When Merrill Lynch announced mid-September that it was beefing up its Latin American business by installing a series of country heads across the region, the US investment bank was probably hoping for a different kind of media coverage than it ended up getting.
The bank’s shock takeover by Bank of America (BofA) completely eclipsed the unveiling of Merrill’s new Latin management structure – the same week Lehman Brothers went bust, an event which triggered the most unprecedented and far-reaching reshaping of Wall Street in its history.
Yet on the morning of Monday, September 15, as the financial world reeled in disbelief at Wall Street’s cataclysm, Merrill’s Latin American president Jimmy Quigley was boarding a plane to Latin America: for the veteran banker, it was business as usual.
Indeed, senior Merrill officials suggest the bank will continue aggressively building out its emerging markets business – despite being incorporated ignominiously into a firm not known for its emerging markets prowess (in fact, BofA has scaled back its emerging markets presence in recent years).
The rationale is straightforward: as developed economies languish near recession and deal flow dries up, tapping new growth markets is a clear way to make up for the calamitous – and possibly permanent – decline in developed market revenues.
So far this year, almost all investment banks have mobilized their emerging markets task forces, some sending their most senior officers to key emerging financial centres, others hiring locally, picking up the most prominent and well-connected domestic bankers and chief executives. Barclays Capital, Citigroup, HSBC, JP Morgan, Morgan Stanley and UBS, among others, have all markedly stepped up their emerging markets push in recent months.
US financial woes have hit global markets hard over the past year, most profoundly in the past four weeks. Money is tight: securitization markets remain closed, leverage has become a dirty word and even basic sources of capital, such as medium-term syndicated loans, are becoming prohibitively expensive. Meanwhile the economic slowdown across western economies is forcing company treasuries to slash their capital requirements.
In contrast, many emerging markets have, by and large, looked relatively appealing. According to management consultancy McKinsey & Co, by the end of the first quarter of 2008 emerging markets had generated only about 7% of investment banks’ writedowns, compared to more than 21% of global revenues. Moreover, revenues from credit and securitization – mostly plain-vanilla corporate bonds – represented just 9% of emerging markets’ revenue pools in 2007. By contrast, credit products were responsible for 18% and 10% of US and European revenues, respectively.
For now, the economic outlook for emerging markets also remains relatively attractive: put simply, compared to developed markets, there’s still economic growth. McKinsey argues that even if trade flows decline in a global downturn, Asian demand for oil and commodities, robust intra-regional trade and huge infrastructure investment will likely continue to drive economic growth in the main emerging regions.
The emergence on the world stage of domestic industry champions has also changed the dynamic, while emerging markets-based sovereign wealth funds and other government-linked investment agencies have similarly begun to flex their muscles in western and domestic markets alike.
Over the past two years, a volley of companies from the developing world has made moves on western rivals. High-profile examples include India’s Tata Motors buying UK car makers Jaguar and Land Rover; Temasek of Singapore snapping up UK ports and ferry group P&O after a lengthy battle with Dubai Ports; Russia’s Severstal acquiring Rouge Steel of the US; and Brazil’s Vale attempt to swallow Anglo-Swiss rival Xstrata.
As the horizons of emerging market corporates grow, so too does their demand for a broader range of investment banking services, the logic has it. “Below the sovereign wealth-type funds there is a layer of corporates and quasi-sovereign entities that are becoming increasingly active in the M&A [mergers and acquisitions] and capital markets,” says Christopher Niehaus, UBS’s new head of investment banking for the Middle East and North Africa. “Although it is early days, we are seeing a big increase in the number of deals for regional borrowers, especially in the equity capital markets.”
Where’s the money?
Yet a glance at bank revenues from primary capital markets (i.e. fees minus expenses from debt capital markets, equity capital markets, M&A advisory and syndicated loans) over the past 31⁄2 years reveals figures that are disappointing when compared with the amount of attention the emerging markets are now attracting [see table p.52].
According to Dealogic, the data provider, emerging market revenues in that period make up a tiny portion of the global total. Even in 2007 – emerging markets’ best year — net revenues of $14.55 billion represented a paltry 16% of the global total. Of that $14.55 billion, central and eastern Europe and the Middle East contributed $5.38 billion, Latin America $2.5 billion and Asia Pacific (ex-Japan and Australia) $6.53 billion.
And the picture might just be getting worse. Despite bank chief executives extolling the virtues of global expansion and, since the credit crisis struck last August, shifting dozens of senior bankers from Wall Street and London to Dubai, Moscow, Sao Paolo and Shanghai, the fee pool in some of these regions might be shrinking.
