2005 WINTER FORUM

2005 WINTER FORUM

Argentina’s Restructuring, Local Markets Dominate London Winter Forum Discussions
Prospects for the Argentine debt exchange offer and local markets opportunities dominated the discussion at EMTA’s Winter Forum. JP Morgan hosted the event, which took place in London on January 20, 2005 and drew 125 attendees.

Sell-Side Economic Predictions for 2004, 2005
To start the meeting off, Sell-Side panel moderator Jonathan Bayliss (JP Morgan) projected a slide comparing a list of economic forecasts made at the 2004 Winter Forum with actual results. Bayliss summarized that higher-than-expected oil prices and interest rates were the chief discrepancies from 2004 analyst predictions. Moving on to a similar slide for forecasts for 2005, Bayliss pointed out panelist consensus for high oil prices, strong US growth, and, in contrast with last year, a common belief that EMBI spreads would tighten more than the implied forward spread forecast.

Providing additional color on his 2005 estimates, Walter Molano (BCP Securities) listed as the main reasons behind his optimistic asset class outlook a relatively flat yield curve in the US, relatively high commodity pricing, and a “slew” of delayed credit ratings upgrades (potentially including Chile, Brazil, Panama, Peru and the Dominican Republic). Bear Stearns’ Tim Ash, who agreed that EM economic fundamentals remained strong and ratings upgrades were likely, cited as the main risks to the asset class the FOMC “getting behind the curve,” the Chinese economy slowing down, and a fall in commodity pricing. Ash was encouraged that all major EM countries appear to be in good financial shape—”we’ve been through all major crises in Brazil, Russia and Argentina; everything is looking pretty solid; there isn’t really a big country event out there.”

Peter Worthington (CSFB) opined that it was “possible, if not likely” that the Fed would find itself behind the curve halfway through 2005, and “that’s going to keep the market very data-dependent in the meantime.” He reiterated expectations of credit upgrades, supplemented the lists of market risks by adding a sharp decline of the dollar and a “hefty supply” of new debt as potential threats, and described his view on the market as “agnostic.”

Interest in Local Markets
Bayliss recalled the emphasis on local markets opportunities made by speakers at EMTA’s Annual Meeting, and solicited panelist comments. Such interest in local markets was justified, according to speakers who followed up by recommending specific opportunities. Worthington expected South Africa, Romania, Russia, Turkey and possibly Poland or Hungary would prove attractive investment plays, and remarked that the Sell-Side would have to devote more resources to local markets coverage in order to keep up with investor interest. He informed attendees that even the Nigerian local press is reporting on foreign interest in the local debt market, which he said underscored the global search for yield even in exotic instruments.

Ash seconded recommendations on Romania and Russia. The Turkish markets are likely to sell off in the first half of 2005, but this could provide a good entry level, he advised. Ukraine’s currency was massively undervalued, according to Ash, and could prove a rewarding trade assuming good relations with Russia and if President Yushchenko were wise in his selection of a prime minister. Richard Segal of Exotix did not share the more widespread enthusiasm of his colleagues, but offered Serbia as a potentially lucrative buy.

For Molano, the greatest potential upside in local currencies in Latin America was in Brazil, Argentina and Chile. “The one warning to give is on Mexico,” Molano cautioned, estimating that the currency could be overvalued by 20% to 30%, and Lehman Aggregate investors could easily be spooked by early reports on the 2006 presidential elections.

Agentine Deal Likely to Proceed
Turning to a discussion on Argentina, Molano stated that some European bondholders were “capitulating” as they calculate the cost of a legal fight, but believed that these investors were selling bonds rather than tendering. Molano anticipated the deal being completed and surmised it would be a relative success compared to initial expectations, with 60-65% participation. However, he criticized the deal, declaring it would ultimately prove a “disaster and a failure for Argentina,” which would raise the country’s cost of capital for a long period of time, regardless of the acceptance level. Segal forecast 55-65% participation, while acknowledging the difficulties of making such predictions.

“Clearly, the market focus is on whether Central Bank foreign exchange reserves will be used as a sweetener,” Bayliss affirmed, warning that the situation would undoubtedly drag on due to litigious holdouts. Breaking from the panel discussion, Bayliss polled Winter Forum attendees about whether they planned to tender bonds, and a show of hands revealed that the audience was evenly divided between likely tenderers and holdouts. As for the likelihood of a sweetener, a similar poll showed a large majority did not expect the current offer would be enhanced.

