Conference Presentation, Panel
Investing in Emerging Markets: Out of the Rabbit Hole?
- Structural Shift in EM Drivers: Liquid EM asset prices are increasingly driven by domestic policies, politics, and capital flows rather than global macro factors, requiring country-specific analysis.
- Political Risk Layering: Recent U.S. election outcomes and domestic political shifts in emerging markets (e.g., Taiwan, China, Brazil) have introduced new variables for winners and losers, potentially leading to unexpected policy actions.
- Market Pricing Assumptions: Current market pricing assumes the positive aspects of proposed U.S. policies (infrastructure, commodities) will materialize smoothly while ignoring potential implementation hurdles or negative trade impacts.
- Investment Horizon Mismatch: Institutional investors often prioritize short-term liquidity (quarterly reviews, daily redemptions) despite structural investment themes (urbanization, middle-class growth) playing out over 10–15 years.
- Liquidity Premiums: European investors frequently demand daily liquidity, which is misaligned with 10–15 year infrastructure horizons; U.S. investors show greater maturity regarding lock-up periods.
- EM Debt Evolution: EM debt has transitioned from being predominantly low-grade and equity-like in the 1990s to mostly investment-grade (BBB or better) today, though investor sentiment lags.
- Corporate Debt Risks: A shift from sovereign to corporate and local currency debt creates vulnerability to balance sheet stress; a significant portion of this debt lacks dedicated research mandates and relies on "crossover" capital.
- Default Rates: Power project default rates in Africa are one-third lower than those in the United States; Brazilian distribution companies have avoided massive defaults for 21 years due to rigorous selection.
- Valuation Discipline: EM private investors compensate for volatility by buying assets at cheaper valuations and utilizing 10-year lockups to avoid ephemeral liquidity flows.
- Growth Projections: Emerging markets account for 75% of projected global GDP growth and 93% of global urbanization over the next 15 years.
- Developed Market Saturation: High leverage and elevated multiples in developed markets (e.g., U.S. infrastructure trading at 37x EBITDA) make emerging markets attractive for value dislocations, despite perceived political risks.
- Country/Asset Specific Recommendations (2017 Outlook):
- Egypt: Highlighted for macro reforms, currency flotation, and fiscal tightening despite low current valuations.
- Vietnam: Preferred for power projects with revenue tied to U.S. dollar construction costs and fuel prices, creating a structural short on local currency.
- Russia: Cited as a top hard currency opportunity with strong oil price stabilization, favorable external reserves, and an optimal information ratio.
- Indonesia: Identified as a local currency buy due to overreaction to anti-Asia sentiment and undervalued local yields.
- Argentina: Favored due to being under-invested for 15 years with a strong policy team; Brazil noted as less clear but improving.
- Negative/Ambivalent: Turkey cited for obvious risks; China viewed as ambivalent due to potential for politically motivated market surprises.
- India Demonetization Impact: The abrupt withdrawal of 80% of the monetary base caused short-term economic disruption, but 12 of 15 trillion notes were redeposited; growth is expected to dip in the short term but recover to >7% by 2018.
- Rule of Law Dynamics: Investors must assess the momentum of legal and regulatory improvements rather than static conditions; private deals can utilize New York Convention arbitration and international enforcement mechanisms to mitigate local risks.
- Sovereign Debt Safeguards: Sovereign issuers are incentivized to maintain debt serviceability due to the high cost of default (e.g., Greece, Argentina's decade-long market exclusion).
- Frontier Market Challenges: The industry lacks a "middle tier" of sophisticated, mid-sized firms capable of sourcing local deals while managing global sales, leading to fragmented performance and historically poor aggregate returns.
- Risk Mitigation Strategies:
- Diversification: Low correlation between frontier markets (e.g., Nigeria vs. Pakistan vs. Vietnam) reduces portfolio volatility to levels close to the S&P.
- Sector Selection: Avoiding cyclical/export-driven businesses in favor of domestic-focused infrastructure and power reduces exposure to global demand shocks.
- FX Hedging: Aggressive FX hedging is often too expensive; firms rely on natural hedges (e.g., revenues in USD/EUR) or buy cheap enough to absorb currency moves.
- Credit Selection: Differentiating between mean-reverting situations and those prone to spiral defaults is critical, particularly in concentrated sectors like Brazilian meatpacking.
- Return Expectations: Compelling 20% IRRs exist in frontier markets but require specialized, on-the-ground expertise and long-term capital; generic "pan-EM" strategies are criticized for failing to generate alpha.