By Taimur Ahmad
Latin markets have staged one of the most staggering runs in history – with bonds returning more than anywhere else in emerging markets last year. Isn’t it about time for the party to end?
In early March, the non-stop rally in emerging market bonds in recent months came to a grinding halt. Latin bond markets took a dive. A slew of sovereign and corporate deals was shelved. And the market held its breath for the first time in months as it pondered the impact of possible US and Japanese interest rate hikes, and the spectre of inflation.
In another era, this might have urged a more profound sense of panic for emerging market debt. This time, it barely cast a shadow over fundraising for the region’s credits, as the market almost unanimously shrugged its shoulders – and moved swiftly along.
“From a credit standpoint, it’s as good as it’s ever been,” says Vincent Truglia, managing director and head of sovereign ratings at Moody’s Investor Service in New York. “The improvement in liquidity is unprecedented.”
Indeed, the asset class has defied all expectations over the last two years. Overall, emerging markets debt trading volumes soared to $1.378 trillion in 2005, according to Emerging Markets Traders Association, the highest since just before the Russian default of 1998. The level represents an increase of 18% from the previous year, although it’s likely to decline in 2006 as governments cut back issuance.
Still, Latin bonds returned more than any other asset class of emerging market debt last year. Spreads are at record lows as emerging markets become mainstream. The imbalance between supply and demand is pushing up bond prices. The JPM EMBI+ index gained 5% year-to-date – despite weakness in the overall fixed income market.
Net portfolio flows to Latin America grew by $11 billion in 2005, from the year before, according to the IMF.
Not so fast
But if history is any guide, Latin markets could inevitably come unstuck: periods of boom have traditionally been followed by periods of bust. The worry is that rich-world financiers are surfing their third post-war wave of investment in emerging markets – and that this time, just as before, the market is being complacent about “easy money” from excess global liquidity.
There are other reasons to be concerned. Although GDP growth in the region, at 4.5%, is up on the last two years, it still trails other emerging markets. Direct investment is insufficient and heavy reliance on commodity exports is a potential threat to many Latin economies.
While praising the markets publicly, many investors, corporates and governments are getting increasingly anxious about how long the good news can last: the commodity price boom and global liquidity glut can’t go on forever.
“We have all the conditions for a global slowdown, and at some point it’s going to happen,” says Bill Rhodes, senior vice chairman at Citigroup. “The question is when and how much?”
At issue is whether Latin America can navigate an eventual adjustment in the US. A lot will depend on how investors react to new political leadership across the region over the coming year and – crucially – the kinds of policies they choose to implement.
“If you’re an investor or a lender, you should be prudent in this part of the cycle. And if you’re an emerging market, you need to be very careful in managing your fiscal, monetary, debt and exchange rate policies,” says Rhodes.
If anything changes in the international environment, including the flotation of China’s currency, the yuan, there could be a reversal of capital inflows to emerging markets and Latin America, Rhodes suggests.
Moreover, the region is not exploiting its potential to reform – and it will only become more difficult to push through tough reforms when the global economic environment takes a turn for the worse.
“You do not see any structural reforms taking place. You also do not see any true motor of growth, besides commodities exports, which are at a very high price right now,” says Lilian Rojas-Suarez, senior fellow at the Center for Global Development and a former chief economist at Deutsche Bank. “Moreover, there is no financial sector deepening, because there is a deficient judiciary across the region.”
As Ken Rogoff, former IMF chief economist, has cautioned: “While it is too soon in the current capital flow cycle to worry excessively about an immediate wave of major sovereign debt crises, it is surprisingly easy to think of the five or six major reasons why problems could arise over the next few years.”
“It doesn’t matter where in the world a crisis starts; it always ends up in Latin America,” adds Rojas-Suarez.
Spread compression
Most analysts seem to agree that spreads are at record lows – and could go lower still. The fear is that emerging market bonds will revert back to average historical spreads once they reach an over-bought level.
“Spreads have declined across the board to unprecedented levels – that worries me,” says Charles Dallara, chairman of the Institute for International Finance. “Even in Argentina – spreads have declined there too, despite their stance against private creditors.”
