As the dust settled in the wake of the Lehman Brothers
collapse, many predicted emerging market assets would rebound
strongly from last autumns devastating lows buoyed
by the relative strength of developing economies.
But in the months since, the outlook has grown darker, with
each progressive shade bringing back painful memories of crises
past. Instead of pulling back, major indices have remained
weak, reflecting acute risk aversion, a structural shift in
global financial markets as well as the prospect of a severe
and protracted global recession.
JPMorgans Emerging Markets Bond Index, having widened to
a six-year high of 8.91% over US Treasuries last October, has
since tightened only a touch to around 6.90% in sharp
contrast to its historic low of 1.65% in January 2007. Latin
stocks have fallen 34.4% to date since the collapse of Lehman
Brothers, according to Bank of America Securities-Merrill
The process of stabilizing the financial system on a
national basis with fiscal resources has driven banks to
withdraw credit, which has led to a collapse in trade and an
unwinding of investor positions in emerging markets, says
Arnab Das, head of emerging market research at Dresdner
Kleinwort. Theres a material risk that the thesis
for investing in emerging markets unravels.
The financial landscape has changed beyond recognition, say
analysts, and the intrinsic value of assets globally must
adjust to reflect the end of abundant liquidity. The
destruction of real wealth has to be a part of the solution to
this crisis, to bring the stock of assets back into line with
the income streams that have to service them, says Philip
Poole, head of emerging market research at HSBC.
The world is not good at destroying excess
capacity, notes Dresdners Das.
Claudia Calich, a senior emerging markets portfolio manager at
Invesco in New York, adds that the investor pool is
shrinking globally, and there will also be fewer dealers and
Meanwhile global markets remain highly volatile despite
historically low interest rates as well as massive fiscal
stimulus and banking sector bailouts in the West.
The view from the south
For Latin America as for all markets the outlook
is acutely correlated with events in core markets of the West,
and specifically whether the policy response in the US keeps
the rest of the world open to finance and investment. Like
never before, Latin American assets are locked in a tug-of-war
between fundamental value the structural strength of
assets and market technicals volatile global
price movements, says Andrea Kiguel, emerging market debt
analyst at Barclays Capital.
Yet for now, Latin-focused fund managers believe they have
plenty of ammunition as they fight redemption requests from
fear-soaked investors. For a start, investors point out, Latin
American assets have outperformed their EMEA (Europe, the
Middle East and Africa) counterparts and some Asian markets
over the past year.
High-yield Latin American corporate bonds in JPMorgans
bond indices were down between 30% and 35% in 2008 compared
with losses in emerging Europe at 43%. Latin America has
outperformed because it never had much leverage or a deep
banking system, while fundamentals have improved vastly in
recent years, says Edwin Gutierrez, emerging debt
portfolio manager at Aberdeen Asset Management in London.
The economics matter. Strong public and private balance sheets,
reduced currency mismatches among borrowers, floating exchange
rates and counter-cyclical policies have bolstered the
regions credit profile. Unlike the 1990s, Latin borrowers
are now much less indebted, reducing the volume of debt
defaults. Public borrowing is largely denominated in local
currency, and floating currency regimes have helped serve as a
shock absorber against the terms of trade decline triggered by
the commodity price collapse.
Thanks to healthy foreign-exchange reserves, many Latin
countries can for now buck the cycle of currency
devaluations and debt defaults. Counter-cyclical fiscal
policies and monetary easing could also help to safeguard the
relative growth prospects of the region.
Strategic non-levered real money investors have historically
been exposed to Latin America through external
dollar-denominated bonds issued by governments or
publicly-backed corporates. While local markets offer higher
returns, enhanced sovereign creditworthiness and the increasing
scarcity of government paper in recent years has meant the
regions external debt is increasingly viewed as a
relatively safe asset class. Moreover, in the teeth of the
market downturn, Latin assets have demonstrated relatively
According to the Emerging Markets Traders Association (EMTA),
Latin America accounted for the bulk of sovereign trades in the
fourth quarter of 2008, comprising 57% of trading with a volume
of $111 billion the same proportion for the full 2008
trading at $575 billion. Indeed, Brazilian corporate and
government paper accounts for 19.6% of all EM hard currency
Investors have ploughed into such defensive plays on market
dips since the onset of the financial crisis in August
But many doubt whether Latin sovereign debt can outperform G3
credit this year. High-yield corporate bonds in G3 markets look
attractive by all historical comparisons yielding 20% on
average this year and representing roughly an 18% spread above
US Treasuries. According to Pimco, it would take a 30% to 40%
annualized default rate to wipe out those returns. Why
take on EM currency risk? Its being crowded out. The
diversification argument [for EM] has been weakened, says
Joyce Chang, head of emerging markets research at
One large institutional investor revealed that crossover long
buyers are now actively shunning investment-grade EM sovereigns
for US high-yield corporates. As alarmingly, massive
borrowing by western nations will drain the already scarce
liquidity that could be put to work in emerging markets
and thereby act as a further drag on prices, fears Paul Biszko,
senior emerging markets analyst at RBC Capital Markets.