Missed Warrant Payments: Intentional or Incompetence?
Recent failures to make oil warrant payments by Nigeria and Venezuela were debated by Sell-Side panelists. Segal opined that, like Bulgaria with its GDP-linked warrants, both Caracas and Abuja “hoped that this would fall through the cracks.” Segal voiced his disappointment that “countries can treat these payments as optional, and only take action when a report appears in the Financial Times—this augurs poorly for countries such as Argentina in the future.” However, he stressed that most countries such as Mexico make all necessary payments in a timely manner.

Worthington disagreed with Segal’s suggestion that such actions were deliberate, countering that it may “reflect more on incompetence.” Any sensible policy-maker would realize that the cost of a ratings downgrade would outweigh the small amount of savings, he asserted. He observed that both countries had confirmed their intention to make any necessary payment, but urged that pressure should be maintained on any country thinking about not honoring such special payment obligations. Bayliss declared himself to be in the “incompetence” rather than “intentional” camp.

Has European Convergence Gone Too Far?
Worthington viewed spreads on new EU country debt as being “far too tight” and admitted to “not buying the argument” that EU membership alone justifies 20-50 bp spreads. EU candidate country spreads (Romania, Serbia, Turkey and Croatia) might also be too tight, he continued, although he conceded that Bulgarian spreads might be justifiable. Ash concurred with Worthington’s assessment, specifying his concern with market overconfidence in Hungary, “a country with massive twin deficits that is not growing, has an overvalued currency, no reserves and is eventually going to crack.”

Ash remained somewhat troubled that Turkey’s EU candidacy might eventually be voted down, perhaps due to xenophobia, although he speculated that Turkey might in the future have less interest in EU accession. As for Ukraine, the country’s massive agricultural potential will trigger a French veto, according to Ash.

Addressing exotic countries, Segal estimated that an Iraqi London Club deal could be signed within nine to twelve months, while noting that the amount of London Club debt outstanding was negligible compared to Baghdad’s other obligations. Worthington declared that Cote d’Ivoire prices of 18-19% were “way out of touch with reality for a country which is going to hell in a handbasket.” The best case one can hope for, Worthington reasoned, is the maintenance of the status quo—a de facto division of the country policed by peacekeeping forces—and even in that case a re-engagement with the international financial institutions will not happen any time soon. “Resumption of debt service is an extremely far and distant prospect,” he cautioned. He concluded that “this is one case that the market has really gotten wrong, and the only reason prices aren’t lower is because it is not more actively traded.”

Russian Credit Rating, Others Likely to be Upgraded
The panel concluded with a brief discussion of credit ratings. Ash asserted that most Forum attendees would probably agree that Russia deserved a third investment grade rating [which was obtained shortly after the Forum], and also criticized a B3 rating of Bosnia. Worthington suggested that Russia deserved even higher than a BBB-/Baa3 rating, and also argued that Ukraine’s ratings were too low.

Indonesia could be rated higher, Segal commented. “An idiosyncrasy of the ratings business is that countries in crisis have to be downgraded quickly, but when it improves, the cycle tends to be much slower,” he remarked. However, Segal maintained that, in the long-term, few countries are misrated.

For Molano, the Dominican Republic, Brazil and Venezuela were under-rated. On the other hand, “in future generations, students at business schools will be given case studies in off-balance sheet financing and there the leading cases will be Parmalat, Enron and Mexico,” he predicted. It is “doubtful” that Mexico should be investment grade at all, he ventured.

The slide of analyst forecasts can be found at: http://www.emta.org/members/EMTA presentation 2005 forecasts.pdf.

Buy-Side Cautiously Optimistic on 2005
Brett Diment of Deutsche Asset Management began the Forum’s investor panel by requesting 2005 return expectations, and asking if Buy-Side speakers shared Sell-Side optimism about the outlook on Emerging Markets.

Simon Treacher (BlueBay Asset Management) noted that, as at the London Summer Forum last June, the main concern of investors remains US interest rates. Treacher identified himself as belonging to the optimistic camp because “Greenspan has got it right,” but expressed bewilderment that more money managers weren’t concerned at the prospect of the Fed chairman’s term expiring. The potential for credit upgrades and strong FDI into countries such as Brazil and Russia provided support for the asset class, Treacher argued.

