Speakers at london winter forum shrug off day's decline
eMTA’s Winter Forum was held in London on January 28, 2007. Over 125 industry professionals attended the event, which was hosted by JP Morgan. Despite market turbulence during the day, attendance was strong and speakers brushed off concerns that the sell-off augured a larger market decline.
Effects of US Slow-Down on EMs
will Oswald of JP Morgan moderated a panel of Sell-Side research gurus, and began by asking speakers to discuss Emerging Market vulnerability to a slowdown in US economic growth. Standard Bank’s Francis Beddington opined that Latin countries, particularly Mexico, were the most exposed. However, Beddington suggested that in addition to recent focus on China and India, the next eight most-populated emerging countries are home to one billion people and a $2 trillion economy. “There are other growth poles around, so I think a modest US slowdown can be weathered,” he stated, while warning that if US growth declined less than one percent, the markets will come under pressure.
Kasper Bartholdy (Credit Suisse) agreed that there was a big difference between 0% US economic growth and 2% growth. Bartholdy reasoned that whether one believed that a close correlation between Emerging Market bond spreads and the US corporate market was fundamentally warranted or not, such a link does exist, and thus a US recession—and subsequent corporate defaults—would have a negative impact on EM bond spreads. However, Credit Suisse’s view is that US growth would accelerate during 2007 and “we don’t think the scariest scenario is the most likely scenario,” he noted.
Deutsche Bank’s Marc Balston acknowledged that, with a forecast of 2% growth, his institution was the most bearish one the panel vis-à-vis the US economy. He concurred with the previous speakers that unless the US completely fails to meet expectations, there should be no dramatic effects on EM economies. Balston added that indirect effects could prove more important, such as declining commodity pricing if a US slowdown dramatically affected the Chinese economy.
“We don’t buy the gross slowdown story,” stressed Tim Ash of Bear Stearns, who shrugged off the day’s market sell-off to “one data release and a Greenspan comment that was taken out of context.” Prompted to discuss the impact of possible increased risk aversion in the event of a US recession, Ash admitted that Turkey’s 8% current account deficit was a source of vulnerability, and expressed concern that record high portfolio flows could “leave very quickly,” citing the upcoming presidential election as a possible catalyst.
New Money and New Opportunities?
the panel discussed asset class inflows and their implications. Bartholdy noted that with sovereign debt stock shrinking, new inflows will naturally move into corporate and local currency debt. Oswald referred to recent JP Morgan research, which showed that pension funds, insurance companies, Central Banks and others were still “massively” underinvested in Emerging Market debt; specifying for example that while pension fund holdings rose 33% between 2002 and 2005, their allocations to EM rose by only 6% during the same period.
Balston highlighted a global shift towards increased propensity to save in both G-7 and emerging countries, which is prompting a change in asset pricing in terms of risk premium. He described the previous trend of Asian Central Banks putting FX reserves into US treasuries as being supplanted a new one of oil exporters looking for the higher returns offered by equities and Emerging Markets.
“It’s not an issue where the next bit of money is coming from; for me, the problem seems to be that there is too much liquidity out there already and we’re struggling to manage that and find assets for investors,” commented Ash. He questioned whether current spread levels adequately compensate investors, and emphasized that EM corporates concerned him the most. “There is probably about $100 billion of corporate borrowing out of Russia next year and its very difficult for analysts in that market to keep up with that,” he observed, adding “Nigerian banks coming to the market at 9½%? Something just doesn’t feel right.”
Beddington, asked to analyze opportunities in sub-Saharan Africa for some of the new inflows, conceded that recent moves into such debt was “a function of the search for yield in global liquidity; however to a degree the world has been underweight Africa for too long.” Balance sheets have been repaired through HIPC debt relief and commodity price increases, and some countries have consistently grown 6-9% over the past five years. Furthermore, these markets have low correlations to other EM assets, Beddington reminded attendees, with exotic African currencies relatively unfazed by recent sell-offs, although illiquidity remains an issue. While most investors have first looked to local markets in Africa, equity markets show “much more promise.” Beddington cited Nigeria as an example; at current official estimates of GDP per capita of $1,000 (a number he implied was “a trifle too convenient” just before an election), one is starting to see a take-off in services, the development of the middle class, demand for mortgages, etc. On the other hand, Beddington warned there are exceptions, “the Seychelles borrowing $300 million in a $700 million economy strikes me as imprudent.”
