2004 Winter Forum

EMTA INAUGURATES LONDON WINTER FORUM

Sell-Side Panel Debates "Bubble" in EM Debt
EMTA continued to bolster its presence in the European market by inaugurating its London Winter Forum on January 29, 2004.  JP Morgan hosted the event, which attracted a crowd of approximately 150 Emerging Markets professionals despite problematic weather conditions (which almost prevented two panelists from flying in from the Netherlands) and market volatility (following unexpected Fed comments on rates).  The event, which featured two panel discussions of Sell-Side and Buy-Side experts, was held in the 19th Century former home of the prestigious City of London School on the Thames. 

Sell-Side panel moderator Jonathan Bayliss (JP Morgan) set the tone of the discussion by projecting a chart detailing key economic predictions from his co-panelists.  Bayliss stressed analyst bullishness on year-end Fed Fund predictions, with two panelists predicting that there would be no rate hikes at all in 2004.  Bayliss also highlighted speaker predictions for the EMBI+ at year end, which were generally more bullish than the implied forward value, although he conceded all five panelists expected an end to years of double digit returns for the asset class (and three panelists forecast negative returns.)  Click Here to see Panelist Economic Predictions.

Bayliss polled speakers for their take on the Institute of International Finance’s recent report that implied that Emerging Markets debt prices were overvalued.  Tulio Vera (Merrill Lynch), observed that, on a historical basis, the asset class had some elements of a “bubble,” which he defined as when market valuations are perceived to be ahead of fundamentals.  Vera speculated that this bubble could be burst by a reversal of some of the trends that created it, for example, signals of US rate hikes which would lead to decreased global liquidity, and reduced risk appetites.

Richard Segal (Exotix) suggested the market would better be characterized as a balloon rather than a bubble.  Segal continued that if Emerging Market debt prices are inflated, the asset class isn’t alone in having “heightened valuations.”  Bear Stearn’s Tim Ash asserted that most market analysts believe that debt prices are ahead of fundamentals.  However, he reminded the audience of the general improvement in Emerging Markets economies in recent years. 

Walter Molano (BCP Securities) and moderator Bayliss disagreed with the majority that pricing might be inflated.  “The market is still relatively cheap,” countered Molano, citing low US rates, a rebound in commodity pricing and several important ratings upgrades “waiting in the wings.”  Molano affirmed that such positive factors had not yet been priced into the market.  Bayliss opined that the market lacked the speculative element that was characteristic of a bubble.

Local Instruments, Equities Recommended
Asked to identify the source of the best returns in 2004, Ash recommended local markets in Latin America based on the weak U.S. dollar, as well as Emerging Markets equities in general.  Molano spoke positively on Brazil, Venezuela and Argentina (“the restructuring will go much better than people expect…and the final deal will be much better than the one that is being talked about in the press.”)  Vera and Segal agreed with Ash in recommending equities (although Segal cautioned that the market could turn bearish in six to eight months).  Vera expected outperformance from Turkish, Polish and South African local instruments, as well as from Uruguayan, Venezuelan and Philippine external debt.

Asked for some non-mainstream suggestions, Segal recommended Sudanese paper (for non-US investors), Iraq (“for those who are willing to do their homework and read the documentation”), as well as Jamaica, Uruguay and, in the second half of 2004, the Dominican Republic.  Asked whether Iraqi debt will become a commonly traded instrument in the near future, Segal predicted that at least a “handful of investment banks” would start trading Iraqi paper in 2005 or 2006.  Segal explained that, while the amount of London Club debt is currently small, eventually bilateral loans, letters of credit and other instruments will become standardized with London Club debt and offer a more liquid instrument.

Bayliss opened the floor to audience questions, and one audience member requested panelist opinions on when the credit derivatives market would surpass the cash market.  Bayliss commented that, with the exception of the very liquid Asian credit derivatives market, the cash market would continue to be the larger market, although he acknowledged the strong growth in the derivatives market.

Another attendee solicited panelists’ thoughts on potential political surprises in emerging countries in 2004.  Molano offered his assessment that the outlook was largely benevolent, with 2004 a generally quiet year in terms of elections (and no major Latin elections until the 2006 contests in Brazil and Mexico).  Ash saw getting the “no brainer” Russian presidential election over with as an important step for the country’s ratings prospects.  Ash voiced his optimism that reformers within the Russian government would be promoted once the election was concluded.  Segal warned that a victory in the Dominican Republic presidential election by the market’s preferred candidate would probably not “come soon enough to prevent a sovereign debt restructuring.”  Segal also expressed concerns about the Ukrainian and Serbian elections.  Vera pointed out the volatile nature of most Emerging Markets elections, regardless of how hotly contested the vote actually was.

Buy-Side Panel Discusses Argentina, Venezuela
Deutsche Asset Management’s Brett Diment led investor panelists through a session that was more focused on the outlook for individual countries while also managing to address several big picture issues. 

Foreign and Colonial Management’s Robin Hubbard noted that Argentina was “probably cheap,” although he conceded that he “wouldn’t bet the bank on it.”  Jerome Booth of Ashmore Investment Management disagreed, “Argentina is not worth anything like current prices.”  The country remains plagued by century-old structural problems, according to Booth, who also expressed concern that Buenos Aires might be headed toward isolationism.  Booth supported an IMF cut-off of the Argentines, fearing an erosion of IMF credibility.

