Outlook 2005: Emerging market debt seen starting strong but weakness expected as year progresses

By Reshmi Basu and Paul A. Harris

New York, Dec. 31 - Emerging market debt appears ready to start on an up note in 2005.

In 2004, the sector wooed investors with a third year of consecutive double-digit returns, thanks to improving fundamentals and strong technicals. External debt in 2004 returned 10.3%, according to the JP Morgan EMBI Global Index as of Dec. 10.

And the prospects are still good looking forward.

November was the second best month for emerging markets bond fund inflows, according to Brad Durham, managing director of EmergingPortfolio.com Fund Research.

"Liquidity is very good," Durham said. "It's a good sign that the level of aversion to risk is very supportive for emerging market bonds. Where before emerging market bonds were really liquidity driven, I think now it's more driven by fundamentals."

Nine out of the top 10 emerging market issuers are now investment-grade, Durham noted.

"It's no longer an asset class for the high rollers."

Many predict that emerging markets' positive run will continue but at a lesser speed into 2005, barring a catastrophic market correction in the U.S Treasury market. Others also caution that with spreads so tight, something must give in emerging markets.

"It's hard to say whether it will be bullish or bearish because is it a relative or absolute thing?" noted a buyside source.

"We will continue for awhile with dollar weakness, low interest rates and a higher commodity price environment, which is pretty good for emerging markets. And that could last for another nine months - maybe 12 months. But certainly more than six months," he said.

"It's not bad for U.S dollar-denominated emerging markets, unless you have a tremendous correction in interest rates in the U.S, which could happen but I don't foresee that for the next six months," he added.

"Unless you see a massive Treasury correction, spreads are fine."

Limits to current rally

According to a sellside source, the current emerging market rally simply cannot continue. But fortunately, the bloodshed witnessed last May as investor concern over monetary tightening derailed emerging markets will most likely remain a distant memory. No repeats of such a heinous market correction are expected in 2005.

"Everybody says that it can't last in a rising rate environment. But the emerging markets are set up for a pretty gradual increase in U.S rates," said the sellside source.

"I don't think people are setting themselves up for 10-year Treasuries in the 5½% or 6% range. It seems like most people are anticipating that the 10-year will stay inside of 5%.

"If you have that kind of scenario, our market could end up wider on a spread basis and lower on a price basis because of Treasuries. But overall it's not a massive sell-off."

Little room for more tightening

Overall, the market sentiment is that the performance of fixed income in 2005 will not be as strong as the previous year.

"On EM spreads, I think it's difficult to imagine EM spreads ending 2005 at or below current levels," said an emerging market analyst.

"Either UST yields go higher - driving up risk aversion and pushing EM and high yield spreads higher - or the U.S economy falters, which would also increase risk aversion as EM exports decline. Either way, EM spreads go higher.

"The real question is whether the rise in EM spreads is gradual and limited, or whether there is some major stress point in the market right now that could prompt a more serious crisis. Anything can happen, but I don't see a major crisis emerging just because of higher EM spreads, so I expect EM to be weaker next year, but that weakness should be moderate," he concluded.

However, a second buyside source believes that spreads will be unchanged throughout the year, if not a little tighter.

"It's going to be a coupon clipping year. That's our basis scenario. If something happens in the U.S that throws us off track, well that's possible," said the source.

Moreover, the year 2005 is going to be very similar to 2004, predicted an investor. And all agree U.S Treasuries could easily play spoiler.

"It will be very tough to get much spread tightening in high yield or the EMBI," he said.

"The key issue is going to be what happens to growth. Does the Fed activity slow down the economy in the second half? And likewise what happens to Treasuries? Does inflation push yields much higher?

"But barring an unforeseen circumstance, I don't see emerging market volatility returning like the way it has in the past."

While the investor does not anticipate the same degree of spread widening witnessed in May 2004, "we are well into the [Fed] tightening phase at this point.

"I think what happened in May has basically allowed the Fed to tighten aggressively without hurting the market. It put a margin of error into the market that wasn't there before May," he observed.

