When the US leveraged loan crisis hit in August 2007, bullish analysts at the bulge-bracket firms argued a sell-off in risk assets would be a healthy cyclical correction to normalize pricing. By early 2008, the financial turmoil had intensified and predictions of a synchronized global downturn became mainstream.
Economists and strategists then emphasized the fundamental credit strength of emerging market issuers and argued economies, such as Russia and the Gulf, with low debt to GDP ratios and current account support could ride through the external storm. Even the bears, who argued dire external market technicals would derail fundamentals, reckoned good relative value analysis and a flight-to-quality could help ensure the safety of EM investments.
And then came the Lehman collapse. All emerging market foreign exchange, credit and equity markets witnessed catastrophic losses. Second-round effects kicked in instantly, with collapsing exports, weak consumption and falling growth. In short, sell-side analysts had failed to predict the biggest crisis to hit emerging markets since the late 1990s.
“I got the market absolutely wrong... I was unable to translate my bearish views on the developed world to the developing world,” says Roland Nash, chief strategist at Renaissance Capital, whose research team in the fourth quarter of 2008 predicted Russia would grow 6% in 2009 compared with the current IMF forecast of -6.5%.
“Clearly I didn’t forecast the financial crisis or the impact on EM trade and markets in the immediate aftermath of the Lehman collapse, but neither did the buy side and nor did anyone else,” says Kasper Bartholdy, chief emerging markets strategist at Credit Suisse.
And after the storm came the flood and the massive resurgence of emerging market risk appetite from March. Liquidity has poured back into emerging markets with investors now overweight EM credit and equity at the expense of developed markets.
But again investors accuse sell-side strategists of failing to predict the shift in market conditions. “When the market came down, the sell side always remained bullish for far too long, and then when the market came up they remained behind the curve,” says Julian Jacobson, an emerging markets fixed-income portfolio manager at Fabien Pictet & Partners.
While analysts argued emerging market assets were due for an upswing after massive losses, many argued the rally was not driven by strategic inflows seeking to normalize asset prices to long-term fair value. Instead, it was down to market technicals: oversold positions and cash on the sidelines.
Spread compression for lower-grade credits may not be sustainable in the short term because of the prolonged global market distress, they argued – so forget about fundamentals for now and concentrate on relative value and liquidity risk. For example, JP Morgan was overweight US high-grade credit and neutral EM credit in March – when the rally in risk assets took off. Although US high-grade spreads have tightened strongly since, investors say many EM sell-side analysts have been too negative on the asset class from the spring.
KNEE-JERK BEARS
“While investors have been making a lot of money, not many analysts at the global banks predicted – or wanted to predict – the rally,” says Edwin Gutierrez, emerging debt portfolio manager at Aberdeen Asset Management. The intellectual and psychological torment from their previously over-optimistic forecasts triggered a competition to see which bear could growl the loudest, he says.
“It was – and it continues to be – a very popular call by sell-side researchers to be as bearish as possible.”
Nevertheless, emerging market economists have, to an extent, been shielded from the blame game, as the burden to predict the shifts in global credit cycles has fallen to developed market economists due to the western origins of the crisis. More generally, mainstream economics has failed to provide a framework to understand the nature of financial, economic and psychological linkages in an increasingly globalized world.
But Peter Twist, CEO of IND-X Securities, a broker of research distribution agreements between investors and research outfits, says the buy side has still been “disappointed by the quality of the sell-side reports since the global crisis began”. The reputational damage has paved the way for the structural growth of independent research providers, he says.
“There is a lot of soul-searching among analysts about how we collectively got the crisis so wrong as well as the questionable accuracy of current market predictions,” says Lars Christensen, senior analyst at Danske Bank.
For example, Bank of America/Merrill Lynch left it until mid-August to change their recommendation on Ukraine five-year CDS to go overweight from underweight.
MISSED OPPORTUNITIES
Credit protection for Ukraine swelled to 8,500bp over in March after fears the country’s leaders would renege on conditions imposed by the IMF after its November bailout. However, as the probability of sovereign default eased, Ukrainian credit protection – as well as cash bonds – staged the biggest rally in EMEA, tightening to 1,400bp at the time of the bank’s revision.
One global macro investor slammed the belated revision. “To change their recommendation only after investors have made massive returns on this trade is hugely embarrassing for them – and in many ways, highlights how the sell side has been behind the curve – before, during and now after the crisis.”
“I clearly missed the move,” says Benoit Anne, emerging market debt and FX strategist at Merrill Lynch. “Back in March and April, my macro team was bearish on the global economy, and I didn’t think it made sense to go long on a risky asset class.”
But as the bears growled, sell-side bulls also charged. “From the spring, we have been very bullish on EM credit and equity, and we came under fire for doing so from many of our buy-side clients,” says Bartholdy.
And while Nash at RenCap failed to warn his clients about the oncoming in asset prices in the EMEA region last year, since December he has touted Russian Eurobonds and blue-chip stocks, which have subsequently staged massive rallies.
