2006 WINTER FORUM
eMTA’s Annual Winter Forum was held in London on Tuesday February 28, 2006. JP Morgan hosted the event, which drew over 150 attendees, in the landmark Great Hall building on the River Thames.
In his introductory remarks, EMTA Co-Chair Mark Coombs (Ashmore Investment Management) reminded attendees of recent EMTA accomplishments and urged those in the audience who had not yet become EMTA members to consider becoming part of the trade association. He also recommended that, with the continued strength in the markets, those firms currently recruiting new employees take advantage of EMTA’s Job Opportunities website page.
Joyce Chang (JP Morgan) projected a slide of key economic forecasts in initiating a panel of sell side experts. Chang joked that her colleagues might have to revise their predictions on 2006 returns, supplied only days earlier, as a result of late-breaking announcements by several EM sovereigns of early redemptions and debt buybacks. Chang noted that when she moderated the EMTA Annual Meeting sell side panel two months earlier, her own firm had produced the most aggressive EMBI+ forecast at 250; in comparison, Winter Forum panelist estimates now ranged between 170 and 200. Chang contrasted current EMBI+ levels with forecasts made at the 2005 Winter Forum, when the consensus view was that the EMBI+ would be at 350 a year later.
Panel Upbeat on Inflows into EM Debt
chang polled sell side panelists for their thoughts on the sources of asset class inflows, how the inflows will be allocated, and what the prognosis is for sovereign debt given the flurry of buyback announcements. BCP’s Walter Molano opined that global investors now recognize the ascendance of China and India, with resulting increase in demand for raw commodities; this has led to increased inflows into Emerging Market commodity-producers from Asian and more conservative investors. Molano speculated that the industry would move gradually to a Euroclear-able local instrument market.
Kaspar Bartholdy (CSFB) described the asset class’ newfound “acceptability,” with inflows from large G-7 pension funds, as well as EM and G-7 Central Banks that no longer see the asset class as exotic. Addressing concerns that there could be a rotation of funds flowing out of debt and into equities, “it is clear that there are individual funds that are doing that, and in particular some of the hedge funds have been doing that for a while, but in aggregate, we are seeing massive inflows into EM debt and EM equity, and that is likely to continue throughout this year,” Bartholdy affirmed. Tim Ash (Bear Stearns) stressed that as the Emerging Market debt industry becomes more centered on local markets and corporate bonds, there is a more pronounced need for corporate credit research.
Deutsche Bank’s Marc Balston noted that increased demand from buyers such as Asian central banks and Japan Post, combined with sovereign buybacks and the limited amount of outstanding debt, all created a demand-supply imbalance. Balston believes that it is hard to determine whether there is a reallocation between EM debt and equity because both are receiving massive amounts of new inflows, and both continue to benefit from positive publicity. A small potential risk is that negative developments in EM equities could carry over into debt, he noted. Balston concurred with Molano that the increased role of local markets, and the move away from a benchmark-centered external debt market, would lead to decreased correlation.
Chang noted that current inflows were the most diversified in recent memory. Asian retail, Asian central bank, Middle East petrodollars, and US pension funds (now free to invest in non-investment grade instruments in the wake of the US auto sector downgrades) are serving as the sources of new inflows, with these new investors much less sensitive to US Treasury movements.
turning to a discussion of global liquidity, Chang asked analysts to discuss how an end to “easy money” could affect the EM industry, and if the market had become too complacent in not fearing the possible ramifications. Chang also solicited panelist opinions on what geopolitical risks could derail EM momentum.
Ash argued that EM fundamentals have improved dramatically over recent years and their vulnerability to US rates has decreased as a result. “The key risk remains growth—that the US economy slows and that would have a big impact on Latin America, but we are generally bullish on G-3 growth,” he affirmed. Ash acknowledged that risk factors such as avian flu and terrorism were hard to quantify, but noted that the tourism industries of Turkey and North African countries had proven “remarkably resilient” following terrorist incidents, adding that terrorism was no longer viewed as the exclusive preserve of ‘unstable Third World countries.’”