Ingrid Iversen (Insight Investment) also expressed little interest in Argentine debt at current prices.  She hypothesized that the government’s incentive to complete a restructuring now should be greater than in the future if politicians expect the economic recovery to continue.  The longer they wait, she reasoned, the more ability they would appear to have to pay; and thus investors should listen to the politicians as the timing of a deal seems a political rather than economic decision.  Finally, Diment argued that there was little downside risk to Argentine debt and that a deal might be facilitated as many creditors purchased the debt at already marked-down prices.

Panelists spoke more in unity on Venezuelan debt, with near unanimity that such instruments were fairly valued.  Rob Drijkoningen (ING Investment Management) stood out as the most bullish panelist, calling Venezuela “still relatively cheap.”  Iversen echoed other panelist comments by remarking that investors are being paid for assuming political risk, but the credit is “not one you can take your eyes off of.”

Turkey as a Ponzi Scheme?
As for Turkey, the panel debated whether Turkey was best understood as a classic Ponzi scheme or an attractive EU accession play.  Iversen suggested that Turkey’s external debt could be classified as a Ponzi scheme, with prices built not on fundamentals but on confidence, technicals and momentum, “and debt prices will be supported as long as those trends continue.” 

Hubbard disagreed, highlighting Turkey’s strong primary surplus, and both he and Diment underscored the strong incentives Ankara has to remain on track for EU accession.  Hubbard considered the credit fundamentally expensive and would not be long (or short) at current levels.  Booth acknowledged that Turkish debt was one of the riskiest assets he owned.  “You have to be very tactical—we look at it very day, it requires a lot of attention.”  He cautioned,  “Sitting on long-term debt is not something I would recommend.” 

Panelist opinions on the local Hungarian and Polish markets also diverged.  Drijkoningen described the markets were interesting but “not for the faint hearted.”  Iversen reasoned, “yields haven’t risen enough to compensate for the fiscal deterioration and market volatility over the last six months or so.”  Booth saw better value elsewhere, and did not rank Polish or Hungarian domestic instruments as core holdings.

Lukewarm Investor Interest in Credit Derivatives
Diment asked whether Buy-Side speakers considered credit derivatives a useful tool.  Hubbard responded that most of his clients do not allow him to trade credit derivatives, and further suggested that Sell-Side firms might underestimate the importance of their own “massive amount of infrastructure” to support credit derivative operations; the Buy-Side’s operational abilities were probably more limited.  “Tedious and practical considerations” have to be taken into account before an investor starts taking positions, Hubbard stated, and “personally, I’d rather look at doing plain vanilla interest rate swaps either to hedge out Treasury duration or to do local markets” as these would enhance his portfolio, while he wasn’t yet convinced credit derivatives offered “fantastic new opportunities that I am missing out on.”

Booth’s interest in credit derivatives was limited although he acknowledged sporadic use.  “We don’t buy protection because we like default risk, we like its being mispriced,” he explained.  Iversen surmised that there would be opportunities for credit derivatives with new clients, although as for existing clients, “the time spent convincing them to broaden their portfolio to include credit derivatives is probably not the best use of an investment manager’s time.”

Recommendations Vary Widely
Investor recommendations for specific assets to own in 2004 varied greatly, with limited instances of assets getting multiple recommendations.  The only asset to receive three “thumbs-up” was Argentina, which Diment, Drijkoningen and Hubbard recommended on a risk-adjusted basis.  Diment and Drijkoningen also concurred in encouraging investors to consider Turkish t-bills, and Drijkoningen and Iversen both speculated Dominican debt might offer better-than-average returns. 

In addition, Hubbard advised the audience to look at Russia for “steady outperformance, but not spectacular returns.”  Booth’s top selections included Uruguayan external debt; Russian and Turkish local currency debt, and special distressed debt situations in South Korea and China.  Iversen recommended South African locals, and Venezuela, and short positions in Turkish external debt, “at some point in the future.”

Brazilian local instruments and Ivory Coast hard currency assets were among Drijkoningen’s choices.  Finally, Diment spoke positively on the “admittedly boring EU conversion stories” of Bulgaria and Romania.

Liquidity Not a Major Obstacle, Inflows Should Remain Strong
The panel was asked for feedback on the liquidity provided by dealers given the buy-side’s increased amount of assets under management. Hubbard offered his assessment that,  “Liquidity from the street has obviously deteriorated substantially, and the asset manager has to change the way he manages his funds accordingly.”  Hubbard viewed lower liquidity as “neither good nor bad,” and that perhaps most importantly it wouldn’t affect the inflows into the asset class.  (He speculated that his clients, not wanting to see their portfolios actively traded, might even see limited liquidity as a positive factor.)

Booth concurred that inflows would not be affected, and that although the job of the asset manager is more difficult over the short-term, eventually the liquidity issue would “sort itself out.”  In a similar vein, Iversen admitted it was “disappointing” that dealers hadn’t kept up with client inflows but had no doubts it would eventually increase.  “Maybe being forced to take more long-term measured views is not a bad thing for the market,” she added.  Drijkoningen described it as more of an issue for larger trading accounts than for his firm.

Investor bullishness on inflows into the asset class remained strong.  Iversen commented, “A lot of institutional money has yet to even start thinking about EM, and as optimal portfolio analyses are always backwards-looking, the numbers for EM will get better and better.”  Booth seconded the optimistic outlook. “We are in year two of a five-year trend, inflows are not slowing down at all,” he affirmed.