"The systemic risks are very low. The key factors are global growth and what happens to U.S capital markets [in 2005], he added.

New paper in 2005

There was a healthy dose of new paper hitting the capital markets in 2004. Bond Radar had a total of $112.5 billion for emerging markets as of Dec. 16, according to the sellside source.

"Different people use different numbers," said the source. "That's pretty high. There have been higher years, but it's up there."

Of course, it is difficult to predict if 2005 will be another banner year, noted the source.

It is "hard to say whether next year will exceed that. It could be a little higher because of Russia, which could push it higher," added the sellside source.

"Everybody expects that January is going to be a busy month. But it's going to be the typical sovereigns that give you the mandate the night before," said the sellside source.

"People figure that Brazil and Mexico and the Philippines and Turkey and all of the frequent borrowers will be there.

"You'll also probably have a bunch of issuance from Russian corporates also.

"And the smaller sovereigns like Colombia and Peru and Venezuela will get in there at some point. Whether it's January or February may be more of a question," noted the source

Strong start to prefunding

According to JP Morgan research, the remaining sovereign funding requirement for 2005 stands at $44.5 billion, of which $8.2 billion has been prefunded as of Dec. 6. The $8.2 billion prefunding is already double the rate of 2004.

"Considering that most of the sovereigns have already prefinanced a pretty good amount of their needs for 2005, we are going to have less issuances than this year," said the second buyside source.

Russia is expected to issue $3 billion in order to fund the repurchase of Paris Club debt, according to the JPMorgan research. The Philippines will likely issue $4.5 billion in new paper, compared with $3.8 billion in 2004.

Mexico is expected to issue $2 billion, in comparison with $4 billion in 2004. Mexico has already prefunded $2.5 billion in 2004, which indicates that they are on the path towards prefunding for 2006.

Brazil is expected to issue $4.3 billion. Czech Republic is slated for $1.5 billion and Hungary with $4.8 billion. Turkey is expected to issue $5.762 billion in 2005, the JPMorgan research said.

"I think supply will rise to meet demand, so if the sovereigns have pre-financed much of their 2005 requirements, I expect it will be corporates which will fill the gap," said the emerging market analyst.

"We've still seen only limited primary market activity from Brazilian and Mexican corporates, so there could be considerable new supply from those issuers.

"Also, similar liability management deals from other EM sovereigns, which could also constitute new supply," he noted.

In terms of the Brazilian corporate issuance picture, another analyst does expect to see less issuance in 2005, given higher interest rates.

"The decrease in new issuance would not be due to worse fundamentals but rather to higher interest cost," said the Brazilian corporate analyst.

"The conditions for the Brazilian economy seem to be in check and experts believe that those conditions will continue for some time, so in turn corporates should perform well in 2005.

"I would assume that we could see new more new issues in local currency, as the appetite for non-dollar currencies seems to be picking up in light of a weakening dollar. Then again, with rising interest rates I would not expect a huge number of these either," said the analyst.

Furthermore, one trend likely to carry into 2005 is the reopening of the euro-denominated market, given the weakness of the U.S dollar.

According to JP Morgan, there has been $9.5 billion in euro-denominated paper over the past three months in sharp contrast to the $5 billion over the same period a year ago.

Allure of local-currency markets

In the coming year, many predict investors will turn their attention to local currency deals. The weak dollar helped inspire the Republic of Colombia to price an upsized $375 million equivalent of global notes due 2010 at 99.658 to yield 11 7/8% via Citigroup. The success of that deal ignited a trend that is expected to carry into 2005.

These types of deals are going to pick up, as investors look to pick up yield in local markets, according to the second buyside source.

"There's a lot for demand for it. The Colombia deal went well and yields are just getting very tight."

Following in Colombia's footsteps, Brazil is expected to hit the market with a real-denominated deal in January. And that new supply will be in heavy demand.

"I think local currency markets will do much better. The market will be focusing more on that and there will be more interest in that," said the first buyside source.

