A question of faith
Despite darkening economic forecasts, investors are flocking to emerging market assets. But faith in central and eastern Europe’s bond markets remains fickle
Heavy levels of borrowing and high exposure to western Europe’s banks has left central and eastern Europe immensely vulnerable to the full impact of the global credit crisis.
That the region’s emerging economies are for the most part in deep trouble is now beyond any doubt; many are contracting between 5% and 10% this year, while fiscal and trade deficits soar and banks and firms buckle under the pressure of foreign currency debt repayments.
Cross-border bank lending has contracted sharply, as has finance from capital markets. The Institute of International Finance, a global banking association, predicts that net private capital flows to the region will fall to $30 billion from $254 billion in 2008.
The EBRD slashed its 2009 forecasts for emerging market nations in Europe to predict a drop of 5.2% in GDP, compared with the 0.1% growth it had predicted. Cutting its forecasts for the second time in six months, it predicted that the Russian economy would shrink by 7.5% this year.
But in recent weeks, a rebound in market sentiment – capped last week by well received US banking sector stress tests – has brought with it a surge in investor demand for emerging market assets – debt and equity. The upturn has been astonishing, partly because it flies in the face of economic data.
At the time of writing, emerging market stocks had risen to their highest in seven months – dramatically outperforming their developed world peers. Emerging market currencies have also risen sharply in recent weeks: the Hungarian forint is 14% higher, the Polish zloty up 13%.
International investors are on balance overweight Asia equities and countries with strong domestic liquidity and external trading positions such as Brazil. In contrast, some analysts argue that debt-ridden emerging Europe and Russia are unlikely to be early beneficiaries of renewed risk appetite, partly because of the scare liquidity available to be put to work in risk markets.
“In emerging Europe you have this massive deleveraging problem, and what you do is go into markets where the deleveraging process is towards the end, but we are not even halfway through this yet,” says Robert Parker, vice-chairman at Credit Suisse Asset Management.
Meanwhile investor demand for emerging market bonds has surged in recent weeks, outperforming the industrialized markets, while an increasing number of sovereign issuers is looking to take advantage of the turning sentiment. Emerging markets hard currency debt, which was down 11% in 2008, still performed substantially better than alternatives: high yield dropped by 22% and emerging equities by 54% last year.
But investor appetite for emerging market bonds may falter in the months ahead as mature economies prepare to raise unprecedented amounts of financing to stimulate domestic demand. Eurozone countries are likely to raise over E900 billion this year, up 146% from 2008.
Parker also warns local markets could fall further. “Most of CEE including Russia – bar Poland and maybe the Czech Republic – has deep-rooted problems... including large private-sector debt and banking problems where we could see some more blowups.”
For Russia, the reversal of fortune in the first few months of the year has been almost as dramatic as its cataclysmic fall at the end of last year. Russia’s RTS stock index was up 50% by April on its February lows. The Russian equity market last year was the worst performing of any major economy, slumping 75%.
Last month investors increased their exposure to Russia the most of any major EM credit, by nearly 2 percentage points to 0.92% assets under management overweight, its first overweight position since October, according to a Deutsche Bank report. Investors may be more inclined to take exposure to the names in this region in search of undervalued assets.
But some fund managers are now switching or combining asset classes in order to maximize returns for their investors. Moscow-based hedge fund group ParusKreml Capital Management, which has traditionally focused purely on equity investment, is launching the Sokol Russia Hybrid Fund, which is designed to give investors a mix of defensive fixed-income exposure alongside the upside from the expected recovery in Russian markets.
As ParusKreml director Thomas Fasbender explains: “The likely movement of the Russian equity market over the next two to three years will be fundamentally sideways... and accentuated by very high volatility,” he says. “At the same time Russian euro and dollar bonds with good ratings, from sovereign or near-sovereign corporates, will offer very attractive yields – 8–15% at the double- or triple-B level.”
