Outlook 2009: Emerging markets - hurt in 2008 by world financial woes - eye market bottom in 2009

By Aaron Hochman-Zimmerman

New York, Dec. 31 - The emerging market sector became a supporting actor at its own show in 2008. What was originally billed as another year of growth and prosperity - or at least the preservation of the status quo - in the emerging world was poisoned by a surging contagion that was continually mischaracterized and misunderstood.

But looking forward to 2009, investors run the range from cautiously encouraged to forlorn. Almost to the last, each feels the fate of the emerging economies became and will remain tightly bound in 2009 to the major markets' suffering.

As the crisis of 2008 took hold emerging countries became increasingly handcuffed to the monetary and political policies of the government in the United States and around the European Union as well.

Even as the year closed, the United States was still embroiled in a debate over how to ease a credit freeze and which of many paths to take out of dire financial straits.

The debate raged among the economists as well. Any number of opinions were available, which either predicted a bottom to the market or a six-month to 12-month global or longer recession battle ahead. All the while, many claimed there were great bargains and still others said the market has farther to fall.

The only thing that was certain was that for a large portion of the year trading of emerging market credit took place at severely reduced levels and the new issue market was virtually relegated to the local markets alone, until Mexico came along.

The $2 billion of Mexican 5.95% 10-year bonds reopened the primary market just as it was closing for the Christmas holiday, but they created only a minor dent in the character of the second half of 2008.

Still, good news was frequently hard to find in 2008 and the successful placement offered investors some hope for a sweet New Year in 2009.

The other side

Gloom and doom were easy to find throughout 2008, but one day credit will return and it will be credit that will "lead out," a strategist said.

"Credit had done a pretty good job of forecasting the market lower," the strategist said. "Spreads and indices will be a better indication of when the market conditions are returning to normal."

Whether the recovery is complete by the second half of 2009 or the first quarter of 2010, "investors generally price in recoveries three to six months ahead of time," another strategist said.

"Until then I would expect sovereigns to weaken," he said.

Additionally, when the recovery comes, the market will likely ease back into good health rather than burst back into mid-season form.

Issuers and underwriters will have to consider their circumstances before retrying the market.

"The sovereign guys are used to looking at certain new issue premiums," a senior syndicate official said. Many perennial issuers may examine their books and say: "I've already funded; why should I pay up?"

"If you can avoid coming to the market, then you should wait," he said.

Many in the market believe that the investment-grade credits will be the ones with strength enough to return early, as was the case in Mexico.

Still, throughout the year "with Mexico, the shoe dropped much sooner, because people linked it to the fate of the U.S.," the strategist said.

Deal incentives needed

"Peru and Colombia," another syndicate official said, the real "blue chip" issuers, will be the first to come to market, he said.

"Chile, Brazil," the senior syndicate official suggested, would be the first back to market, but "how long can [Mexico's] Pemex stay out of the market?" he asked. "They have $6 billion in financing needs."

The deals will come, but not easily, he said.

"People are going to be very choosey, looking for yield," he said.

They will need "equity-like returns in the 25% area" with "fat coupons and warrants," he said.

"You're going to need a lot of bells and whistles to get deals done," he said.

Bailing out

By late September, the U.S. Treasury department had submitted a $700 billion bailout package for the financial industry, marking a turning point for emerging markets activity.

"The beginning of October was when the shoe dropped for EM," a strategist said.

The International Monetary Fund stepped in with loans to reluctant borrowers in Hungary Pakistan and Ukraine, and a deal was close at hand for Turkey.

"They've been much better at monitoring risk," a strategist said about the IMF.

Despite the lifelines, emerging markets were dragged up and down with the fate of equities as the market repeatedly and schizophrenically rallied and crashed on headlines from Washington, D.C.

By the close of 2008, fears of equities falling to 5,000 on the Dow Jones Industrial Average had been assuaged, for the time being.

However, the ball of bailout and market fluctuation was clearly still rolling.

"Sovereigns are way too tight," the strategist said.

"If this is the worst crisis since the Great Depression, they should not be trading at 800 basis points, they should be over 1,000 [bps] on the EMBI Global," he said about JPMorgan's index of sovereign debt, which determines the amount of extra yield investors will demand to hold assets in emerging market debt versus U.S. Treasuries.

The global diversified index has a less strict liquidity rule for inclusion than the EMBI+ index.

For this type of crisis, "yields should be in line with U.S. high yield," he said, adding that a period of defaults, mostly from the corporate sector, is expected to follow what began in 2008.