After the EMBI
while there has been a general move towards absolute return funds in recent years, fund managers like to have benchmarks for comparison purposes, according to Bartholdy. Some hedge funds do peer comparisons; and while others create benchmarks out of existing specialized indices, there is probably still a need for benchmarks which mix asset classes, he reasoned. “One area where the benchmarking is underdeveloped seems to be the EM corporate debt market, where I think there’s still some work to be done,” he concluded. Oswald concurred that there are many questions being asked about how a corporate bond index should be constructed.
Balston noted that no benchmark “captures the imagination” as the EMBI did in the first decade of the market. Whereas the daily performance of the EMBI once immediately captured what was happening in the market, this is no longer the case due to the diversity in local markets. In addition, whereas the EMBI spread once gave a simple tool for valuing the market, and identified what an investor was paid to take on extra risk, an index of local markets will be unable to serve those functions. In the future, more total return funds and possibly more peered-benchmarking are likely, Balston predicted.
EM Post-“Original Sin”
discussing the ramifications of the move towards sovereign issuances in local currency-denominated debt rather than Eurobonds, Bartholdy pointed out that this has been very positive for the market in general as it has not only reduced the vulnerability of countries’ debt/GDP ratio to shifts in the real exchange rate “but it has also genuinely reduced the risk that a default will happen in the first place.” Bartholdy expressed sympathy for countries which try to prevent excessive and rapid currency appreciation as a result of increased foreign participation.
Following up, Beddington offered the example of South Africa, whose officials, in contrast to China, have “basically concluded there is nothing they can do about it, so they focus on inflation and take appropriate responses.” He concurred with Bartholdy in expressing sympathy for the motives of countries such as Egypt which restrict foreigners from buying money market instruments.
Balston noted ironically, “we used to complain that EM sovereigns couldn’t issue in domestic markets…now we are complaining that they’ve borrowed from us domestically and it’s all owned by foreigners!” While acknowledging the risk of foreign capital outflow, he also pointed out that the countries most successful in replacing their foreign debt stock with local-currency obligations were those with reasonable current account surpluses.
As for panelist favorites, Ash believed that investor’s calls on Turkey might prove pivotal this year and expressed surprise at the lack of market focus on the upcoming presidential and parliamentary elections. He referred to himself as a short-term bear but sees potential in light of improvements in public finance. Ash argued that there are still “funky” stories out there that are not well covered but are potentially lucrative investments, citing Bosnia as a recent precedent. He spoke positively on Ukraine (“basically a commodity story”), Argentina, Brazil and Colombia.
Beddington saw Turkey as cheaply-priced. He also was optimistic about the long-end of the Israeli curve, as well as Egyptian and Nigerian trades (“a very poorly understood country with a presidential election which in my view will be a complete non-event.”). Bartholdy was also bullish on Turkish debt and thought Argentine debt and the short-end of the Brazilian curve were attractive on the day’s weakness. He seconded Beddington’s optimism on Nigeria and Egypt.
The Egyptian pound also appealed to Balston, as did Turkish lira though funded through South African rand rather than dollars (he recommended this as a way to hedge out some systemic EM risk). He also offered Kazakh tenge and select Argentine assets (including GDP warrants but not NY-law dollar bonds) as favored investments.
The event’s Sell-Side panelists accurately predicted that Ecuador would not default on its upcoming external debt payment, as it has repeatedly threatened in the months prior to the Forum. “Ecuador realized it wasn’t a cost-free exercise,” surmised Balston who despite expressing confidence that a default was not in the cards for 2007, would not rule out a failure to pay in 2008. Oswald agreed, seeing next year as potentially more an ability to pay issue rather than willingness to pay. Panelists were unanimous in predicting that as a default would not be completely unexpected, market ramifications would be limited.
