, the Governor broke down growth by sector and highlighted that “domestic demand has become the key driver.”
Next, Meirelles summarized Brasilia’s efforts to improve its sovereign debt profile, including the exchange of A-bonds for old C-bonds, the issuance of real-denominated external debt, the repayment of IMF and Paris Club debt, the calling of Brady bonds and the buyback in the open market of other external issuances. He contrasted Brazil’s current use of the favorable international environment to carry out such transactions with historical examples; in the past, emphasis was often placed on boosting growth as much as possible while ignoring the country’s balance sheet. “The idea now for Brazil is to create a longer-term, sustainable growth pattern and to prepare the country for [less benign international] scenarios,” he stated.
Meirelles credited the enactment of the Fiscal Responsibility Law with improving Brazil’s institutional and legal framework. “It has spread to all government levels …and it’s something that really works,” he emphasized, pointing out that the country’s net public-debt-to-GDP ratio has declined from 62% in mid-2002 to 49% in October 2006. Proactive debt management—the gradual reduction in interest-rate-linked debt and the increased issuance of fixed-income paper—has also served to reduce Brazil’s vulnerability to external shocks.
“A permanent commitment to fiscal responsibility, improved external debt sustainability indicators and enhanced policy transparency all suggest Brazil may well be at the threshold of a period of higher non-inflationary growth,” Meirelles predicted. He continued that new measures to stimulate investment were being discussed by the cabinet and the Congress and “we will have to go through a very painful process of negotiation.” Although he declined to specify what policies might be adopted during the discussions, Meirelles expects an announcement to be made in the near future.
Click Here for a copy of Governor Meirelles’ slide presentation.
Sell-Side Panel
Joyce Chang moderated the Annual Meeting’s panel of sell-side analysts. Summarizing the year, Chang noted that last December this panel had predicted that the EMBI would have negligible or negative returns. Yet once again the asset class surprised with better-than-expected performance. [NB: The EMBI+ returned 10.5% in 2006].
Chang also pointed out that, according to JPMorgan estimates, $27 billion was invested in EM debt in 2006, with perhaps as much as 40% of inflows going into local markets debt. “The real surprise this year was that local markets, in general, didn’t perform better, with local markets in aggregate showing returns that barely surpassed the EMBI,” she stated. Referring to a chart of speaker forecasts for 2007, Chang observed that her colleagues remained somewhat cautious about local markets returns in 2007 given the surge of inflows, with only her own firm calling for double-digit returns.
To De-Couple or Not to De-Couple?
Chang asked Tulio Vera (Merrill Lynch), whose firm had one of the more bearish economic forecasts for 2007, for his thoughts on whether EM debt would de-couple from a US economic slowdown. Vera responded that Merrill does in fact expect a global de-coupling from slow US growth in what he termed a “global slowdown, local strength” theme. According to Vera, growth in Asia, Europe and emerging countries will increase and provide support for commodity prices, which should bode well for Latin American commodity exporters. According to Vera, Investors should focus more on OECD countries because they, not the US, are currently the providers of capital. In addition, Vera expects liquidity in 2007 to be generally supportive of the asset class, with Latin America probably better positioned than at the end of previous cycles because of improvements in liability management, while emerging Europe is “somewhat” more vulnerable because of imbalances.
Paulo Leme of Goldman Sachs, whose firm also forecasts relatively slow US growth, concurred that there would be a decoupling. He commented that while his firm’s US growth forecast is below consensus, “we are much above consensus for China, for Asia and for Emerging Markets in general, as well as for Europe and Japan.” As a result of strong non-US growth, commodity exports should continue their rapid expansion. Leme did observe that, if US growth stalls more dramatically than expected, risk appetite will be affected; in addition, many current account surpluses would diminish, putting pressure on exchange rates and raising inflation expectations. Leme concluded that such a scenario is unlikely.
Piero Ghezzi (Deutsche Bank) drew a distinction between decoupling in the real economic arena and in the financial assets arena. Based on his assessment that US economic growth is probably less important now than it has been historically, and that this is due to internal rather than external factors, Ghezzi agreed with his co-panelists that a decoupling was occurring in the real economic sector. On the other hand, a hard landing in the US would trigger increased risk aversion regardless of economic strength in other areas around the globe, and EM assets would suffer as a result.
