Merrill Lynch hosted EMTA’s 11th Annual Summer Forum in London on Thursday, June 26, 2008. The event drew over 175 attendees as portfolio managers and sell-side analysts discussed strategies in light of the marketplace’s concerns about inflation.
Pablo Goldberg of Merrill Lynch moderated the investor panel that led off the event. Goldberg observed that, during recent visits with European clients, the most obvious theme to emerge was the difficulty in identifying returns in 2008 due to the clouds overhanging the global economy. Goldberg asked panelists to rank their greatest concerns for the Emerging Markets.
Jerome Booth of Ashmore Investment Management stressed the difficulty in generalizing, as each country has its own dynamics and that in fact most of the risks currently are in developed markets. Overall, however, inflation, which has come from domestic demand growth in the EMs, remains the greatest challenge to the markets. Political risk will rise, but Booth was not concerned about a US recession “at all.” EM growth will slow down, he opined, as a result of actions taken by local authorities to slow down growth.
Paul McNamara (Augustus Asset Managers) concurred that inflation remains investors’ largest concern. “The question mark over EM is the capacity and willingness of policymakers to do the right thing to fight inflation,” he stated. In several economies, governments have allowed inflation to rise, hoping it would then fall on its own without rate hikes. In contrast to Booth, McNamara expected that a US recession would have carry-over effects on emerging countries via the equity markets.
How much are investors concerned about the financial system generally? Booth wasn’t over-concerned about further problems with US or EU financial institutions. “They won’t disappear…all it means is that they end up being owned by the Chinese or somebody else,” he responded.
“Anyone who doesn’t think that defaults aren’t going to go through the roof this year is mad,” declared BlueBay Asset Management’s Simon Treacher, who projected that financing for corporates will become much more difficult. “There are names out there that you won’t believe are going to have to restructure,” he warned.
Panelists were asked to suggest potential surprises for the market. Tom Fallon (La Française des Placements) ventured that an unexpected drop in the price of oil would be a very welcome surprise while an attack on Iran or a breakup of the euro would not be well-received. For Treacher, the departure of the Kirchners from Argentina would provide a positive shock. McNamara feared a Chinese economic slowdown occurring before a US/EU recovery would be “very ugly indeed.” A very unlikely, albeit positive, surprise would be for pegged currencies to be guided down slowly, according to Booth.
Closing the formal part of the discussion, panelists revealed their top long and short recommendations. Booth spoke positively on Brazil while McNamara and Fallon voiced concern over India (Fallon cited a recent report that New Delhi may now be spending more on oil subsidies than on education). Treacher recommended Uruguay’s inflation-linked assets as well as Iraq and rated any corporate issue without a “decent” covenant package as a sell.
After the panel was opened to audience questions, one participant asked what topics would be addressed at EMTA’s 12th Annual Summer Forum next June. Treacher hoped that the global situation would correct itself and the discussion topics would return to EM-specific issues. Booth predicted that the size of institutional investor and Central Bank allocations to EM would be addressed
The investor panel was followed by Brett Diment of Aberdeen Asset Management leading a discussion of sell-side analysts. Diment noted that, while the year had begun with investors fearful of the effects of a US slowdown, the greater concern, as had just been discussed, was now inflation.
“One has to be cautious in saying anything confidently about inflation, given that this round of inflation came to us—and everybody else—as a big surprise,” reasoned David Lubin of Citigroup. Three things one should consider in determining whether inflation would continue to haunt the markets, according to Lubin are (1) the policy response by Central Banks, (2) growth, with downward pressure on growth in some countries leading to downward pressure on inflation and (3) capital flows, as countries with high inflation and current account deficits could experience an inflation spiral if they are unable to finance their deficits.
Arend Kapteyn (Deutsche Bank) surmised that the average inflation forecast on the Street calls for a drop of 3 percentage points by the end of 2009. Kapteyn viewed inflation as “a commodity story.” Thus it is highly linked to BRIC growth, he commented, as the BRIC countries are the main source of increased commodity demand, rather than emerging countries in general.