An Investor panel followed, with Aberdeen Asset Management’s Brett Diment chairing the discussion once again. Diment polled investors to see if they agreed with the previous panel that the market’s sell off in the previous days represented a buying opportunity. Jerome Booth (Ashmore Investment Management) conceded he probably “sounded like a broken record…but institutional are massively underweight” and he continues to expect strong inflows will support the asset class. Simon Treacher of BlueBay Asset Management also saw the sell-off as a buying opportunity.
New Inflows, and Where the Money Will Go
on inflows, “you’re going to hear the same thing year in, year out hopefully…I think I said last year and the year before that I have never seen flows like this,” Treacher observed. He added that some of BlueBay’s new mandates come from investors who have not previously ventured into external debt, and confirmed that much of these funds are being interested in local currency or corporate portfolios. John Carlson of Fidelity emphasized that most new opportunities would be in the EM corporate arena, and saw additional upside in equities, which his mandates also include.
Booth stated that while the bulk of Ashmore’s inflows are from pension funds, 10% of his firm’s assets under management are Central Bank or other government funds. He expected in three to five years that his firm would have more funds invested in local currency debt than dollar-denominated paper, a shift from current allocations, where dollar debt outnumbers local instruments by a 2:1 margin. Some of his investors were expressing interest in taking entire corporate debt issues, possibly one day disintermediating investment banks (Treacher later revealed his interest in owning an entire corporate issue if he likes the story).
How will performance in these new inflows be measured? Booth “didn’t envy” the job of index creators, but would welcome an attempt to create a corporate bond index. Diment stressed that “rightly or wrongly, clients do want managers to manage themselves against a benchmark” and “we’re not quite there yet” in having appropriate corporate or local bond indices.
Limited Use of Derivatives
diment questioned investors on what roles derivatives play in their portfolios. Treacher responded that with recent buybacks affecting the liquidity of external debt stocks, credit default swaps (CDS) are “where the liquidity is,” although specifying that portfolio mangers are probably better being long high-coupon Brazil bonds rather than Brazilian CDS because of eventual buybacks.
Booth acknowledged that Ashmore’s use of derivatives was limited, thought it uses CDS in the local currency area, as well as non-deliverable forwards (NDFs). There is little need to hedge currency risk because “if we don’t like currency risk, we sell the whole thing.” Carlson’s portfolios, like fellow panelists, were long-only and do not use derivatives. Diment tends to use CDS “reasonably actively.” Diment and Treacher both voiced concerns on more complicated derivative instruments, and suggested that investment bank fees on these assets were not always clear.
Favorite Local Market, Corporate Plays Discussed
carlson viewed Turkey, Colombia and Sri Lanka as the most attractive local market investments. Treacher disagreed with Sri Lanka but joked it would probably be too late now in any case. For him, there are local markets opportunities in the Dominican Republic, Uruguay and Argentina and for “the first time in twenty years,” he was bullish on Turkey, although he had recently taken profits. He suggested shorting the rand and Kazakh tenge.
Booth chose Russia and Turkey as potentially profitable local market investments. “Brazilians just haven’t worked out that they are a low inflation country; they still don’t believe it and that includes everybody in the central bank.” Brasilia will have to move more aggressively to cut rates in order to alter their debt dynamics and get an investment-grade rating. He predicted that sell side forecasts of year-end rates will prove to be too cautious, arguing that in fact they will be cut to levels below street consensus. Diment agreed on Brazil, and added Egypt and Thailand (due to a low correlation, among other factors) as favorites.
In the corporate arena, new issues from Turkey, Latin America and Asia were of interest to Booth. He highlighted the possibility of Chinese yuan-denominated corporates, noting official interest in developing the local markets. Treacher looks for M&A targets when sifting through Russian corporate issues. He stressed the need for more corporate bond analysts to cover the myriad of issues in the market, as well as the need to understand bond covenants. Carlson eyed certain sectors in Russian, Brazilian and Argentine corporates but declared that liquidity as a key factor in his investment decision. “The part of the market that really excites me the most, and I haven’t seen much of it lately, is the distressed market in corporates,” he announced. Diment concluded the topic by mentioning that corporates represent 10 to 15% of total risk, mainly in Argentine and selected Russian issues.