As a result, investment options increasingly fall into two
camps: safe, liquid but expensive assets such as Brazils
2040 bonds, the most liquid global security in emerging markets
which offers 8.75%; or paper with higher yield, such as from
heterodox economies like Argentina, Venezuela and Ecuador,
where default risks are high. Mainstream investors have
cautiously built up exposure to the latter group, attracted by
the risk-adjusted returns. EMTA calculates that Argentine hard
currency trades in 2008 total around $89.6 billion, or 10.5% of
all emerging sovereign trading that year. The carry alone
is attractive so these markets dont need to rally,
says Gutierrez at Aberdeen, which has cautiously snapped up
Argentine and Venezuelan debt in recent months.
Says Sam Finkelstein, emerging markets portfolio manager at
Goldman Sachs Asset Management: If you look at absolute
levels of debt and their sheer ability to pay, these countries
are not levered. His firm has neutral exposure to
Argentina but is overweight in Venezuela.
On the face of it, the pitch for strategic asset allocation
into Latin corporate debt this year would seem a no-brainer.
These bonds represent simple capital structures from
lower-leveraged credits in countries at a different stage in
their economic cycle than in the West; in theory, they also
offer an extra yield to compensate for EM risk.
The fear factor
But widespread fear over liquidity and pricing levels has blown
a hole in investor confidence in corporate bonds. Analysts are
predicting huge adjustments in spreads and outright
bankruptcies this year as the economic downturn intensifies. In
particular, many fear the deteriorating financial health of the
regions large oil, gas and steel exporters as well as
mid-tier firms whose revenues are tied to the commodity
Merrill Lynchs high-yield emerging market corporate index
at its current spread implies a default rate this year of 25%
among issuers. The spread reflects not only the probability of
default but also likely low recovery rates in the event that
debt covenants are broken.
The global crisis has also forced investors to take stock of
historical trends. EM credit had enjoyed a bull run since the
1997/8 Asian and Russian crises, thanks to expanding global
output, declining external public debt and de-dollarization.
These factors changed the sensitivity of sovereign
spreads with respect to global factors most notably,
risk-free international rates and corporate spreads in core
markets, says Kiguel at Barclays Capital.
But in todays febrile climate, so-called risky assets are
repriced at breakneck speed, since these markets are less
liquid and so more prone to capital outflows. As a result, says
Kiguel, models based on the most recent period may
understate the incidence of global factors. They might
also fail to capture the extent to which US high-yield
corporate debt prices drive the performance of investment-grade
emerging market bonds, he adds.
Latin-focused investors are now increasingly concerned with
technical credit work as they figure out the right moment to
snap up undervalued securities.
But this change in allocation philosophy from banking on
an intrinsic value of a credit to instead emphasizing relative
valuation has come at a time when investors
confidence in calling the bottom of the market is being tested
to the limit. The result has simply made investors more wary of
upping exposure to Latin credit.
The local bid
Fund managers are now also more selective about Latin local
credit markets: many managers have cut local currency exposure
in the wake of a strengthening dollar and the precipitous drop
in commodity prices.
Local currencies once touted by some as relatively
immune from global asset repricing are not the one-way
appreciation bet many had presumed. Moreover, as commodity
prices continue to plumb the depths, local currency weakness
looms large for the foreseeable future. As a result, Latin
currency markets are trading with increasingly less liquidity,
a fact which only exacerbates large swings on low market
volumes, while local currencies remain victim to unpredictable
shifts in global risk appetite.
I am reticent on Latin currency trades despite the
fundamental value. We have had and continue to see a lot of
volatility, and with the regions declining terms of
trade, exchange rate weakness could continue this year,
says Gutierrez. Long local currency trades are no longer a
popular risk/return trade-off as a strategy to achieve
Some would still argue that investors should now snap up local
currency long-duration assets before Latin central banks slash
rates further. But George Estes, analyst for the $4 billion
emerging country debt fund at US-based Grantham, Mayo, Van
Otterloo (GMO), says rate cuts are all priced in local currency
debt. You are not being paid much above short-term
interest rates, he says.
So far the collapse of commodity prices has hit stock markets
more severely than bond markets. Battered by the collapse in
oil prices and capital outflows, the MSCI Latin America Index
dropped 53% in US dollar terms in 2008 versus 2007s 47%
The region remains dogged by currency weakness and slowing
economic growth, all bets are off on whether the bottom of the
market has been reached. In fact, analysts expect Latin credit
markets to outperform equity markets comfortably this year as
disinflation looms large.
Eric Jayaweera, an emerging market trader at UBS, observes that
equity investors are increasingly snapping up Latin paper. The
investment case is made more compelling considering the
expected earning yields for emerging equities are 10% for 2009
compared with the 11% returns that investment grade corporate
bonds are offering.
The financial crisis has reordered the pricing levels, market
functioning and investor base for all emerging markets.
There are very few Latin-specific factors that will
determine Latin bond and stock markets this year, says
Paul Biszko at RBC Capital Markets.
But a silver lining from this crisis for Latin America could
emerge if and when the world economy eventually picks itself
up. Marc Balston, head of emerging markets quantitative
research at Deutsche Bank, sums it up: After this crisis,
those Latin countries that come out relatively unscathed
relative to EMEA will have their reputations amongst investors