Attendees were reminded by Credit Suisse’s Kasper Bartholdy that in 2000 and 2001, the industry also discussed whether European growth could remain strong during a US downturn. Following up on Ghezzi’s comments, Bartholdy noted that five years ago a collapse in asset prices during the US slowdown was a factor in transmitting a slowdown to Europe, and that once again “the likelihood that the growth slowdown in the US will be reflected in a significant growth slowdown in the rest of the world is crucially affected by the extent to which US asset markets respond to that slowdown.” However US growth is unlikely to fall to a level that will drag global economic activity down with it, he argued.
Chang concluded the topic with the JP Morgan house view that 2007 would likely not be problematic, but that 2008 US growth is of greater concern because of the expectation of Fed interest rate hikes. Yet JP Morgan calculates that the probability of a hard-landing recession is no greater than 25%.
Role of Liquidity vs. Fundamentals in Asset Class Performance
Discussing whether current pricing in EM debt was more a result of structural improvements or global liquidity, Ghezzi stressed that, while there are enough structural reasons to support higher EM debt pricing, “it’s almost impossible to justify current levels purely with fundamentals; you need to be very heroic in your assumptions.” Ghezzi suggested that investors should not be complacent regarding recent low volatility, as this remains a vulnerability of the market. At the same time, Ghezzi noted “significant improvement in the balance sheets of EM countries,” due to strong commodity markets.
Leme spoke more optimistically on the EM asset class. “We have seen credible and lasting changes in the overall quality of policy-making in all regions,” he asserted. But he concurred with Ghezzi that investors should not be complacent about the unusually low level of volatility in the markets recently–countries are “less vulnerable for sure but they’re not immune to a very violent reduction in risk appetite and also a more negative scenario for the US economy.” Leme also predicted that large current account surpluses and increasing Central Bank reserves will have to be invested, and that much of those funds will continue to find their way into EM assets.
“We’re probably past the sweet spot in terms of liquidity,” offered Vera, reasoning that some mixed signals are beginning to evolve but that a liquidities squeeze is unlikely in 2007. Balance sheet and cash flow improvements, the switch to floating exchange rates and increased policy and information transparency all point to a paradigm shift in EM economics. However, according to Vera, the jury is still out on whether a paradigm shift has occurred in volatility after three years of noticeably lower market fluctuations.
Bartholdy stressed that spread compression in EM debt is not unique, pointing out that high-yield spreads are also low by historical standards. Thus it is not clear that EM debt has de-coupled from the rest of the financial world. Chang contributed her thoughts that EM policymakers are now focusing on retiring external debt and that supply will continue to contract, although corporate debt remains a different story.
As for an appropriate industry benchmark, several panelists believe that the single-index era is over, as the industry has evolved away from a focus on the external sovereign debt of relatively few countries. “Nobody really has a good handle on the optimal balance between local markets, external sovereign and corporate debt,” Vera summarized.
Market Correlation
Discussing the increased correlation between EM debt and other financial markets, Bartholdy attributed this to the “very stable” economic policies of EM countries, which means that the main risks to the asset class are now external rather than internal factors. He also suggested that the greater linkages between the asset classes are too often credited to crossover investors and hedge funds. Bartholdy noted that, in contrast to the recent past, the S&P’s rally in the second half of 2006 was not matched in the EM debt world, and identified this as something to watch.
Leme argued that, although convergence is likely to continue, at some point “not too far away” this trend will decelerate or we will end up having a systemic, non-diversifiable risk.” Vera attributed market correlation to the common factors of liquidity, low volatility and high risk appetite driving financial markets.
Local Markets in 2007
Chang asked panelists for thoughts on the future of local currency debt issuance and local markets. “Clearly rates have come down quite significantly from last year, and the local markets are not as compelling as when we discussed them last December,” Leme observed, although generally the local markets remain attractive, with rates especially high in Brazil and Mexico. Leme noted that the BRL-denominated external bond was extremely successful and could be followed by similar issues in the future. High custody costs and taxation issues are dissuading some foreign investors from buying Brazilian local instruments, and policymakers should consider this in the future. Vera suggested that Mexico and Brazil might avoid issuing foreign-currency denominated debt completely in 2007, although this isn’t necessarily an optimal debt management approach.
