Emerging Markets Debt Strategy Outlook 2006

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Emerging Markets Debt StrategyOutlook 2006
Pablo GoldbergCo-Head LATAM Fixed Income
Strategy Economics
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Table of Contents

• 2002-2005 You Showed me the Money
• Global Backdrop and EM Fundamentals
• What a Wonderful World Spreads tighten amid low
  volatility
• EM Unplugged Have We Gone Too Far?
• 2006 The Year We Lived Dangerously? Re-pricing
  Risk
• Roll over of liquidity, commodities, yield curve,
  global imbalances
• 2006 Investment Themes
• Mitigants Technicals, Fundamentals
• Catalysts Indebtedness, Electoral cycle
• Macro Trades
• Argentina GDP Warrants CPI-Linked
• Brazil Local Rates Elections
• Mexico Steepeners, then Local Flateners
• Venezuela Liability Management Re-rating

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2002-2005 You Showed Me The Money

• Global Backdrop
• High commodity prices
• Ample global liquidity
• Strong appetite for risk
• Down the credit ladder across countries, across
  assets
• Strong asset correlation
• Low volatility
• Improvement in the EM economies
• Improvements in country balance sheet and cash
  flow
• Floating currencies
• Positive cyclical conditions becoming structural
• Stronger institutions

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Global Liquidity Trends
Global Backdrop
Global liquidity (monetary base, plus total
marketable securities - US government and agency
held in custody by the Fed for foreign
accounts).Biweekly data, as of October 12,
2005. Source Merrill Lynch
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G-3 Central Bank Rates
Global Backdrop
As of November 3, 2005. Source Merrill Lynch
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Asia Recycling Money
Global Backdrop
As of November 1, 2005. Source CEIC, Merrill
Lynch calculations
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FX Reserves to Total Debt
EM Improving Fundamentals
Source IMF, International Financial Statistics,
Merrill Lynch
Chart reflects the average change level. As of
October 28, 2005.
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Other Indicators
EM Improving Fundamentals
External Debt as GDP
External Debt as GDP
Total External Debt / Exports GS
FX Reserves to Imports GS Coverage
Source Merrill LynchAs of October 28, 2005.
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Credit Quality A Full Notch Higher
EM Improving Fundamentals
As of October 13, 2005. Since January 2002,
Holding Market Cap. Constant Source Merrill Lynch
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Risk Aversion vs. EM Spreads
2002-2005 What A Wonderful World
As of October 28, 2005.
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Commodity Prices vs. EM Spreads
2002-2005 What A Wonderful World
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Standard Deviation EM Countries Monthly Returns
2002-2005 What A Wonderful World

• The standard deviation has been declining
  steadily.
• Even though standard deviation has recently
  increased to 2.25, it returned to its low level
  of 1 for October.
• Excess returns via country-specific or long /
  short positions have diminished considerably for
  external debt.

• Source Merrill Lynch IGOV
• Based on country-to-country monthly standard
  deviation of total returns of country-specific
  IGOV sub-indices.

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A Flatter Credit Curve
2002-2005 What A Wonderful World

• Source MSCI, Merrill Lynch
• Based on country-to-country monthly standard
  deviation of total returns of country-specific
  MSCI sub-indices.

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Re-pricing Risk Have We Gone Too Far?

• Greenspans conundrum remains unresolved
  global imbalances may adjust drastically.
• The creation of global liquidity is rolling over.
• Risk appetites remain under pressure, as swap
  spreads, volatility, inflationary expectations
  and risk-free rates have all been on the rise.
• The process of risk normalization appears to be
  resuming, albeit from historically low levels of
  risk premia.
• A concerted G-3 monetary tightening scenario now
  appears to be in the cards for early 2006 and
  poses an increasing risk to global liquidity
  conditions. Potential currency revaluation in
  Asia would add fuel to the process.
• We have been and remain near-term cautious on the
  Emerging Markets (EM) debt market, based on the
  evident gap or disconnect between our risk
  metrics and EM debt valuations.
• As that gap has begun to close, the environment
  for EM debt and other asset classes at the far
  end of the risk spectrum has become more
  challenging. We think this process has more to
  go, and EM spreads remain biased to widening.
  This may not happen until 2006.

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Creation of Global Liquidity Rolls Over
Have We Gone Too Far?
Global liquidity (monetary base, plus total
marketable securities - US government and agency
- held in custody by the Fed for foreign
accounts).Biweekly data, as of October 12,
2005. Source Merrill Lynch
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Treasury 10Y-3M Yield CurveTougher Credit
Conditions, Wider Spreads
Have We Gone Too Far?
Source Merrill Lynch January 2, 1988 October
24, 2005.
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EM Debt Net Carry (EM Debt Yield3M Libor)
Have We Gone Too Far?
As of November 8, 2005.
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EM Spreads - GT10 Ratio
Have We Gone Too Far?
As of November 8, 2005.
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Comparison of EM and HY Spreads by Rating
Have We Gone Too Far?
BB and Lower Rated EM vs. US High Yield Spread
B Rated EM vs. B US Corps Spread
As of November 8, 2005. Source Merrill Lynch All
statistics, within the graphs, calculated since
September 1, 2000.
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EM Unplugged
Have We Gone Too Far?
As of October 28, 2005.
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YTD Risk Aversion vs. EM Spreads
Have We Gone Too Far?
As of October 28, 2005.
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2006, The Year We Lived Dangerously?
Global Imbalances Divergent Opinions