According to Dealogic, investment banks have earned fees worth $1.1 billion in the Middle East in the year to September 2008, more than a quarter less than the $1.5 billion made during the same period last year. Its total so far this year represents just 2.8% of the global investment banking fee pool – tiny compared with the amount of attention the region is now getting. In particular, fees from Latin America and Asia have struggled, with income from both regions down about a third.
Risk aversion among investors has also soared on the back of fears about slowing of world growth, the general state of the banking system and weakening commodity prices. According to EPFR Global, the data company, outflows from emerging markets equity funds have hit over $40 billion so far this year, the highest recorded level.
The benchmark MSCI emerging market index has lost 32.1% so far this year.
Recent events have done little to calm investors’ nerves. On September 15, China cut its interest rates – the first time for six years – in an effort to prop up economic growth amid the turmoil in global financial markets and slowing US consumer demand. Meanwhile, that same week, the Russian government took the extraordinary step of closing the country’s two main stock exchanges, MICEX and RTS, in an attempt to stem losses, as panic gripped investors following the sharpest declines seen since the financial crisis of August 1998.
And while many analysts still contend that, despite a likely sharpening economic downturn in developed economies, strong emerging market GDP growth will buoy overall world growth in the 3–4% range next year, an increasing number of commentators are predicting a reversal of fortune for emerging markets, possibly causing an outright contraction of global GDP.
“While most focus on the rapid deleveraging currently being forced on financial institutions, it is important not to miss that a rapid correction in the US trade deficit will now bring about a second round of financial deleveraging,” says Albert Edwards, chief equity strategist at Societe Generale in London.
“As the baton of domestic US recession moves from the housing sector (which has a very low import propensity) to the consumer (which has a high import propensity), expect the headline US trade deficit to almost totally vanish over the remainder of this year. Hence the EM liquidity squeeze will intensify ferociously and, much to the shock of most commentators, recessions will unfold in the EM universe (including China in case there is any doubt). All things connected with EM will become toxic waste.”
Investment banks therefore face the real risk of spending their increasingly dear cash on – and sending their best and brightest off to – regions that may be on the verge of sharp declines; the risk is that they will suffer a brain drain in markets that, as yet, still provide the bulk of their revenues. Indeed, according to Dealogic data, while investment banking fee growth in the US has stagnated, it still accounts for 45% of global investment banking fees, despite the credit crunch, compared with 46.7% in 2005. Fees from western Europe, although down from 37.7%, remain impressive at 35.8% of the global total.
Long-term potential
Investment banks respond that it is not today’s revenues that are exciting them, but rather the medium- and long-term prospects for emerging markets that are driving the institutions’ expensive and high-profile outlays.
And while cynics might point out that such a line would represent an extremely rare example of long-term thinking among the investment banking community, research by McKinsey backs up their stated long-term rationale. Drawing extensively from the consultancy’s Global Capital Markets Survey, which provides forward-looking estimates of gross revenues from all investment banking activities (i.e. all sales and trading, including rates and FX, and primary capital markets, including securitization and strategic derivatives) for the years 2006 to 2010, McKinsey argues that even in the worst-case scenario, emerging Asia and Europe, the Middle East and Latin America will probably show absolute revenue growth over the next three years.
“Under all likely outcomes, the proportion of global revenues from emerging markets will jump sharply,” the McKinsey report says. “Collectively, indeed, revenues from investment banking and capital market activities in these regions are projected to match those in North America by 2010; in 2006, before the credit crunch, they amounted to less than half.”
The consultancy offers two outcomes for emerging market investment banking – one based on a “steady recovery” of global capital markets and the other on what it calls a “long chill”.
In the “steady recovery” scenario – a one-year setback, with growth resuming in 2009 – McKinsey forecasts that revenues from investment banking in emerging markets will increase by 16% a year from 2007 to 2010, when they will generate 28% of the global total. In this outcome, Asia will continue to represent the lion’s share (66%) of the emerging markets’ revenue stream of almost $120 billion.
But in the event of the “long chill” – when the industry contracts more sharply during the second half of 2008, with a much slower, even faltering recovery in 2009 – the firm forecasts that revenues from emerging markets will still rise sharply (6%) and will probably exceed $90 billion by 2010. In this case, the emerging markets will account for a bigger share of the global total (30%) than they would under the “steady recovery” scenario.
As for investment banking products, on McKinsey’s analysis commodities and equity derivatives will probably be the big winners, regardless of how markets perform more. Foreign exchange, interest rate swaps and futures, and equities (including derivatives) “will do well under our benign scenario and will be relatively resilient even in the tougher one”, it adds.