In Kapteyn’s view, a successful investor has the ability to recognize incorrect calls, and is able to cut losses rather than adhering inflexibly to a position that has not borne fruit. Lubin believed EM investors need to be obsessive, with a willingness to focus on their job “to the exclusion of everything else in life!” For Ghezzi, a successful portfolio manager should play devil’s advocate with his/herself and develop alternative scenarios to one’s base case.
The panel concluded with analyst recommendations. Miles reiterated a cautious posture towards EM corporates generally although she saw value in the Asian high-yield market “which has underperformed.” She admitted she had few Latin American recommendations (Brazilian corporates are tight although Mexican telecoms could be attractive). Concerns over a large supply pipeline led her to maintain a neutral view on Russia corporates.
Kapteyn recommended long positions in Kazakh banks. Ghezzi urged investors to buy Latin American currencies, with an emphasis on the real and Mexican and Chilean pesos. Hungarian debt was one of Lubin’s candidates for overperformance.
Turning to a discussion of currencies, the strength of the Hungarian forint and Turkish lira puzzled both Kapteyn and Lubin. Lubin expected emerging European currencies to have varying reactions to a slowdown in euro-zone growth. The zloty is in the best position, he argued, because Poland is a relatively closed economy and is not export-dependent. In contrast, the forint will be under pressure as Hungary is much more dependent on euro-zone growth for its exports. He added that Hungary has a major structural problem as benefits for unemployed workers combined with other state payments roughly equal the country’s minimum wage, locking the country into weak growth and “killing” foreign and domestic investment.
Piero Ghezzi of Barclays Capital noted that the real was supported by strong fundamentals, including high commodity prices. While technical factors have probably weakened, a sell-off would probably require a specific trigger. Ghezzi acknowledged that while he is not a rand expert, the South African currency was “clearly the most vulnerable; the most positive thing to say about it is that technicals are good because no one likes it!” He would take long positions in oil-exporter currencies, the Chinese yuan and the Singapore dollar but would avoid most other Asian FX including the Indian rupee.
Diment polled speakers for thoughts on whether the time had come to buy the EMBI’s underperformers, pointing out Argentina, Venezuela, Indonesia and Ukraine as the countries showing the poorest returns in recent months. Ghezzi offered his assessment that Venezuelan debt issuance had very little to do with funding needs but rather was a way to supply dollars to the market; this created distortions. Caracas now is changing its strategy and debt performance will likely improve, he predicted. Argentine debt prices were fundamentally cheap, and though he doesn’t believe the country will default, the possibility is high enough that the debt should be avoided.
Kapteyn described his concerns for Ukraine, including liquidity risk, although he conceded it was “starting to look interesting.” He echoed Ghezzi’s reluctance to recommend Argentina, while acknowledging that some of the short-term dollar debt was tantalizing. Indonesia did not merit a buy, and Venezuela would probably offer better entry levels in the future.
Victoria Miles (JPMorgan), the panel’s corporate specialist, discussed potentially vulnerable EM banking systems. Miles expressed greatest concern over the Russian and Ukrainian banking sectors. Although Russia’s state-owned banks are benefitting from Russian cash inflows and are increasing market share, the balance sheets of private banks are being stretched as they attempt to maintain their businesses. Imbalances are building in the Russian banking sector, and a hike in reserve requirements is likely. Refinancing risk remains a concern in the Russian corporate market, she believed.
Miles spoke more constructively on Kazakh banks. Although non-performing loans are probably understated, and local banks remain exposed to depressed real estate pricing, the re-accumulation of Central Bank reserves provides comfort, granting the government greater latitude in handling banking sector issues. Pro-active government policies, and a desire to avoid any banking failures, have led JPMorgan recently to raise Kazakhstan to a market-weight ranking, from the “underweight” maintained for the previous 18 months.
Diment asked panelists to describe what makes a good investor in the EM debt asset class. Miles emphasized that most successful investors are open-minded, able to adapt to the unique circumstances of each country, and have both patience and tenacity. Finally, she cited an interest in economic development as a crucial quality.