• Large and growing current account deficits in
  the US financed by rest of the world. This is
  coupled with very low interest rates and
  inflation in the US (Greenpans Conundrum)
• Causes
• 1) Low savings rates in the US fiscal deficit
  and wild consumer
• Diagnosis The US condition is unsustainable as
  providers of funding (the Asian central banks),
  will stop doing so as their currencies appreciate
  and reserve accumulation reverses course, or
  comes to an end.
• ? Adjustment will not be smooth and will
  potentially be accompanied by significantly
  higher US interest rates, a USD crisis and hard
  landing in the US
• 2) The US productivity capital account leads
  current account
• Diagnosis The financing of the US current
  account deficit should not be a source of
  concern. It reflects foreigners willingness to
  invest in the US story, its the flip side of
  low investment opportunities in Asia and Europe.
• ? An adjustment will occur, but it will be
  gradual and related concerns are exaggerated.
• Timing now or long-term?

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2006, The Year We Lived Dangerously?
Global Imbalances Three Scenarios
We see the closing of global imbalances as an
important risk that may tip the scales away from
the goldilocks backdrop that the Emerging
Markets have enjoyed in the past few years.
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2006 Investment Themes
2006, The Year We Lived Dangerously?

• 2006 returns are hostage to the global
  environment
• Timing of long-short strategies given by risk
  appetites rather than domestic factors
• Country-specific strategy for returns is more
  difficult to achieve due to reduced deviations of
  returns within EM asset classes
• If adjustment to global imbalances is dramatic,
  country fundamentals will driven relative returns
  again
• Riding the electoral cycles in LATAM could end up
  being a profitable investment
• Re-pricing risk means going back to basics in
  terms of asset classes, but inflation cycles in
  LATAM could provide interesting opportunities in
  local markets

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Emerging Markets Debt Mitigants Catalysts
2006, The Year We Lived Dangerously?

• Fundamentals
• Using liquidity maturity extension, insurance
  policies, degrees of freedom, reserve
  accumulation
• Institutions Central Bank independence,
  inflation targeting, fiscal anchor
• Technicals
• Improved country information standards greater
  transparency and monitoring Improved risk
  management and leverage standards the CDS market
• A more mainstream market Broader investor base,
  Less leverage and more stable money
• Less room for cross-market misalignments
  (relative liquidity and repo markets)

Source Merrill Lynch
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LATAM Macro Adjustment to Sudden Shock
2006, The Year We Lived Dangerously?
Trade Balance Adjustment 1998-2004 ( of GDP)
Primary Balance ( of GDP)
Source Merrill Lynch
Source Merrill Lynch
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Brazil Building Shock Absorbers
2006, The Year We Lived Dangerously?

• 5. Will Debt Dynamics Fears Return?
• Not likely debt/GDP ratio up-tick this year (to
  51.8) explained by higher interest-rates
  increase would be higher under more adverse
  external scenario but sensitivity now is lower
  than generally thought 4.25 GDP primary surplus
  target will be over performed but quality of
  surplus is deteriorating (current spending
  pressure underscores need to de-link Social
  Security benefits).

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EM Debt Mutual Fund Flows
2006, The Year We Lived Dangerously?
As of October 28, 2005. Source Merrill Lynch
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EM Sovereign Issuance Tradable Debt Service
2006, The Year We Lived Dangerously?
Source Merrill LynchAs of October 31, 2005.
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LATAM Full Blown Electoral Cycle
2006, The Year We Lived Dangerously?

• Barring a major change in the global backdrop,
  the election cycle in Latin America should not
  present major risks to investors.
• The end of political risk is to us, however, a
  function of the current ample global liquidity.
• In the long term, politics still matter as much
  as the reforms need to be consolidated and
  deepen.

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EM Debt Total Returns Scenarios
2006, The Year We Lived Dangerously?
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Argentina GDP Warrants CPI-Linked
Macro Trades

• Be long inflation
• Output gap is closed
• Monetary policy remains passive
• Administered prices likely to increase
• Be long AR
• BCRA acting as fixed exchange rate
• Expected AR range 2.85-3.00

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Brazil Low Rates Elections
Macro Trades
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Macro Trades
Mexico Steepener Now, Flatener Later
Source Merrill Lynch
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Venezuela Re-rating Liability Management
Macro Trades
Ratings and Real Oil Income
Foreign Assets vs. Liabilities
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Spread vs. Rating (Spread Adjusted as if
Duration Were the Same as IGOV)
GEM Debt Strategy
As of November 8, 2005. Source Merrill Lynch