AIG’s Anders Faergemann voiced his opinion that, “at the outset of 2005, there is very little out there that may be considered fair value and even less that appears attractive.” Despite record spread levels, Faergemann refused to rule out a repeat of 2004 returns, although he projected “minimal” profits as being more likely. Trading opportunities exist, and a more active style in portfolio management is now needed because of the number of “consensus trades which become more or less over-crowded,” he continued. Faergemann reasoned that new asset class inflows and the fact that many countries had already pre-financed 2005 needs may act as a buffer against new supply concerns.

John Carlson (Fidelity Investments) conceded that he had wrongly forecast 2004 returns, but echoed Treacher’s emphasis on Greenspan-watching. He contrasted the current environment with that of 1982, when he first entered the financial markets, warning that it behooved money managers to be cautious in 2005, and “your aggressiveness really depends on your view of the Fed, US rates and US growth.” Carlson also pointed out that, in contrast to Emerging Markets, credit downgrades had surpassed credit upgrades in the high yield market for a number of years and “at some point—I can’t tell you when and I don’t think it’s 2005—the high-yield markets are going to become a very compelling story.”

“The easy part is figuring out where our market is going—and there we can see tighter spreads for the year as creditworthiness improves; the difficult part, and the part we all got wrong last year, is the US treasury market—that’s what is going to make a difference to the level of returns,” Insight Investment’s Ingrid Iversen remarked. Ms. Iversen predicted the US treasury market would have a negative pull on EM debt returns in 2005, lowering them to perhaps 5-6%.

Sticky Inflows?
Diment asked whether recent new inflows into the asset class, which are coming in at record tight levels, would remain in EM debt even if spreads widened significantly. Ms. Iversen replied that “marginal money,” which she defined as the last 5%, could be “twitchy.” However, this did not rate as a major concern, she reasoned, as the decision to invest in EM debt is often a long process, and the return and volatility analyses done by investment committees would still show EM debt as an attractive investment.

Faergemann concurred with Ms. Iversen that inflows were, and should remain, “pretty stable.” Carlson surmised it would take “abysmal” performance before EM debt inflows were reversed, although noting that tactical and hedge fund money would be more fickle.

Treacher admitted to being troubled about a potential exit of crossover investors in a market crisis. He announced his firm had received dramatic new inflows over the past year and assumed most of his colleagues had similarly received new mandates. However, it was not the demand side that could be the source of potential problems, but rather the supply side, according to Treacher. He lambasted investment banks which give large allocations of new bonds to macro hedge funds in order to increase deal size, blaming this “complete nonsense” for additional market volatility. A careful investor can avoid this in a number of ways, Treacher advised, such as focusing on local market debt. He specifically criticized the recent issuance of the new Turkish 2025 bond, declaring that “if people believe there was really $15 billion in demand for the recent $2 billion Turkey issue, they should not only not be doing EM, they should not be doing investments.”

Investor Appetite for Local Markets
Following up on Treacher’s recommendation for local debt, Diment invited other panelists to discuss their local markets instrument appetite. Ms. Iversen advised clients now looking for new local opportunities that “if you can live with illiquidity, and are willing to do some homework, go for the credits that other people don’t think are worth looking at.”

Carlson observed that the growing index inclusiveness, as well as the resources dedicated to research over the past 15 years, have made the search for alpha increasingly difficult. Carlson spoke enthusiastically about using local markets in quest of alpha in his long-term dollar bond portfolio. In contrast with Ms. Iversen, Carlson affirmed he “loves liquidity and am willing to give up 150 bps to have the ability to be able to get out of something in 24 hours.”

Treacher revealed that 50% of his fund is currently invested in local currency and local rate trades. Liquidity can be a problem, as he experienced previously with Romanian and Uruguayan trades. The most appealing local trade was Brazil, although he described COPOM rate hikes as self-defeating if Brasilia is concerned by an overvalued real or hot money inflows. Treacher expressed little interest in EM corporates.

Investors Agree with Sell-Side: Argentina's Deal Will Proceed
Investors showed little interest in battling Argentina over its debt restructuring offer. Carlson admittedly ducked the question of whether he would tender, stating “seriously, I haven’t decided.” Carlson believed deal participation would exceed 50% and would promptly be declared a success by Buenos Aires. He rejected arguments that other countries would be encouraged to follow Argentina’s default because of the geopolitical considerations of such behavior (e.g., Brazil would be denied the UN Security Council seat it seeks, etc.).

