2006 FALL FORUM
EMTA’S FALL FORUM FOCUSES ON WORLD HOT SPOTS
Hosted by UBS in its Sixth Avenue offices, EMTA’s New York Fall Forum was held on Thursday, October 19, 2006. After a brief overview of the immediate future of the Emerging Markets, panelists looked in depth at three countries where much has been happening, both politically and financially: Brazil, Ecuador and Turkey.
Moderator Filippo Nencioni of UBS opened the discussion by asking each panelist to describe what he sees happening in the EM over the next 3-6 months, and also to reveal his favorite trade. First up was Amer Bisat of Rubicon Fund Management, who, using a baseball analogy, said “we’re somewhere in the eighth inning.” At some time in the next few years, the current cycle will turn, and “you do not want to be in risky assets. You might as well go out and find another job.” Until then though—”I don’t believe in a gradual bear market,” declared Bisat—over the next 6-12 months the market will be doing fine, and “I will continue to play it on the long side,” he announced. Bisat plans to change his trading strategies, placing more attention on liquidity. Credit—sovereign debt—will have lower returns but will also have lower volatility. “Within that, I have a particular preference for Turkey, which has seen a disproportionate dislocation in its risk assessment” he noted. “It should continue to be a good credit player over the next 6-12 months. I’m enamored of Venezuela, even though I’ve been completely wrong about it the last 3 months. The big play in 2007 is going to be Turkish rates—local markets. The third thing for me is inflation linkers in Brazil.”
Guillermo Mondino of Lehman Brothers stated that the market drivers over the next 3 months would be, first, the behavior of U.S. rates markets; the Fed will not be cutting rates soon, which will lead to a correction in the rates market. When it happens, it will “take some of the steam out of our market,” he noted. Global equity markets will continue to perform well, providing some additional support to EM, benefiting from the soft landing in the U.S. Second, real-money investors are having a decent year, while hedge funds are very uneven; those who are down will be adding volatility to the market. Third, continued Mondino, “while assets are pricey in general throughout the EM, we don’t think this market will sell off in the near future.” Low-risk, low-yield credit is a favorite asset. Mondino believes that “perhaps the biggest trade in the next year will be the convergence of real rates across the EM, especially Brazil and Turkey.” Finally, “GDP warrants are the most underpriced asset remaining in the EM spectrum.”
Piero Ghezzi of Deutsche Bank noted that he also believes there is an 80% chance the US economy is in for a soft landing, without the housing market pulling it down, which is a good scenario for the EM overall. Rates are likely to do better than currency and credit. “In LatAM, local rates continue to be the most attractive play,” he asserted, whereas FX is neutral—positive for Peru and Brazil—and CDS should be used more as a hedge instrument. In terms of specific favorites, GDP warrants are the ones with the biggest upside right now in EM. “Real rates in Brazil, at least over the next 6-12 months, and rates in Mexico and Colombia, also make a lot of sense,” observed Ghezzi.
Bracebridge Capital’s Mike Rashes’ key point was that external debt trading now in EM reflects the extreme level of liquidity in all financial markets. “Recently we’ve seen rallies in rates and equities in the US, which is driven by the perception that the Fed is done and on the way to reversing itself; we’ll have soft landings in housing and in the economy, inflation will come down.” But Rashes himself disagrees: “I think recent comments by the Fed indicate that further hikes, not cuts, are expected—not in the next 3 months, but by the end of 2007.” On a more optimistic note, Rashes concurred that “there are certain countries where one can imagine positive surprises in the coming year.” And he agreed that “positive news could cause a rally in Turkey, both locally and externally.” The credits that will outperform in the next 6-12 months are some of the more highly rated credits like Pemex and El Salvador, he predicted. Rashes also agreed that “local markets will present a lot of opportunities going forward; the next great trade is probably something that’s not denominated in dollars.” There are also opportunities in non-dollar external debt, as well.
The moderator then asked Ghezzi to speak about the Brazil presidential election. With less than 10 days before the election, and incumbent President Lula about 20 points ahead in polls, it seemed unlikely at conference time that he would be unseated. [Lula did in fact win the Brazilian election on October 29 with over 60% of the vote—Ed.] Thus, Ghezzi focused his remarks on what will happen in a second Lula administration. He feels Lula’s goals will be to enhance growth while keeping inflation low, but this may be difficult, as he will face more opposition in Congress this time around. Ghezzi predicts that monetary policy will not change, but “pension reform must be addressed; the pension system generates a deficit of 2% of GDP, a level that is projected to remain that high even within the most optimistic of growth forecasts.” Ghezzi does believe that Brazil will go investment-grade over the next few years, provided that debt-to-GDP ratio continues to decline. “The equity market has been a major underperformer when measured against, for example, the Mexican equity market, because it is heavily weighted toward commodities, and the mortgage market is ripe for a boom as well,” he concluded.
“From my angle,” chimed in Mondino, “it’s a pity we’ve come to this position,” with Lula likely to win, perhaps even by a landslide. However, he agreed with Ghezzi that Brazilian macro policies are unlikely to change. He views the country’s overall outlook in terms of debt sustainability. It has had great success in reducing its level of external debt, and improving its flexibility in debt management, since debt moved from the Central Bank to the Treasury, and this should continue. Mondino believes that Brazil may sustain a growth rate of 5-6% over the short term, driven by the decline in interest rates; mortgages, real estate and construction, and the overall Brazilian economy, will all benefit greatly from this decline. Thus, debt sustainability should continue to improve. “But they will have to introduce some changes in fiscal policies, just to keep what they have in place,” asserted Mondino. But he holds out no hope for structural reforms, however, and fears that the corruption scandals of the last year will continue as well, possibly even leading to Lula’s impeachment.