Recently, local currency markets have rallied on the dollar's weakness, according to the sellside source.

"We've seen big moves in the Mexican peso and the Brazilian real, even to the point where Colombia imposed currency controls on Wednesday because the currencies moved so much and they want to stop it because it's killing exports; it didn't help much because they imposed the controls and the currency still ended stronger on the day," noted the sellside source.

"The fundamentals in these countries are improving. Commodity prices are still very strong. But recently the strength has been attributable to the U.S. dollar moves. Because these currencies are pegged to the dollar, or at least traded versus the dollar rather than the euro, they've depreciated a lot versus the euro, so now they're rallying against the dollar," the sellside source told Prospect News.

Local currency instruments accounted for 49% of trading volumes in the third quarter of 2004, up from 43% in the preceding quarter, according to the Emerging Markets Traders Association.

"I know for a fact that all the investment banks are knocking on the doors of the different public credit agencies in the respective countries to follow these kind of deals," said Alberto Bernal, head of Latin America research for think tank IDEAglobal.

"It makes sense from the perspective of international investors searching for yield and international investors that are very comfortable, with the view that the dollar will continue to trade weak in the foreseeable future, to buy this paper."

Brazil's love affair

In 2004, Brazilian paper was the darling in 2005. In the year ahead, the question is whether Brazil can hold its own amid the backdrop of rising interest rates.

One strike against Brazil in the coming year will be higher U.S Treasury rates.

IDEAglobal sees the Federal Reserve tightening monetary policy by year-end 2005 to about 3.25% or 3.5%. That expectation of higher interest rates will have a negative effect on Brazilian sovereign debt, but the dollar weakness should help negate the effects of higher rates, according to IDEAglobal's Alberto Bernal.

"The deal is the following - the fact that you are going to have continued dollar weakness around the world because the dollar needs to continue adjusting in order for the U.S economy to be able to gradually fix its current imbalances on the current accounts and on the fiscal balance.

"The fact that we are very likely to continue seeing that - despite the Fed continuing to raise interest rates - will help assets that are denominated in everything other than dollars - continue to see good bids," he said.

For instance, Brazilian stocks are the perfect place to diversify risk for investors holding too many dollars, said Bernal.

"The fact that people are going to see further inflows into Brazil from foreign investors on the portfolio front and on the foreign investment front will allow Brazil to continue performing in the eyes of international investors.

"That positive scenario on the local front will ameliorate some of the sell-off or some of the depreciation of the Brazilian bond on the sovereign market," argued Bernal.

Adding those pieces together, Bernal believes that 2005 will not be as positive "because of the fact that it is very unlikely that we will see capital appreciation on bonds from the current levels.

"But the fact that good inflows will continue to go into Brazil because of dollar weaknesses and better structural factors helping that economy - meaning growth and fiscal responsibility and so forth - that specific issue will make that country a more worthy candidate in terms of risk perspectives," he noted.

On that note, Bernal predicted that rating agencies will likely upgrade Brazil in the coming year.

"All in all, there are some positives from the dollar weaknesses and good structural issues in the Brazilian economy which will contain the price appreciations, but the continued adjustment of U.S monetary policy will have a negative effect on the sovereign debt market.

"So my perception is that we will probably see a total return of around 5% next year, which implies that the holders of Brazilian bonds will earn the carry, but are very unlikely to see additional capital appreciations."

Upgrades in 2005

In 2004, many countries received upgrades from the rating agencies, which helped boost emerging markets debt's reputation as more than a game of chance.

"It's been a key year [2004] because of the series of upgrades," said the investor. "I think that's really reinforced emerging markets as a solid investment, not just a trading opportunity," he said.

Market sentiment is that 2005 will not be as fruitful as 2004 in terms of ratings upgrades, said the investor.

"This year was a result of not what just happened this year, but many years of work.

Market consensus is torn as to whether Brazil will be on the receiving end of an upgrade.

