Previous international debt crises were all too predictable in their wash-down effect on Latin America. They swiftly led to an exodus of cash, north over the Rio Grande in search of the safety of US Treasuries.
The crisis, triggered by the US subprime crisis that started in July, did see Latin American primary markets slam shut, with a pipeline of close to 15 deals put on hold, a seeming repeat of previous patterns. But this time, the turmoil was neither as deep nor as long lasting.
Just two months down the line and deals were being priced while volatility in secondary markets had reduced significantly. The knee-jerk ‘flight to quality’ was avoided; some say that the pattern has been reversed, with cash coming out of high-risk US assets, such as asset-backeds, and into the safety of Latin American markets.
Carlyle Peake, emerging markets debt syndicate head at Merrill Lynch in New York, has been in the area for 15 years and says it is the first time that he has seen such a muted reaction from emerging markets in a crisis situation, reasoning that in part it is because the US no longer looks so secure.
He says: “It’s hard for investors to gauge just where the US economy is going and the high-yield sector in the US is tricky while billions of dollars of leveraged financing still needs to be worked out.”
Fund managers identify several other reasons why Latin American markets got off lightly. The first is the much-improved macroeconomic picture. Current account surpluses and strong international reserves offered a cushion for sovereign debt, says Imran Hussain, portfolio manager and managing director of the BlackRock emerging markets debt fund in New York. Growth is likely to remain more robust in the region than in the US as the commodities-to-Asia story continues unabated. He is overweight in Latin American markets. “Decoupling between the US and the rest of the world really is in effect,” he says. Improvements are reflected in the series of ratings upgrades that Mexico, Brazil and even Colombia have been enjoying.
Countries where the government is a net creditor, including Brazil, have fared particularly well, believes Ricardo Penfold, fixed-income fund manager at Goldman Sachs Asset Management (GSAM). He notes as well that the composition of debt has improved, with a fall in overall issuance, strategies to build out a yield curve and shift to local issuance.
The development of local currency markets, particularly in Mexico and now in Brazil, has protected these countries from the vagaries of international fund flows, agrees Mr Peake, who points out that beta, the measure of volatility, was restrained in the crisis. “Technicals are strong in these markets. The declining stock of external bonds and development of local bond markets bolsters them.”
Market contagion has been confined to developed markets, adds Curtis Mewbourne, executive vice-president and co-head of the emerging markets group at Pimco, which has some $20bn invested in Latin American debt. He points out that the UK and Europe suffered because they have similarly sophisticated financing structures and leveraged profiles.
Structured debt, including mortgage-backed securities, are still considered exotic in Latin America and account for a very small part of total issuance, he notes.
Finally, fund flows to emerging markets have also been strong and while they took a hit, the general trend has been upwards. Furthermore, low levels of issuance in the first half of the year gives scope for issuers to return to markets fast, says Brad Durham, managing director at fund trackers EFR Global in Boston. By mid-September, emerging market bond funds had raised $3.3bn and August was the first true month that saw outflows at just over $900m, says Mr Durham. The outflow trend has already reversed.
US decoupling
Fund managers adopted different strategies in light of the choppier market conditions. Pimco’s Mr Mewbourne did not carry out any large-scale reallocations in portfolios, partly because he was already focused on higher credit quality names. The dynamics between Latin American and US markets are very different and he continues to have an overweight position in Mexican house builders. “The link between the US and Mexican housing market may seem intuitive, but this is an absolutely different market,” he says. The US has seen a significant drop in house prices which is related to borrowers’ financing ability. In Mexico, the government is putting in place a programme to develop financing which remains nascent at less than $10bn.
Pimco’s largest regional exposures are in Brazil, where it has sovereign and corporate holdings such as blue-chip commodity exporter CVRD and significant investments in Mexico’s corporate sector including telecoms, such as América Móvil, as well as house builders. Because they are less studied and less liquid than sovereign issues, corporates offer a yield pick-up. Those with strong fundamentals are ideal for long-term investors, he believes.