Rashes’ contribution to the Brazil discussion was to wonder what—if anything—the future will hold for Lula’s party without Lula at the head of it. “All indications are that Brazil will continue to be an improving credit story in the short to intermediate term,” he said. But “four years from now, will we be looking back at Brazil as a strong investment-grade credit, or a former investment-grade credit?”
Bisat eagerly jumped in to take the other side of the argument: “Over the past four years, Brazilian society has shown a level of maturity that has surpassed that of most other Latin American countries. The recognition that the left can be fiscally responsible represents a huge paradigm shift.” Bisat continued, “The responsible center left of Brazil has proved that you can have your cake and eat it too; if you have good fiscal policy, you can at the same time care about social infrastructure, without which long-term development is impossible.” So, now that Lula has “proven his colors” in the economic area, Bisat expects him to do even more in the areas of health, education, and security. “I am more optimistic about the second Lula administration than I was about the first,” he concluded.
Staying within Latin America, moderator Nencioni then asked the panelists for their analyses of the upcoming Ecuador run-off election and its impact. Mondino opened by quoting a first-round election loser’s comment on the two winners: The Ecuadorians are choosing between two undesirable outcomes. Rafael Correa has frightened people with his policy statements; Alvaro Noboa is center-right and a supporter of dollarization who has used his various public offices over the years to further his private business interests and has often abused his suppliers. “He’s a traditional Latin American populist politician,” stated Mondino, who gave Noboa a 60-65% chance of winning. The economy will probably not flourish under either candidate. Mondino believes that, if elected, Correa might indeed make good on his threat to default: “He’s made a lot of campaign promises, and one of the easiest to fulfill might be to restructure foreign debt.”
Ghezzi pointed out some added complexities of the election in Ecuador: opinion polls there have a poor record for accuracy, and also the interesting fact that the poorest citizens seem to be supporting the rightist Noboa rather than the leftist Correa. “I would agree with Guillermo that Noboa is the favorite, but this is 60-40 odds,” at best, declared Ghezzi, who also agrees that a default is possible. “The market really should not move over the next six weeks based on polls,” given their unreliability, “but in general I see more downside here than upside,” he concluded.
Asked to speak about Turkey, Bisat opened with this volley: “People in New York love to hate Turkey. There’s this massive aversion—I don’t know why.” “If there’s one thing we know,” he continued, “it’s that Turkey’s balance sheet has been cleaned up.” From a credit quality standpoint—five or six years of 6%+ primary surplus, sharply declining debt-to-GDP ratio, a strongly dynamic and entrepreneurial corporate sector, a well-run banking sector—”Turkey is the kind of story we love to love” if it happens to be in Latin America, declared Bisat. “It has no business trading so much wider than our favorites.” Clearly there are political issues that must be watched, but Bisat feels that the AKP should be regarded as an Islamic Democratic party—similar to the Christian Democratic parties of Western Europe—rather than as a threat.
Turning to the short term, Bisat posed the question of why Turkish interest rates have been so high; they recently peaked at 25%. Subtracting an inflation rate of between 6% and 9% leaves a real interest rate of 17–18%, “which does not correspond to the balance sheet story,” he emphasized. Bisat’s explanation: a “perfect storm,” a confluence of four factors that all hit at once. Treasury bills were overbought, especially by Londoners, in anticipation of the locals doing so; local banks had stopped buying Treasuries, causing a liquidity crunch and a duration mismatch; because the government issued many bonds between July and September, there was a lot of supply in the system. These three things have already improved, but one has not: The Central Bank is “sucking liquidity out of the system,” keeping interest rates extremely tight. “I thought at one point this was a mistake,” stated Bisat, “but no longer.” Why? He believes that the Bank is wisely putting the brakes on an overheated economy, which should slow down over the next three to four months, allowing liquidity conditions to ease. “At that stage,” Bisat concluded, “I expect a rally in local interest rates of many hundreds of basis points, which makes it a super-attractive opportunity next year.”
Rashes agreed that “Turkey is potentially one of the most promising places to invest over the next six to twelve months,” though his reasoning differed somewhat from Bisat’s. There are several pockets of uncertainty there, and therefore “you’d expect a higher return; finance theory tells us that,” he noted. Rashes argued that the election is producing fiscal and inflationary pressures that preclude the imminent rate cuts Bisat predicted, so rates are “a better trade with a 24-month horizon than a 12-month horizon.” In addition, way too much of the GDP is going toward interest payments; this is coupled with a poor technical position in which the locals are close to “being full to the gills with paper,” though this situation has begun to improve, admitted Rashes. Many observers believe that Turkey will ascend to the EU soon, and some own Turkish credit because they think it will be a convergence credit, but Rashes is less sanguine. “Truth be told, I think 20 years from now the EU is going to realize they need Turkey—which has a young, vibrant economy—more than Turkey needs the EU,” he declared.
Ghezzi added that Turkey’s inflation target for next year is 4%, “which is extremely ambitious.” Deutsche Bank’s own prediction is a more relaxed 8%. “In general, it’s a trade we like,” Ghezzi affirmed.
Finally, Mondino contributed two more points about Turkey: “Their budget for next year stinks,” he proclaimed. Both spending and revenues are projected to increase 20%, “which is unthinkable without a significant tax increase.” Secondly, Turkey needs to increase foreign direct investment quickly to finance its current account deficit and EU accession is critical to such investment. If there were suddenly news that “the EU is not happening,” the currency would take a hit, local markets would trade off, equities will not do well, and “there will be a mini-replay of May of this year”—although Mondino himself forecasts that the EU will happen and the issue will not be as much of a hurdle as people think.