Bartholdy speculated that only a “very sharp slowdown in the global economy or a serious pickup in inflation risk would throw us off course in Emerging Markets debt.” For Bartholdy, the asset class’s greatest vulnerability is an event which drives up oil pricing substantially and affects global growth, and in his view the most likely cause of such a spike would be military intervention related to Iran’s nuclear research program.
Balston agreed that only a “massive change” in the global environment or dramatic change in oil supply could throw the asset class off track. Avian flu could be contained regionally and have substantial implications on that area, most likely to be in the emerging world; or it could be on a global scale and harm global growth, thus also hurting EM economies.
Molano speculated that liquidity would remain high for a long period of time. He added that with the rise of the Chinese economy, the yuan could become the new international reserve currency. As the yuan is not fully convertible but is pegged to the dollar, many of China’s trading partners are holding dollars in its stead; once the yuan is freely floated and convertible, there will be a dramatic change in liquidity. However as the Chinese do not currently want to accept such leadership, the status quo will persist for some time. For Molano, anti-globalization forces in the G-7 are a greater immediate concern; if the US and European countries took steps to stop the globalization process, it would prove the “death knell for EMs.”
Chang also expressed concern about US protectionist sentiments. She noted that dramatic effect of SAARS on the Chinese GDP growth and refused to rule out the possibility that avian flu could also cause substantial harm in the emerging world.
Panel Reviews Turkey, Hungary and Latin Election Cycle
the panel also addressed political and economic factors in the major EMEA economies. Bartholdy commented that, from a long-term perspective, Turkish policymakers should probably be concerned by the strength of the lira. However from a short-term investor perspective, the recent build-up in FX reserves at the Central Bank could lead to a debt buy-back and “abstaining from international issuance.”
“There has been a shift in emphasis on Turkey,” added Balston. “We used to worry about their fiscal position and their ability to pay the debt; now we have moved positively to worrying about structural issues and economy-wide issues, and this shows what progress Turkey has made.” Ash emphasized the country’s robust export growth and large inflows of foreign direct investment, which he believes are better attributed to the country’s fundamentals than to a bet on its EU accession prospects.
Balston was skeptical about the prospects for fiscal reforms in Hungary, stating “there seems be no appetite from the likely winners of the upcoming elections to implement any reforms.” He also speculated that the country’s credit ratings could be lowered.
Chang also asked panelists to discuss upcoming Latin elections. Most panelists opined that regardless of who proved victorious, no major policy U-turns would result, although optimism for future reforms under incoming governments was notably muted. Ash pointed out that his team was “relatively sanguine” about a Humala presidency in Peru, noting that the candidate’s economic policy advisor had worked to develop the domestic yield curve under Pedro Pablo Kuczynski. Bartholdy countered that it was still an open question whether the advisor would really be part of a Humala government.
Based on their comments during the discussion, panelist recommendations were of little surprise. Molano and Bartholdy concurred that Argentine GDP warrants were an attractive investment, with Molano recommending that investors avoid shorting in general.
Ash spoke positively on Turkey, Bosnia and Serbia while Balston conceded he was being “dull” by selecting Hungary as an asset to avoid. Bartholdy urged investors to think twice about some Middle Eastern credits, including Iraq, in light of concern over military intervention in Iran.
Investor Panel Confident in “Sticky,” “Quality” Inflows
brent Diment of Aberdeen Asset Management moderated the event’s second panel of leading investors. Diment got things rolling by noting that inflows into the asset class were an important driver of recent performance. He asked the panel to enlighten the audience on the sources of these flows, and what new investors are expecting in terms of returns.
John Carlson (Fidelity Investments) replied that while he’s seeing a lot of inflows, from a broad geographic range, there’s been at least one substantive change over the last couple of years. “The investors giving us money now are investment-grade focused, so they are looking at the asset class with a different set of eyes and a different set of objectives than, historically, people like myself have,” he commented. Carlson added, “We’ve looked at it with equity-like returns, equity-like volatility; the new investors come in with the expectation that the story that’s played out over the last 10 years is going to continue.” But Carlson believes the new investors will stay in this market because the credits seem inexpensive to them, in contrast to managers with 15-year hindsight who deem them expensive.