For GSAM, the tactic is to avoid the toxic spillover emanating from the US. “We are moving away from debt markets with big exposure to the US,” says Mr Penfold. He is predisposed to be wary on Mexico and Colombia because of their relative reliance on the US as an engine for growth. A global manager, he notes that Indonesia and Colombia fell in unison when the subprime crisis hit markets but that because Colombia is more exposed to the US economy, Indonesia has looked more attractive.
For BlackRock’s Mr Hussain, the crisis was a salutary reminder to fund managers of the importance of monitoring the liquidity profile of their portfolios and having an exit strategy. “For corporates in aggregate, liquidity has been poor,” he notes, adding that he has been defensive in corporate credits, but reasons that as liquidity returns they will outperform. The fund also took a bet on high beta Argentina after the crisis hit: “The crisis had a massive impact on Argentine inflation-linked debt” and he suspects that this will unwind as speculative players that had shorted scramble to cover positions.
Investors weighed individual Latin American markets more on their merits during this crisis with riskier Venezuela and Argentina suffering the brunt of the sell-off, continues Mr Hussain. But even these renegades have recovered fast from the sharp, sudden shock, he adds. The other area to watch has been currencies, cautions Mr Penfold. The Colombian peso was weakened by the August sell-off whereas the Peruvian sol held up very well. “There has been great differentiation from country to country.”
Worries, present and past
Although fund managers are broadly relieved by the performance of markets, new concerns are making themselves felt. The biggest potential headache is inflation. Developing countries are more sensitive to increases in food prices, the principal driver in the latest bout of inflationary pressure. The threat of renewed inflation will pressure the region’s central banks to keep tight monetary policies and may lead to rate decreases slowing or even reversing.
“We are following this very closely and have noticed food price inflation in Brazil, Mexico and Chile,” says Mr Mewbourne. This is an important theme because it is not yet clear what is driving it. It may be a secular story deriving from long-term demand trends in Asia. That said, Mr Mewbourne reasons the demand-supply balance will even out with less consumption and more crop planting and notes that food prices tend to be cyclical. Furthermore, the credit crunch and housing slowdown in the US and UK and economic activity in Japan and Europe are all global macro deflationary influences, he notes.
A shorter-term worry for the region is the risk posed by the bunching up of new deals to exploit what might prove to be short windows of opportunity. “We’re likely to see clusters of deals and that has the potential to overwhelm the market,” says Mr Hussain. He is keeping a careful eye on those issuers that need to refinance and is worried that the street will try to clear the backlog of issues. A good example to watch would be Argentina, which has to roll over debt, he says.
Merrill’s Mr Peake agrees that there is a risk of cramming. Issuers are unsure where markets are headed and they want to get borrowing needs met quickly, he says. They are willing to pay more in spreads to roll over debt. That has particularly been the case with deals that were put on hold from earlier in the summer where issuers had to come to market.
Cov-lite structures
Last but not least, the global crisis is leading to closer scrutiny of the lite covenants – loans that do not carry the legal clauses that allow investors to track the performance of a risky borrower or declare a default if financial measures are breached. Some bankers and lawyers regard the emergence of ‘cov-lite’ structures as a sign of dangerous overheating that are retrospectively being blamed for worsening the crisis. “Historically, emerging market investors have not been too sensitive to covenant packages. That’s been changing and will be hastened because of what markets have been through. There’s much more critical analysis of covenants,” says Mr Peake.
The hunt for yield led to some indiscriminate purchases and risk taking allowed some issuers to come to market that should not have, admits one fund manager. Still, he points out that this is just as big a concern in developed markets. “Accounting and financial statements are as much an art as a science. Deep credit analysis is essential everywhere in the world.”
Latin American market investors’ sanguine reaction to the crisis shows how far developing countries have come in cushioning themselves through strong macro policies and solid growth. Their reaction sets up the next stage of development through local sovereign markets issuance and the emergence of local corporate markets, and local high yield financing.