Concluding the discussion with recommendations for the coming year, Chang expressed caution at the large supply of Kazakh banks, while seeing a buy opportunity in Fiji after the recent coup. Leme’s favorite trades are Mexican local instruments, plus Mexican and Brazilian high-grade corporates on the external side. Leme also favored BRIC currencies as well as the Philippine peso and Indonesian rupiah. Vera recommended Brazil, the Philippines and Venezuela on the external debt side, as well as Brazilian NTMBs, Hungarian locals, the Singapore dollar, the Russian ruble and the Polish zloty. He would avoid short-dated dollar debt of most EM sovereigns, Lebanon and the ZAR. Bartholdy chose long-dated Brazilian locals and Argentine Nobacs as well as Argentine hard-currency debt, and was more positive on Turkey than other panelists.
Ghezzi ventured that there is at least a 35% probability “we will have a very bad year” but thought Argentine debt would be priced higher in 2007. He added that Peru could go investment-grade in 2008. On the other hand, “Ecuador is a country to avoid—don’t do anything there because anything could happen!”
Buy-Side Panel
Citibank’s Don Hanna chaired the panel of investor experts which concluded the Annual Meeting. He opened the discussion with a request for general thoughts on the global economy and the EM debt asset class.
Oppenheimer’s Art Steinmetz acknowledged that, after years of “terrific results across the board, with the markets evolving and maturing, and embryonic local capital markets being fleshed out…it is certainly going to be more challenging.” He added that while “the window is still open” for local markets, “it has been open for a while now and certainly we could argue the best gains are behind us.” Steinmetz suggested that portfolio managers consider trading “more volatility” rather than “just direction” in order to help boost returns.
Dave Rolley (Loomis Sayles) attributed much of the market’s low volatility to the People’s Bank of China’s desire to limit their currency appreciation, as well as carry trades. “Once again I can blame the low-vol environment on that dubious combination of communists and hedge funds,” he quipped.
“I’ve been doing this since 1990, and the EMBI+ probably looks as cheap as I’ve ever seen it,” declared Simon Treacher (BlueBay Asset Management). Treacher noted that almost half of the index is slated for possible upgrades, and he predicted that Brazil will join the ranks of investment-grade-rated countries in 2007. “If you compare EMBI countries to many other countries with similar macro fundamentals, these spreads are far too wide,” he commented.
Treacher acknowledged that at EMTA’s London Forums earlier in the year he had been more bullish on external debt than local instruments, but “in the last few weeks I’ve started moving to local markets,” while emphasizing longer duration. He added that corporates are also attractive “but you have to know what you’re doing; they are a bit trickier.”
Jim Barrineau (AllianceBernstein) revealed that he sees the US current account deficit leading to dramatic increases in Central Bank reserves overseas. EM Central Banks buy reserves to prevent their currencies from appreciating; this sets off a virtuous circle as investors move into the local markets when they see currency stability, and local interest rates stabilize. Worth noting, according to Barrineau, is the fact that central banks are diversifying away from the dollar and some of that capital is going into other EM currencies, a trend he expects to accelerate in the future. From Barrineau’s viewpoint, a decrease in the US current account alone will “take an awful lot of liquidity out of the market; people are going to think a lot differently about risk and its going to increase volatility across asset classes.” But for now, the global imbalance story will help bolster the asset class, with individual policies having little relevance, as proven by the market’s lack of volatility during the recent wave of presidential elections in Latin America.
Hanna pressed for a further examination of the benign global outlook, and Rolley expounded on the windfall terms of trade gain many emerging countries have experienced. “Chinese and Indian policies, the fact that they have abandoned 50 years of autarchy and rejoined the world economy” has been an important component. Plus, recently “we have rediscovered that commodity prices can go up as well as down, something we had forgotten for thirty or forty years!” Rolley added that in this new era of local markets, investors no longer need concentrate on balance of payments and reserves and a debtor nation’s access to hard currency; now, investors should focus on inflation, which could result from the rapid growth of the foreign exchange compound of the monetary base.
What other factors might alter the current global scenario, Hanna asked. Barrineau replied that the dollar’s response to a US recession followed by Fed interest rate cuts would be interesting. “Do central banks buy dollars to protect the huge investment they already have or do they just completely shun the dollar?” Additionally, dramatic changes in oil or commodity pricing could derail the supportive global environment.