Previous international debt crisis 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 primary markets close, with a pipeline of close to 15 deals put on hold, a seeming repeat of previous patterns. But this time round, the turmoil was neither as deep nor as long lasting. Just two month down the line and deals were being priced and volatility in the secondary market had reduced significantly. The knee-jerk flight to quality did not happen and some say that perhaps the pattern has been reversed, with cash coming out of high risk US assets and into Latin America.
Market contagion has been confined to developed markets, says Curtis Mewbourne, executive vice president and co-head of the emerging markets group at PIMCO, which has some $20 billion invested in Latin American debt. He points out that the UK and Europe suffered because they have similarly sophisticated financing structures and leveraged profiles.
Carlyle Peake, emerging markets debt syndicate head at Merrill Lynch in New York, has been in the area for 15 years and says its the first time that hes seen such a calm reaction from emerging markets in a credit crisis situation, reasoning that in part its because the US no longer looks so secure. Its hard for them to gauge just where the US economy is going and the high-yield sector there is tricky while billions of dollars of leveraged financing still need to be worked out.
Fund managers identify several other reasons Latin 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, notes 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 and he is overweight in Latin markets in part because of the robust underlying economic picture. Decoupling between the US and the rest of the world really is in effect, he says. That is 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 been particularly well insulated, believes Ricardo Penfold, fixed-income fund manager at Goldman Sachs Asset Management (GSAM). He notes as well that the composition of that countrys debt has improved as it has developed a current account surplus and consequently huge reserves.
Fund flows to emerging markets have also been strong and while they took a hit, the general trend has been upwards. More demand and low issuance in the first half of the year should allow issuance to return to normal fast, says Brad Durham, managing director at fund trackers EFR Global in Boston. By mid-September, emerging market bond funds has raised $3.3bn and August was the first true month of outflows for this year at just over $900 million, says Durham. The outflow trend has already reversed.
The development of local currency markets, particularly in Mexico and now in Brazil, has isolated these countries from the vagaries of international fund flows, notes 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.
In addition, structured debt, including mortgage-backed securities (MBS), are still considered exotic in the region and account for a very small part of total issuance, points out Mewbourne.
Fund managers adopted different strategies in light of the choppier market conditions. PIMCOs Mewbourne did not carry out any large scale reallocations in portfolios partly because he is focused on higher credit quality names. The dynamics between Latin and US markets are so different that Mewbourne continues to have an overweight position in Mexican housebuilders. The link between the US housing market and Mexican 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. Mexicos story is very different as the government tries to put a program in place to develop a financing market which remains nascent and is less than $10 billion in size.
For GSAM, the tactic is to avoid the toxic spillover emanating from the United States. We are moving away from credit with exposure to the US, says Penfold. Penfold is predisposed to be wary on Mexico and Colombia because of their relative reliance on the US as an engine for growth. He notes that Indonesia and Colombia fell in unison when the subprime crisis hit markets. However, because Colombia is more exposed to the US economy, Indonesia looked more attractive.
The crisis reminded fund managers of the importance of monitoring the liquidity profile of their portfolios and having an exit strategy, says Blackrocks Hussain. 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 become more attractive.
Worries, present and past
Investors weighed individual Latin markets more on their merits during this crisis with riskier Venezuela and Argentina suffering the brunt of the sell-off, notes Hussain. But even these renegades have recovered fast from the sharp, sudden shock administered by the US subprime crisis, he addds. Indeed, the re-appearance of inflation is a biggest preoccupation than the self-inflicted crisis in the developed world.
The other area to watch has been currencies, says 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.
Still, although fund managers are greatly relieved by the performance of markets in the crisis, new concerns are starting to make themselves felt. The biggest potential headache is a resurgence in 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 regions 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 Mewbourne. This is an important theme because it may be partly a secular story deriving from long-term demand trends in Asia where an increased demand for commodities of all sorts has been witnessed. That said, Mewbourne the demand-supply balance will even out with less consumption and more 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. The official statistics are not reflecting the underlying reality in Argentina and Venezuela, which require extra attention, adds Hussain.
A shorter-term worry for the region is the risk posed by the bunching up of new deals to exploit what might prove short windows of opportunity. Were likely to see clusters of deals and that has the potential to overwhelm the market, says 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 that has to roll over debt, he says. Peake agrees that there is a risk of this 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 been particularly the case with deals that were put on hold from earlier in the summer where issuers had to come to market.
Last but not least, the global crisis is leading to closer scrutiny of the lite covenants that are retrospectively being blamed for worsening the crisis. Historically, emerging market investors have not been too sensitive to covenant packages. Thats been changing and will be hastened because of what markets have been through. Theres much more critical analysis of covenants, says Peake.
The hunt for yield led to some indiscriminate purchases and risk taking allowed some issuers to come to market that shouldnt have, admits one fund manager. Still, he points out that this is an even bigger concern in developed markets. Accounting and financial statements are as much an art as a science. You just have to look as the tricks Italys Parmalat was able to pull off to realize that deep credit analysis is essential everywhere in the world. Latin market investors sanguine reaction to the crisis shows how far developing countries have come in cushioning themselves. The next stage will see the further development of local sovereign markets and the emergence of local corporate markets opening up, with more local high yield financing getting done, reckons Peake.