Panelists Not Expecting an Ecuador Default
treacher’s assertion at the EMTA Annual Meeting in December 2006 that Ecuador would not default “caused me no end of problems—I was inundated by calls from clients, the press, even the Evening Standard called!” He criticized street research on Ecuador earlier in the winter, and thanked one investment bank’s dramatic report for prompting fire sales of Ecuadorian debt, while BlueBay was a buyer. Treacher reasoned that at the end of the day, Quito had always planned to pay despite the demagoguery. Carlson agreed with Treacher’s Ecuador call, while adding a caveat that external debt would be serviced as long as oil remains at current levels. Being less of an oil bull, Carlson expected to revisit Ecuador in 2008 when both willingness and ability to pay could be issues.
Panelist opinions on whether Argentina would re-open its debt exchange were divided. “Not this year, it’s as simple as that,” stated Booth. Carlson thought a re-opening was possible – “we’ll probably strike a deal and in some ways we’ll bail out those who didn’t jump the first time.” He reminded participants of Treacher’s 2006 remark that those who didn’t tender their bonds should not be allowed to run money, and reaffirmed his sympathy with that viewpoint.
Debt not Aid for Africa?
diment asked panelists if they had any exposure to Africa. Carlson cited lack of liquidity for venturing into Africa beyond Egypt and South Africa. Treacher revealed he has been a small buyer of Nigeria. Booth suggested a new economic framework was needed for the continent, speaking of the need to get international aid agencies “out of the way.” Booth offered Rwanda as an example of a country with improved fiscal performance and with no debt overhang, but with 50% of its government budget provided condition-free by relief organizations. “That’s exactly what we should be providing,” he stressed, “not the aid agencies.” He continued, “what we are talking about is making a lot of people in the aid business unemployed and saving the tax payer a lot of money and taking countries off the welfare check.” He proposed that an international multilateral organization draft a set of conditions that must be met by African nations before sovereigns could tap the bond markets with Brady-style collateral. Currently, the markets don’t work, according to Booth, because the issue size of African bonds is generally very small, limiting the appeal to “wackier hedge funds” who are quick to unload the bonds at sign of any problem.
Panelist Recommendations
at the close of the panel, Treacher reiterated his interest in Ecuador. “If I get my coupon this year I make 12%, that’s all that matters to me…how many points must it go down before I lose money, its just basic math,” he stated. He also likes Venezuela, especially when Chavez rhetoric, which he dismisses, causes spreads to widen. Treacher favors countries that actively manage their liabilities such as Brazil and shuns those such as Indonesia which look at him “as if I am completely mad” when he brings up the topic at investor meetings. Carlson spoke enthusiastically about Brazilian equities and Turkish rates.
Booth declined to list specific picks but acknowledged that Ashmore’s largest exposure is with Brazil, including the equity side. He urged investors to sell US treasuries, because “that’s risky, there is a flat curve, you’re not being paid for the risk, the dollar could weaken, and frankly it looks more volatile than Emerging Market debt.” He called for investors to adopt a new outlook which does not automatically assume G-7 debt is less risky than their EM counterparts. Comparing Russia to Italy, he note the latter’s lackluster growth, high debt to GDP ratio, “and a very possible scenario where they get downgraded a couple more notches and the ECB doesn’t accept their bonds as collateral…a little bit worse on the fiscal side, a bit of employment and there’s a real discussion politically about leaving the euro…So you tell me as a fixed income investor, that’s safer than Russia, with its huge FX reserves, appreciating currency, a huge need for foreign investment, etc.?”.
In response to audience questions, Booth noted that there was no relationship between spread tightening and his firm’s performance, and suggested that some investors are focusing on the wrong part of the picture. He used an escalator as a metaphor for fund performance. When one goes up the escalator; he philosophized, “we all get very worried when we’re getting close to the summit and what we’ll do at the top when spreads are very tight.” Instead, one should focus on what is driving the motor of the escalator—which would reveal that the same force will drive the motor for another 30 years, he concluded.