Faergemann focused his attention on local opportunities in Argentina, rather than restructured debt. Ms. Iversen confessed to not owning Argentine instruments, but guessed she would probably tender bonds if she did (“I wonder how many people have any appetite for the fight”). She anticipated “surprisingly good” upside for the new bonds and concluded that “Argentina has won round one.” Restructured Argentine debt should trade 300 bps wide of Brazil, but would probably trade much tighter according to Ms. Iversen.

Treacher announced that he had amassed a large holding of Argentine debt at 28-29 and would tender his holdings. With all due respect to GCAB, “they are vulture funds and holdout merchants and their business is quite different from mine—I don’t have time to see lawyers, it’s not my game,” he commented. Are the Argentines getting away with murder, he asked metaphorically. “Probably, but I bought at 28 so I don’t really care.” Treacher predicted that Argentina could complete the deal (“but if there is anyone who can mess it up, it’s Argentina!”) with adequate participation, that there won’t be too many investor lawsuits and that the debt could trade through Brazil. Again insisting that no disrespect was intended to GCAB firms, Treacher emphasized that his sympathy for Argentine default victims was restricted to individual investors, declaring “we don’t really need vulture funds.”

Diment agreed that the deal would probably go through, with most creditors having acquired the debt at low levels. “If then Argentines went the rational route and added a sweetener, they could get even north of 90% participation possibly, certainly at least 85%, but we will find out if they are rational in the next month and a half,” he stated.

There was no dissent from a suggestion that Russia should trade through Mexican spread levels. Carlson compared Russian debt favorably to much higher-rated Chinese debt. “Even though Russia is the consensus trade, and you try to be contrarian, occasionally the consensus trade works,” Treacher opined. (Proving no one was safe, Treacher also voiced disapproval of Standard & Poor’s delay in rating the Russian Federation investment grade, which occurred ten days after the meeting, asserting it would probably “rank up there as one of the most ridiculous situations I have seen in my 25 years in the financial markets.”)

Liquidity Revisited
The panel revisited its 2004 discussion on the imbalance between street holdings of EM debt and liquidity, with panelist opinions varying. Treacher described investment bank efforts at liquidity as “reasonable,” but reiterated his criticism of their syndicate efforts, which he maintained have become more important to their bottom line as the profitability of proprietary trading has diminished. Treacher recognized that low fees have prompted larger deals, but urged deal managers to unite and refuse to do deals at such low fees. He called emphasis on firm placement in league tables as “misplaced,” and recommended that investment banks should focus more on the profits of each deal, not the quantity of deals.

“Liquidity is a concern for AIG,” stated Faergemann. The industry is increasingly concentrated, especially with growing numbers of consensus trades and “the exit window tends to be smaller,” he added. Ms. Iversen offered her opinion that liquidity had not worsened in 2004 and repeated her 2004 comment that less-than-ideal liquidity “is something we have to live with and you factor it into the way you run your money.” Carlson, in contrast, posited that liquidity had decreased in the past 2-3 years, and echoed Faergemann’s concerns over “correlated beliefs” —observing that it was of concern to the Sell-Side as well.

Argentine debt and Turkish local instruments appeared to be the consensus trades recommended by the panel. Ms. Iversen underscored that she was “hardly inspired,” but chose the Mexican peso as an appealing buy and Mexican external debt as a short. Carlson spoke enthusiastically about the Egyptian local market, but cautioned “let’s not all get into it at once as it is a very small market!” Treacher favored the Uruguayan and Argentine currencies, Ukrainian debt (speculating that Standard & Poor’s would be overzealous in its upgrades of Ukraine in order to dispel negative sentiment from the delay in upgrading Russia). Faergemann recommended Brazil, if purchases were well-timed.

Diment invited questions from the audience, one of which focused on the threat to the market by US “uber-funds.” Carlson agreed with the questioner that large funds posed a risk for the market, while Diment saw possibilities for profits (“there are opportunities if they are on the wrong side of a trade”). Treacher observed that such dynamics are part of the unique risks and market structure of EM debt, “but that’s why we do it. Can you imagine anything more boring than trading US treasuries?”