Simon Treacher of BlueBay Asset Management concurred that recent inflows involve “sticky” money from “quality” accounts. “We’re in a position now where it’s easy to attract hedge fund money, so we can effectively turn that down and focus more on the long-only portfolios,” he stated. Treacher noted that the development of the new JP Morgan local markets index has also boosted inflows into the asset class.
Ashmore Investment Management’s Jerome Booth also stressed the “stickiness” of new inflows. “These new institutional investors are very slow and very sticky, because the allocation, unlike to emerging equity or private equity, is coming out of fixed income,” he noted. Booth asserted that new inflows “have nothing to do with spreads, and nothing actually to do with fundamentals in Emerging Markets—it’s got everything to do with a push factor, which is unfunded pension liabilities.” Booth noted that most pension funds in the US must return 8% or 9% to meet their liabilities. They are unlikely to get this from the US equity market, he believes, nor from the US Treasury market. Peer group pressure has also helped, according to Booth, as one pension fund manager tells his/her colleagues about EM investments. Finally, consultants have to start learning about the asset class; in the 1990’s it was considered esoteric, and demanded lots of work—and thus was easy to reject. Unless conditions change dramatically (e.g. unfunded liabilities go away, other major asset classes offer superior performance, a prejudice against Emerging Markets returns, volatility in the asset class increases, or global liquidity decreases) inflows are unlikely to slow down.
Booth echoed the sell side panel that the more likely threats to the asset class are factors such as protectionism or the rise of anti-globalization sentiment. Central Banks, Japanese pension funds and German insurance companies have just “put their toe in the water; there’s a whole swathe of countries out there that have also got unfunded liabilities, and they’ve only just started doing it,” Booth concluded.
Five years ago, when one attempted to sell Emerging Markets in Japan, one would have been met by a “polite bow and smile,” according to Anders Faergemann of AIG. “These same investors are now calling us, and they want to get invested not only in external debt but in local currency debt,” he remarked.
External vs. Local Debt
diment inquired how the panelists were structuring their risk. He also asked whether the asset class would continue to exist in the next four years, or, for example, would EM corporates just be added to the high-yield desks, and Brazil be included on the FX desk.
Faergemann responded that the asset class is here to stay, but whether there will be much external debt to be traded is a valid question. Investors in external debt will hold on to any paper they have. On the other hand, Faergemann pointed out that local markets might be more interesting as “there’ll still be volatility there.” He referred to inexperienced players coming into the market right now that will face a sell-off at some point; he will be watching to see how they react. His portfolio is evenly divided between hard currency and local currency debt, “but it’s only moving in one direction,” he stated.
Ashmore manages $12 billion in dollar debt, $4.5 billion in local currency debt, and $4 billion in special situations, estimated Booth. He predicted that in five years, his firm would mostly be doing local currency and private equity/special situations. Booth also expects that in five years, investors will be putting money into private equity, real estate, mortgage-backed securities, etc. While some investors complain of a “lack of paper,” Booth highlighted the massive potential of Chinese companies.
Treacher defended external debt, while conceding that he was a “dinosaur.” He voiced some concern regarding volatility in local markets debt. Finally, Treacher noted that although he had spent his career by making money in external debt, he now believes that “we may be at the start of a 20-year EM equity run.”
Carlson agreed with Treacher that the future might well belong to EM equity, citing the credit improvement on the debt side. These credit improvements, in terms of ratings upgrades—but more importantly corporate governance, FDI and the institutionalization of the processes—makes a better equity market. Carlson also concurred with Treacher that the external debt market is going to stay, and echoed Booth’s comments that market participants would benefit from more fully developed capital markets in developing economies. “There’s a future for all sorts of investors, because the Emerging Markets are in a different part of the macroeconomic cycle than the US and Western Europe; they’re on the upswing,” he affirmed.