Barclays Capital has been the most bullish this year, arguing at the end of March that green shoots of global economic recovery had arrived and recommending greater EM exposure.
While there is plenty of research into the correlation between investor flows and sell-side analysts’ forecasts for developed market stocks and bonds, research into the emerging market sell side is thin on the ground.
EM research outfits are far from homogenous. Morgan Stanley is one of the most bearish and, in particular, its emerging Asia research under Stephen Roach, who has long warned of the perils of global imbalances and argues China’s economic recovery has weak foundations. Meanwhile, the shop’s Latin America research team predicted in March that Brazil would contract 4.5% this year against the TKTK 2.0% consensus estimate at the time and the IMF’s current -1.9% forecast.
Investors credit Goldman Sachs for providing interesting long-term, macroeconomic trend pieces while JP Morgan’s emerging markets research, headed by Joyce Chang, is favoured for its consistent quality.
So where does emerging market research need to improve?
Blaise Antin, head of research for the $1.9 billion TCW Emerging Market Fixed Income Fund in Los Angeles, says eastern Europe coverage leaves a lot to be desired. “The sell side did not do a good job at warning about the accumulating leverage in eastern Europe.”
WHY THE WRONG CALLS?
Christensen at Danske, who warned of an economic crash in eastern Europe as early as autumn 2006, offers one theory. “A lot of the central and eastern Europe analysts at the global banks tend to be quite junior, due to the small size of regional economies, and so they have less experience and feel the pressure to follow the consensus.”
Antin says these regional analysts lack the knowledge or local contacts to capture the legal, political and market dimensions to opaque debt restructuring in the region.
Sell-side research often provides a useful aggregating service, helping to pool primary and secondary data about a credit or an economy into one document. But, to add real value, investors demand quality and opinion-orientated pieces rather than streams of empirical forecasts. Antin is not alone in calling for “more scenario-based pieces as the world is not black and white”. This demand is partly driven by a shift in investment strategies.
There is unprecedented uncertainty about the medium-term direction of the world economy, meaning that global macro management strategies, which rely on predicting systemic shifts in market conditions, will become more popular, investors say.
This contrasts with traditional alternative investment strategies such as mean-reversion analysis that target underpriced securities based upon the long-term fair value of assets – a strategy that failed when the crisis erupted at the end of 2008.
“We are now getting our analysts to have better cross-regional understanding of macroeconomic conditions so they can make better informed country and sector recommendations,” says Nash at RenCap. “My view is that more than 50% of individual stock performance is driven by economic and political conditions so, if you get that right, then the right calls will follow and vice versa.”
The sell side is, in theory, well positioned to offer the broader picture. Analysts at the bulge-bracket firms can offer unrivalled intelligence, thanks to their army of international economists and G-7 strategists to provide a top-down view of developments in the global economy.
Nevertheless, “a good credit analyst is also attentive to credit and economic fundamentals as well as market technicals,” says Matt Ryan, fund manager of more than $3 billion in EM fixed income assets at Boston-based MFS Investment Management. The credit risk and the liquidity risk – together with macroeconomic factors – in sovereign securities have always been incorporated into emerging market research.
Emerging market credit has enjoyed a tremendous bull run since the Asian and Russian crises, thanks to expanding global output, declining external public debt and de-dollarization. These factors changed the sensitivity of EM sovereign spreads with respect to global factors and blinded both the buy side and sell side to the underlying weakness of the marketplace.
Ryan says a lot of research published by research shops in the grip of the radical repricing of risk from the fourth quarter of last year was not realistic from a liquidity point of view, given the storm of forced selling. As a result, the sell side needs to beef up their research on market structure, liquidity and transparency at the micro level, he says.
Claudia Calich, who manages $1 billion of emerging markets debt at Invesco in New York, says analysts may now be stepping up to the challenge. She notes an increase in research output from desk analysts – whose research is not traditionally published and is primarily used for proprietary trading – to investors via Bloomberg to bypass compliance issues.
But some investors are still not satisfied. Sell-side research houses at bulge-bracket firms, with their huge global debt and equity distribution capabilities, international client base and large proprietary trading networks, have unrivalled knowledge of the flow of funds.
Jacobson at Fabien Pictet says research houses refuse to disclose information of real interest to investors – trading volumes of stocks and bonds by geography and investor type – as this would put their own traders at a competitive disadvantage. In response, sell-side analysts argue that trading flow information from banks is of limited use, as they are lagging indicators of market trends, while independent data providers already offer this information.
The crisis has made investors aware of the fallibility of all forecasting and may have triggered fund managers to go it alone, says John Cleary, managing director of Focus Capital, an emerging market absolute return fund of funds.
But he warns: “Fund managers can become dangerously wedded to a position due to an emotional and investor-time bias.” By contrast, the sell side are, in theory, motivated to be more objective about their predictions – and if they are right, stand to gain fortune and fame.