"They've gotten two upgrades - one apiece from S&P and Moody's," said the sellside source.

"People think that Moody's could have another upgrade in the cards.

"The upgrades for Brazil were both in September, which is pretty recent. So I don't think people anticipate that they will be upgraded in January again.

"But the key is that people feel that the next move is an upgrade rather than a downgrade."

The investor believes that a Brazilian upgrade is "a resounding no for next year.

"I'd be surprised. They still have a lot of work to do. They are nowhere near where Russia or Mexico is.

"There's a lot of structural reform still. Improving corporate governance is key. From a rating agency, the focus is getting debt down, continuing to run more stable fiscal policy and reducing your dependence on international markets," he said.

In terms of Latin America, Peru and Colombia will be upgraded, according to Bernal.

"Peru will be upgraded because of very high growth and the continuation of the implementation of good policies. Moody's will upgrade Peru as well as Fitch. Both of them will very likely put them at the same level as S&P," predicted Bernal.

Moody's will move Colombia from a negative expectation to a stable expectation.

"If Argentina restructures its debt successfully, that country, of course, will be upgraded immediately because it will be going out of default.

"And I do believe that there is possibility that we will see an upgrade for Venezuela as well," said Bernal.

Overall, there will be fewer upgrades in 2005, a signal that "the end of the party" is in sight, according to the first buyside source.

Good countries, bad countries in 2005

On the macroeconomic front, higher interest rates, inflation, rising oil prices and a weaker dollar pose a long-term threat to the performance of emerging markets, according to Jephraim Gundzik, president of Condor Advisers, Inc, which provides emerging markets investment risk analysis.

Wall Street's poster child Brazil is headed for a fall, according to Gundzik.

"Brazil still poses the biggest threat in Latin America," he said.

"One reason is that inflation expectations are so sensitive in that country with an upward bias to interest rates. Second reason is that the government has such large amounts of domestic debt. The average maturity is around a year and almost half of that gets rolled over next year. That's going to pressure interest rates higher," he said.

With oil prices rising, that will also push up interest rates in Brazil.

"The biggest problem they have is that there still is this IMF-driven idea that they have to have tight fiscal policies. The public sector is not investing, pretty much destroying private sector investment," Gundzik said.

Something will have to break as political dissatisfaction and fiscal policy collide, he predicted.

Gundzik recommends holding paper at the short end of the curve in oil-exporting countries such as Russia. Investors should have short maturities in Venezuela and Ecuador.

On the other hand, paper from Russia, Panama and Peru is attractive, according to the investor.

"I think Russia is one that really pops out as a mis-pricing."

This may also be the year where investors see results from Panama's fiscal reforms, he said.

As with Peru, the fundamentals are very good, but the story will get more interesting as the elections approach.

Meanwhile, he is avoiding paper from Venezuela and the Philippines.

Yet, the first buyside source is baffled at to why everyone is so down on the Philippines.

"I don't quiet understand everyone is shying away from Philippines. It sounds to me like the Philippines is not a bad place to be. It sounds like they are starting to get their act together, mildly so.

"But hey - it's high yielding, especially in Asia. If Asia continues to do well and commodity prices continue to do well, then it will continue to grow," he noted.

And he cautions that he does not believe Turkey will not make it into the European Union.

"Turkey is just like Argentina, it never ceases to disappoint. But it has momentum," he said.

While he is not bearish on emerging markets, he does believe that there are countries that should continue to do quite well, including Brazil.

"I don't see why Argentina won't do well at year-end. I don't see why Brazil can't continue to do well, maybe less well but still well. Other countries' net debt will continue to increase, which is Russia.

"I don't expect a terrible year, provided that interest rates in the United States continue to go up, but not at a scary pace of 50 or 75 basis points in one or two weeks.

"So let the party continue like the '70s. Emerging markets were doing quite well. And commodity prices were going up.

"And all these countries were growing. Eventually, it got to a point where 'Hey, there's a lot of inflation everywhere else in the world' and the free money, free lunch and free party was over."

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