“The pricing of risk today is not adequately capturing the risk in emerging markets,” he adds.
Nevertheless, understanding global investor behaviour is the best indicator of what’s driving flows into emerging market debt, according to Jerome Booth, head of research at Ashmore Investment Management. “Macroeconomic fundamentals are not as important in understanding flows into emerging market debt as global investor behaviour,” he says. “Funds will flow into the asset class until the majority of pension funds are allocated – i.e. for the next ten years.”
Booth says that in order to properly understand where the vulnerabilities are in emerging markets, it’s important to understand the “push” factors that have led to the recent rally, namely: “unfunded pension liabilities in the US, translating into target rates of return of typically 8% per annum. This is difficult to achieve out of US equities, 10-year Treasuries, and so forth,” he points out.
“For the flow to slow, you need unfunded liabilities to go away; you need prejudice about EM debt to be reacquired; you need global liquidity to slow. This last scenario is the real risk, but still not likely.”
On Booth’s view, languishing structural reforms in Latin America are largely irrelevant to investor behaviour. Although he doesn’t deny the lack of such reform in much of the region, he thinks that the global environment, together with the cushion already built up – both in reserves and more importantly fiscal discipline and surpluses – is “sufficient for us to think of individual countries having problems in future as in the past, but not the region as a whole”.
“The nature of risk is also being re-examined,” he says. “One definition of an emerging market is as follows: all countries are risky, but emerging markets are those where this risk is priced in.”
Upbeat, by and large
“I feel pretty good about the outlook for the region as a whole,” says Nicolas Aguzin, chairman for Latin America at JP Morgan. His firm has ranked among the top bookrunners for Latin American debt and has helped broker some of the best transactions in the region in recent months.
Yet there remains the niggling doubt that global bond investors – who have driven bond spreads down to their lowest levels since before the 1997 Asian financial crisis – are not always discriminating between good and bad credits in their persistent search for yield.
“International investors have said ‘EM is doing well, has yielded so much – what else can I buy?’ The worry is: this new wave may not be as discriminating as it was before,” says the Latin chief at a major international bank. “That’s what worries me most.”
“Is the market over the top, and are some investors being too aggressive in their decisions? The answer appears to be yes. Investors know the market is ‘expensive’, but the flows to emerging market assets continue and they cannot afford not to be invested,” says Carlos Mauleon, managing director at Barclays Capital in New York.
“I’m surprised at how aggressive some investors have been. The macro fundamentals for most Latam economies appear strong, and dedicated cashflows continue to grow. It’s unclear what specific event or factor can derail this market, and therefore investors have become increasingly comfortable adding more and more risk.
The question is: how significant will the adjustment be – when and if it comes? “It’s not like you’re going to see a major off-loading of assets,” says Mauleon. “I would not expect people to run for the door.” With so much liquidity and improved macro variables, he suggests, the markets are sufficiently insulated from most near-term tremors.
Political risk?
“With spreads where they are, it’s time to focus on geopolitical risk – the least predictable factors,” says Joyce Chang, head of emerging markets research at JP Morgan.
She also points out that, in the long term, Latin America’s growth prospects are bleak. “The institutional developments that drive growth aren’t there. In the longer term, this is likely to affect the political outlook.”
Other analysts remain buoyant. Walter Molano, head of research at BCP Securities, doesn’t think political risk is as relevant today as a decade ago: “Politics was very important in the 1990s – the region ran large current account deficits. Now they have large current account surpluses so, in a sense, who cares what the politicians look like?” he says. “IMF programmes don’t exist anymore. As these countries become more solvent, pay down their current account obligations, politics becomes less important for the international investor.”
Yet politics do, it seems, take their toll. Markets have already begun to reflect the possibility of Ollanata Humala, a nationalist former military officer, winning next week’s presidential election in Peru. Bonds, shares and the local currency have been falling. Peruvian bond spreads – the most widely acknowledged measure of political risk – have widened by nearly three-quarters of a percentage point in the last month, and the paper now trades at a substantial discount to that of Brazil or Venezuela.
The shape, perhaps, of things to come?