"Companies were able to hold off for a really long time," he said about defaults.

Opportunities eyed

Still, the deep discounts offer good value in some cases, he said.

Mexico's Cemex SAB de CV trading at a bid price in the 50s and China's Nine Dragons Paper Ltd. trading below a bid price of 35 present strong opportunities for those who have the money and nerve to buy, he said.

"There's plenty of value out there," he said.

It rolls down

At the beginning of the year there were some in the market who saw a bubble building either in the U.S. mortgage market or in emerging markets themselves, but few saw the two becoming so intertwined.

The result was a continual spillover of toxicity from the major markets into the emerging economies while investors, forever blowing bubbles, went running en masse to Treasuries.

Even as the crisis developed many were confident that the slowdown, the volatility or the problem would not last beyond the loss of Bear Stearns, then the summer doldrums, then Lehman. The market hung its hopes on firewall after firewall and Federal Reserve action after stimulus package, but nothing provided any more than a temporary easing of the ever-present downward pressure.

It was fairly common, even for those deeply involved in the market, to have forgotten how they felt at the beginning of the year.

"A lot has changed," said a trader focused on emerging Europe, as he tried to recall what sort of year he expected from 2008.

"The only thing I can say is: not the year we've had," he said when asked what he was expecting for the year.

In January it seemed like "everything is fine; the world's a nice place," he said, although "we had the roots of what we've got now."

For many investors and the public at large, the first harbinger of impending doom was trouble at Bear Stearns, but before Bear, there was Northern Rock.

The British lender was nationalized on Feb. 17, but the problem was noticeably more systemic as the aptly named Bear took an emergency loan from the New York Federal Reserve on March 17 and quickly fell to $2 per share.

A former emerging market trader at Bear Stearns said, at the time, he felt like he had been "kicked in the ß@££$ ... repeatedly" shortly after relatively buoyant JPMorgan swooped in to buy Bear at fire sale prices. After the Fed engineered a bailout, Bear Stearns' shareholders approved a $10-per-share sale of the storied investment house.

The felling of the mighty Bear brought earnestness back to the market, but only for an instant in many cases.

"It caused a blip," a trader said, but "we carried on."

At once the market was surprised by how it was able to fall so far so fast, but immediately assumed that the worst was over.

In 2008, we learned that "moral hazard doesn't exist, until it does," he said.

After Bear the question of "too big to fail?" was asked about almost every firm on Wall Street and in response the answer was most likely "yes" until Sept. 15, when Lehman Brothers Holdings Inc. filed for Chapter 11.

What could possibly go wrong?

Market watchers may have been caught off guard by the severity of the impending crisis, but at the outset of 2008 there were at least some known enemies as well as entrenched bears.

"I felt bearish in January and I felt bearish all the way through," a strategist said. "I still feel bearish," he added.

"Bonds were overpriced in Latin America and would have to pull back at some time," said Enrique Alvarez, a Latin America debt strategist at think tank IDEAglobal.

"The credit issue was out there," he said. "We had an overstressed spread relationship."

The fate of the emerging markets was highly dependent on "the decoupling question," he said. At the beginning of 2008, everyone wanted to know which way the cards would fall.

By the end of 2008, all of the decoupling cards had been blown off the table.

"It was all highly U.S. dependent," Alvarez said.

Still, "LatAm was able to fend off one or two waves of the risk aversion coming from overseas," he said.

Through the early stages the category "remained relatively stable, even compared to its own equity," he said, but "after Lehman, it just went down the tubes," he said.

"The decoupling theory went down the toilet after Lehman," he added.

A lack of confidence in the market as a whole, as well as local political desperation and poor decision-making slammed Latin America's high-betas.

Oil exporters hurt

Ecuador suffered along with its oil-producing brethren in Venezuela, Russia and elsewhere as oil fell from its weak dollar inspired $147-per-barrel highs.

Still, Ecuador forced the hand of sellers as president Rafael Correa flirted constantly with the idea of defaulting on what he sometimes considered "illegitimate" or "illegal" debt in order to focus on social spending.

Shocks to the market had already pushed Ecuador's three dollar-denominated issues to default levels when Correa and his government decided to skip a $31 million coupon payment on the 12% bonds due 2012.

The market was not stunned by the government's default as much as the waffling over its intention to pay when the money was available.

Looking forward, Ecuador's ability to access the debt market is now strongly in doubt, but like the other oil producers, it has another problem.

