Investing in Emerging Markets: The Returns Are in the Details

Regional Investment Perspectives and New Acronyms

• Bob Diamond (Atlas Merchant Group) – "Nigeria":
  • Cites Nigeria's peaceful 2015 democratic election transition as a historic, unprecedented event.
  • Highlights Nigeria's population of 175 million, projected to surpass Brazil as the world's fifth most populous nation within 5–10 years.
  • Contrasts banking market caps: Brazil at ~$300 billion vs. Nigeria at $12–13 billion, indicating massive growth potential.
  • Notes Nigeria will generate more children this year than all of Western Europe combined, signaling a rising discretionary income demographic.
• Ana Maria Caresquilla (Fondo de Reserva Latinoamericano) – "PAC" (Pacific Alliance):
  • Identifies Mexico, Colombia, Peru, and Chile as a unified investment bloc due to shared institutional strengths.
  • Cites strong monetary/fiscal policy, controlled inflation, and positive external liquidity ratios as key drivers.
  • Points to significant private sector involvement in long-term infrastructure projects as a differentiator.
  • Projects superior growth expectations for this bloc compared to other regional and global markets.
• Jingdong Huang (IFC) – "EMMO" (Emerging Markets Mean Opportunities):
  • Reminds audience the term "Emerging Market" was coined by IFC in 1981.
  • Details 2014 performance: $22 billion invested in 600 projects across ~100 countries via private equity, debt, and mezzanine finance.
  • Emphasizes IFC's 50-year data track record on risk-return profiles as validation for EM investing.
• Penny Foley (TCW) – "Fragmented Returns":
  • Focuses on EM fixed income, noting a 62-country index yielding ~5.5% with strong balance sheets (40% debt-to-GDP).
  • States EMs account for 70% of projected global growth in 2015 and hold 80% of global reserves to pursue countercyclical policies.
  • Discusses the "fragile five" (Brazil, India, Indonesia, Turkey, South Africa) introduced in mid-2013.
  • Notes India and Indonesia successfully reformed policies post-2013, while Brazil and Turkey face ongoing challenges.
• Victor Chiu (First Eastern Investment Group) – "CHIM":
  • Selects China, India, Indonesia, and Mexico for their combined 3 billion consumers and sophisticated policy leadership.
  • Highlights sustained high growth and scalability as primary investment thesis criteria.

Fixed Income, Leverage, and Currency Dynamics

• Currency Strategy:
  • TCW has been underweight local currency EM bonds for five quarters, underperforming dollar bonds by ~20 percentage points.
  • Local currency yields are currently ~500 basis points over Treasuries; local rates have risen from 5% to 6.5%.
  • Forecast local currency may become an opportunity later this year or early next as Fed normalization potentially peaks early.
  • Vulnerability to Fed rate hikes is concentrated in countries with large current account deficits, high inflation, and low central bank credibility.
• Leverage and Credit Quality:
  • Total EM corporate stock is $1.7 trillion; IFC and panelists reject the "bubble" narrative.
  • New issuance is primarily refinancing short-term bank debt into longer-term bonds, extending maturities.
  • Mining and oil sectors (20% of CEMBI) benefit from dollar revenues offsetting dollar liabilities.
  • Idiosyncratic risks exist for domestic companies with local revenue and dollar liabilities.
  • Projected corporate default rate is 5.5% for the year, but excluding Ukraine, the rate is ~3.5% (slightly up from 3.3% last year).
  • Sovereign debt-to-GDP has dropped to 40% from ~100% in the mid-90s; debt denomination has shifted to ~75% local currency.
• Local Currency Market Development (IFC):
  • IFC shifted issuance strategy: 50% of $15 billion annual issuance is now in local currency, increasingly used to fund local projects rather than swap to dollars.
  • Successful "Masala bond" (Indian Rupee) issuance in London saw demand require a 60% upsize from 10 billion to 16 billion.
  • RBI permitted Indian corporates to access offshore rupee markets following IFC's success in establishing a yield curve.
  • Infrastructure senior debt in EM shows similar default/recovery profiles (80 cents on the dollar) to OECD but with higher yields (LIBOR +400 vs. LIBOR +200).

China: Slowdown, Political Risk, and Market Structure

• Economic Outlook:
  • Panelists view China's slowdown as a sustainable evolution rather than a collapse, with growth projected at least at 6%.
  • The slowdown is expected to make global economies more resilient long-term.
• Political Risk and Anti-Corruption:
  • Long-term anti-corruption campaigns are viewed as positive for political stability and regime legitimacy.
  • Short-term dislocation and decision-making delays are acknowledged as transitional costs.
  • Judicial reforms include "circuit judges" to reduce local government influence on rulings, enhancing the rule of law.
• Equity Market Risks:
  • Recent equity rally is viewed as a mix of catch-up demand (due to frozen IPOs) and new liquidity channels (Hong Kong-Shanghai Connect).
  • Victor Chiu warns that when retail participation (taxi drivers, domestic help) becomes high, it signals a market top.
  • Regulatory uncertainty remains a concern; "implicit guarantees" (no loss of principal) persist but are being challenged by allowing defaults to occur.
  • World Bank and regulators are partnering to improve frameworks, but credit culture development is still ongoing.

Africa: Infrastructure, Demographics, and Financial Services

• China's Role in Africa:
  • Chinese investment is characterized as a "win-win," exporting not just manufacturing capacity but technical expertise and capital.
  • Chinese banks primarily follow their corporate clients into Africa rather than building standalone retail networks.
  • Gap exists in domestic financial inclusion; high treasury yields (12–14%) disincentivize consumer and SME lending.
• Investment Strategy and Risk Mitigation:
  • Atlas Merchant Group targets 10–15 specific countries with manageable, priced risks.
  • Business model relies on majority ownership, operator status, and LSE listing to ensure governance and control.
  • 90% of Atlas Mara IPO investors were US-based, with many making their first African investment due to the listing structure.
  • Regulatory reforms are seen as positive; OPEC reports Africa as their highest-returning portfolio with no historical losses.
• Fixed Income and Capital Markets:
  • Africa is no longer a niche; it represents 10% of EM fixed income and 30% of the frontier segment.
  • Sovereigns are tightly priced on dollar bonds; local currency opportunities are selective due to liquidity constraints ("Hotel California" risk).
  • IFC notes corporate debt in Sub-Saharan Africa is underdeveloped (low single-digit % of GDP vs. 100% in US or 70% in Korea).
  • Long-term development of local currency markets requires regulatory overhauls, as seen in Nigeria's 4-year process to issue Naira bonds.
• Venezuela Specifics:
  • Venezuela faces severe macro challenges beyond capital market underdevelopment; FLAR stands ready to assist but lacks precise data on default risk.
• Market Integration:
  • MILA (Latin America): Integration of Mexico, Colombia, Peru, and Chile exchanges is ambitious but not yet perfectly smooth; other exchanges are considering joining.
  • Southeast Asia: Stock market integration favors cross-listing over consolidation to preserve national champions; bond markets require regional settlement standards.

Forward-Looking Statements and Conclusions

• Demographics: Africa offers a significant "peace dividend" and labor force growth unmatched by China.
• Infrastructure Gap: Estimated at $1–2 trillion globally, representing a major investment opportunity for private sector capital.
• Fed Normalization: Expected to be measured; only the weakest EMs with structural deficits will face serious headwinds.
• Investment Horizon: Panelists emphasize medium-to-long-term holds (5–10 years) to capture the normalization of interest rates and the development of deep local capital markets.
• Risk Pricing: Success depends on selecting specific countries, understanding idiosyncratic risks, and pricing political risk correctly.