Panel Sanguine on Asset Class Outlook
diment asked panelists what risks keep them up at night and what could derail recent euphoria in the market. Treacher downplayed geopolitical risks (“the Philippines proves whenever you get a military coup, buy it, it always works!”) but cited a contraction of global liquidity as a greater risk to the market.
Carlson’s base case of a benign, low-inflation, growth environment supported Emerging Markets bonds and equities. While acknowledging there are always risks to the asset class, he viewed most of them as unlikely and difficult to hedge against. Booth referred to his earlier comments on the “push” factor for new money to enter the markets. He also stressed that for every potential risk, there were opportunities for investors. Moderator Diment expressed his own concern that a hard landing in China, which has been such a driver of many emerging economies, could negatively affect the market.
The panel then turned to several region-specific discussions. First up was Latin America. Booth spoke positively on Brazil while criticizing the Central Bank for cutting interest rates too slowly. History prevents Ashmore from taking a long-term view on Argentina, according to Booth, but he was comfortable with the short-end of the curve and private equity. Faergemann alluded to the Argentine market as being relatively illiquid in times of market moves, and added that its neighbor Brazil “could hardly be in better economic shape.”
“Brazil is an investment-grade credit for all intents and purposes,” Treacher asserted. He also repeated his previous EMTA forum criticism of hold outs of the Argentine debt restructuring. “If you held out, you should not be in this asset class,” he declared, calling the GDP warrants the “cheapest thing you have ever been given free in Emerging Markets!” Diment preferred local-law Argentine bonds in case of attachment issues from holdout creditors. He offered limited praise for Argentine authorities for having “learned about fiscal policy” after the country’s debt crisis.
African debt markets were next on the panel agenda. Treacher preferred private equity situations in Africa to African local markets, while conceding that “I’m sure someone will prove me wrong.” Carlson’s view on the ZAR was “constructive from a range-trading standpoint.” He was a keen investor in Egyptian local treasury bills last year, but has moved on to local corporates. Booth declined to reveal his investments in Africa, stating “that’s the really interesting stuff!”
In Asia, Treacher saw the Indonesian rupiah as “still offering value” and admitted to being a trader of Philippines debt (“it really is the new Brazil ’40 – you basically just buy it when people are getting suicidal about things that don’t matter too much.”) Carlson announced he was constructive on Philippine debt both local and external, while differing from Treacher in that he saw external debt as a long-term story rather than a trading opportunity. Booth had positive comments on Indonesia and the Philippines, and was optimistic on opportunities in India and China. Ashmore’s largest exposure in Asia is concentrated in special situations, with FX a close second, he stated. Faergemann thought a gradual appreciation of the Chinese renminbi was possible, “though whether that will matter to the market, I don’t know,” he admitted.
Liquidity Concerns Limit Exposure to EM Corporates
"At Ashmore, we do very little corporates,” Booth informed the audience explaining that this was due to the firm’s focus on liquidity management. However, in the future, Booth expected this would change. 5% of Carlson’s portfolio is in corporates, with small positions in any one issue because of his similar concern for liquidity. Carlson expressed interest in wireless as well as steel company issues.
Treacher took the opportunity to praise corporate bond analysts, who he declared have a much harder job than sovereign bond analysts. “It’s a hard market, having to look at 50 or 60 situations a week,” he observed.
Panelist Picks Vary Widely
Diment concluded the panel with the traditional request for panelist picks. Carlson reiterated many of his earlier comments, recommending Argentine GDP warrants, Philippine external debt and Egyptian corporates. Treacher also returned to his earlier theme of de-emphasizing political factors in selecting Ukraine (asserting that the low debt/GDP ratio matters more than the elections). He thought the Latin real estate market offered opportunities, and would be willing to short Peru while cautioning that “every once in a while a short will kill you.”
Booth declared that the BRL was an obvious choice and refused to short anything in Emerging Markets. He thought that 2006 would offer more alpha opportunities than 2005, based on his expectation of FX volatility resulting from the end of the Fed fund tightening cycle, as well as election-related market movements. Faergemann’s selection included the Brazilian, Turkish and Indonesian currencies.