Under the strategy of the long only fund, an initial 100% of assets will be invested in short- to medium-term bonds with solid risk ratings, while towards the end of the equity bear market ParusKreml will add liquid stocks to capture the upside of the expected market rally. ParusKreml is by no means the only traditional equity investor to have recognized the attractions of Russian Eurobonds amid the sharp sell-off in the Russian equity market at the end of 2008.
As Bruce Bower, portfolio manager at Kazimir Partners in Moscow, says: “International fixed income was king in Russia at the start of the year.” He adds that concerns over the level of foreign debt owed by Russian companies have eased as debt repayments peaked in the fourth quarter of 2008. While there are plenty of fans of international bonds from Russia, the same cannot generally be said of domestic bond issuance.
“Defaults are almost becoming fashionable,” claims Neil Smith, managing director at Florin Capital Management. He adds that the Russian authorities should look at setting up a ‘bad bank’ to reduce the financial pressures on the Russian banking system – some 50% of whose balance sheet is invested in corporate bonds – which is facing a potential deluge of defaults on domestic bonds by corporates unable to keep up with their repayment schedules, given the sharp deterioration in the business environment in Russia.
Bernie Sucher, head of Merrill Lynch Securities in Russia, says that to preserve the credibility of the domestic bond market, where over 100 issues are in actual or technical default, the authorities in the Kremlin urgently need to upgrade market legislation to give investors greater protection. “If you want true capital markets you need to resolve issues such as the growing number of corporate bond defaults, which are hitting the Russian banks hard. I think the debt problems could last for years.”
Kase in point
Another local market where the global economic downturn is taking its toll is in Kazakhstan, where a growing number of domestic bond issuers are struggling to service their debt. According to the Kazakhstan Stock Exchange (Kase) some 10 companies that issued debt tradable on the bourse in Almaty are no longer able to service their debts, mainly due to delayed payments for goods and services, falling sales and the overall difficult economic situation.
As Andrei Tsalyuk, vice-president of the Kase admits: “The list of defaults is likely to rise as the crisis continues.” Bauyrzhan Tulepov, head of research and risk management at local investment bank Tengry Finance, agrees, adding: “We analyzed 58 companies, whose bonds are listed on Kase. The overwhelming majority of those companies show low turnover of assets and also very low profit margins. Most of the companies have almost no competitive advantage; all they are trying to do is survive.”
But elsewhere, investor sentiment for emerging European debt has improved marginally due to rising global stocks and IMF pledges to make emerging market funds available.
But attitudes towards fixed-income markets remain mixed. In Hungary, for example, although the long end of the yield curve has rallied strongly and the forint has stabilized recently, as bond analyst Orsolya Nyeste at Erste Bank Hungary, points out: “The still low amount of forint papers held by foreigners suggests cautiousness.”
In the Czech Republic, investor sentiment has improved on the back of the enthusiastic reception of a E1.5 billion Eurobond by the sovereign, which helped to reduce the level of credit default swap spreads and has helped to curtail the burden on the Czech government’s domestic funding programme. “All in all, Czech yields are ripe for decline,” says Martin Lobotka, bond analyst at Ceska sporitelna.
In neighbouring Slovakia, the picture is less favourable. While improved global market sentiment should help to push yields lower for the latest recruit to the eurozone, recent domestic auctions point to still lacklustre demand, with an acceptance rate of only 75%.
In Romania, fixed-income strategist Dumitru Dulgheru at Banca Comerciala Romana says that sentiment will be driven by the government’s determination to push forward a number of reforms agreed with the IMF and whether it can demonstrate a greater degree of fiscal responsibility, especially in an election year. “Any slight improvement in investor confidence right now should be viewed as more of a welcome respite,” he says.
In Croatia, the key event will be the government’s planned E750 million Eurobond, likely to be launched in early June, which will provide a key test of overseas investor appetite for Croatian risk and also set the tone for the domestic bond market, where sentiment has been hit by fears of increased foreign exchange risks.
“The Croatian market is very quiet right now – nobody’s selling, nobody’s buying, they’re just waiting to see what happens with the Eurobond,” says Tonic Korunic, head of asset management at InterCapital Securities in Zagreb.