Many oil-rich nations calculated 2009 budgets based on $80-per-barrel oil, Alvarez said, adding that the quality of oil in many places does not even fetch the full listed price of West Texas Intermediate crude.

"We were expecting a lot more commodity producers to come to market," a strategist said.

Brazil was another major force that helped shatter confidence in the market, the strategist said.

"I think it did hinge on Brazil. When it looked like Brazil could be weak, I think that was unexpected by this market," the strategist said. "You had CVRD coming out and saying they were stopping production at mines; that was unexpected."

That "combined with Argentina ... the pension fund has really driven a lot of capitulation there; Argentina is sort of disappearing," the strategist said.

In emerging Europe, "the [Commonwealth of Independent States] was heavily hit, as would be expected ... Russia was really hammered," he said.

"Russia has got a lot of corporate debt outstanding, which is not in the interest of the government to support," he said.

Even new Russian sovereigns may have to wait until the end of 2009 to be issued, he said.

In 2008, a great deal of the problems stemmed from the fear of the unknown, "we're going to have a lot of volatility," assumed a trader focused on Asian markets after seeing the VIX spike past a then-shocking 40.00 in the summer of 2007.

Still, "I didn't expect the markets were going to seize up the way that they did," he said.

Shortened deal season

After the loss of Bear Stearns, during the spring and early summer it seemed as though things might return to a more predictable seasonal routine. Many felt that as investors returned from summer holidays, the liquidity drought would be cured with some autumn rains, but the primary was not in shape to play a full season.

Indonesia actually provided one of the few highlights of the abbreviated new-deal year, the trader said.

One of Asia's strengths was avoiding oversupply, but one bit of supply that was welcomed into the market was Indonesia's reopening of old bonds to the tune of $2.2 billion on June 17.

The 6¾% bonds due 2014 were retapped for $300 million at 100.25.

The 6 7/8% bonds due 2018 were retapped for $900 million at 97.25.

The 7¾% bonds due 2036 were retapped for $1 billion at 95.5.

Credit Suisse, Deutsche Bank and the ill-fated Lehman Brothers acted as bookrunners for the deal.

While Indonesia may have impressed, Brazil's Arantes International Ltd. caused a collective cringe among investors.

The beef producer clumsily marketed and placed a $150 million 10¼% bonds due 2013 on June 12. Arantes had originally hoped to sell a $200 million bond.

The deal was priced on its talk at a discount at 99.046 to yield 10½%.

"It was very poorly placed and timed," a strategist said. "People that knew beef, knew it was a weak company."

For worst deal of the year awards, Arantes could be considered "a multi-year winner," the strategist said. By the end of the year, the bonds traded in the 30s.

The summer doldrums gripped the market tightly, but many believed October would see the primary ship underway.

Unfortunately for anyone interested in having a live primary market, Turkey's $1.5 billion bond was the veritable finale for the year that never was, until Mexico's buzzer beater.

The 7% bonds priced at 99.633 to yield 7.05%, coming at their talk, via Deutsche Bank and UBS.

By October, Lehman was gone and had taken the primary with it.

In the meantime, syndicate officials sat waiting for a break in the volatility, but nothing came. Most knew the cue would come from the U.S. investment-grade market, but the cue never came.

Full recovery predictions have been numerous and as varied as from the second quarter of 2009 to the first quarter of 2010.

Along comes Mexico

Mexico did little to change the nature of 2008 with its blockbuster $2 billion deal at the close of the year, but it did offer hope as it was able to take advantage of a small window opened by the Fed's historic rate cuts.

Mexico's $2 billion 10-year bonds were sold at 99.784 to yield 390 bps over Treasuries on Dec. 18.

"It's a timing issue," said IDEAglobal's Alvarez about after the sale.

Mexico must have figured "we're one of the two top tier names and the largest one ... there's money on the sidelines; yields are declining," he said. "They're taking advantage of that."

Mexico also had to offer up 40 bps more than the 350 bps the curve indicates, he said.

The timing of the deal was also ahead of many contractionary economic figures, which have not been released yet.

"Come January and February, they may not be able to get this off the ground," he said.

Still, "kudos to them for getting $2 billion off the market," he said, adding that this issue will likely fulfill Mexico's issuance goals for 2009.

"I wouldn't think they'd do anything more after that," he said.

The trailblazing issue "was incredible for our sector," a syndicate official said. "It set a benchmark."

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