When the global financial crisis hit Latin America, the sub-continent was well positioned to confront it. Banks and capital markets were robust and even pension systems were stronger than during previous financial crises, according to James B. Quigley, President of Merrill Lynch for Latin America and Canada. How should investors respond to the volatility of equity and asset markets? In an interview with Knowledge at Wharton, Quigley, a 26-year Wall Street veteran, explains his firm’s strategy for Latin America and why it would be a mistake to become ultra conservative.
Knowledge at Wharton: What impact has the financial crisis had on Latin American economies?
James B. Quigley: For the first time in my 26-year career on Wall Street, Latin America’s financial sector was well-positioned for this crisis. The banks are fairly well capitalized, local capital markets are generally active with a fair degree of capital formation, and the pension systems are far more developed than they were back during the 1997-98 crisis. These factors have helped insulate the region from some of the volatility it’s seen in the past.
But the fact is that the financial crisis has broadened and become global. It is calling into question people’s prognostications on GDP growth around the world, including China. This has had a broad impact on commodity prices and real asset prices. For better or worse, Brazil, which has been the star of Latin America, found a way to brand itself as a commodity-based economy. The fact is, it’s a much more diversified economy than that. The commodity-oriented branding was terrific on the upside, but there is a lot of downside when commodity prices are coming down. Of the IPOs that were successfully executed in Brazil in the last 12 to 18 months, I would say, maybe all but four are under water.
Knowledge at Wharton: What will this market mean for investors and for world capital markets? Where will capital come from in the future?
Quigley: The Congress bailout package may help, as also the initiatives of governments in other parts of the world. In effect, many securities aren’t marketable at this point in time and they are clogging the system. I hate to be over-simplistic, but if you’re a plumber and you’re cleaning a drain, you’ve got to clean out everything so that it can work again; that is where the capital markets are right now. So, the ability of the authorities to liquify the system by dislodging the inertia in the capital markets will be a positive thing. There is money out there; there is liquidity in the world. Mobilizing liquidity is largely a function of confidence in the system, and we need that to come back as a precondition to re-liquefying the system.
Knowledge at Wharton: How does Latin America compare with the BRIC economies (Brazil, Russia, India and China) as a growth area?
Quigley:. If you look at the demographics of Latin America — the age of the population, the middle class, the growth in housing markets, the increasing sophistication of local capital markets, pension funds, increase in foreign direct investment and so on — when you pool together the core Latin American economies and look at them as a region in relation to the Middle East, China, India and some of the growth markets you’ve talked about earlier, on a graph they actually emerge as a more compelling investment alternative for firms like Merrill Lynch going forward. The demographic in places like Mexico and Brazil is extremely positive with a long-term view. The young population is increasingly well educated in these countries. They also have growing middle classes and expanding consumer finance markets and local economies.
As an investment area Latin America has been very hot for the last four or five years. It has, however, fallen victim in large part to being branded as a commodity-oriented region. Right now what’s happening in the marketplace is a bit of a visceral reaction. As commodity prices are deflating, predicated on the view that the world is moving into a global recession, it’s having a tremendous impact on deflating equity markets in Latin America.
Knowledge at Wharton: Given your view of the Latin American economies, what is your business model for the region?
Quigley: The view that Latin America is a homogeneous space is flawed. We have a business model in Latin America, which I think is unlike most other financial services business models. We have not migrated to a Brazil-centric strategy. In the present environment — where Wall Street and financial services firms are capital constrained — it’s tempting to put all your eggs in the Brazil basket to generate revenues and margin without incurring a lot of risk elsewhere. But the history of Wall Street in Latin America is littered with failed business models.
The important thing to me in that region is ensuring that whatever we do, even in very difficult times, is sustainable through cycles. So, as opposed to pursuing a business strategy that’s overly dependent on one asset class or one country, we have deliberately for the last couple of years built a pan-Latin American business model. Opening an office in Bogotá, we acquired a 106-year-old broker dealer – equity broker dealer in Chile. We re-opened our equity broker dealer in Argentina a year ago; it’s now number one. We are banking actively a subset of clients in the Caribbean Basin in Central America for the first time in the history of the firm. We have a large business in Mexico that has tripled in three years. Mexico is a huge and stable opportunity in the long term, in my view.
We have integrated our Latin American wealth management business with our institutional business. The ownership structure of businesses in Latin America consists of family-owned companies and small private companies. As such, the synergy from connecting the dots between the wealth management and investment banking businesses is more pronounced than anywhere else in the world.
Still, the geographies are very distinct. When we acquired the broker dealer in Chile, I went to meet senior public officials It was not a large acquisition financially but a big one for the Chileans. Everybody asked me whether the bankers covering Chile were going to be based in Sao Paulo. It was a bit of a rhetorical question, because they don’t want to be served from Brazil. Sao Paulo has emerged as, for better or worse, the financial center of choice in Latin America, but I don’t look at Latin America as a homogeneous space. It is a series of distinct spaces that have to be banked differently and broadly. That implies that our business model has to be diversified across industry, asset class and business line to make sure that we mitigate volatility in our earnings through cycles like this.
Knowledge at Wharton: What is Merrill Lynch’s strategy for various markets in Latin America?
Quigley: In Mexico the local fixed income markets are well developed. The fixed-income markets have been our number one business in the region. Equity markets in Mexico have not developed. Last year, there were probably 85 or 90 IPOs in Brazil and less than five in Mexico. Equity capital formation in Mexico is an issue in large part because of the family-owned nature of the economy, the lack of willingness of these families to divest ownership stakes in their companies, and the emergence of several large monopolies that own big pieces of businesses. At some point in time that’s going to have to be deconstructed for the equity markets to open up. That said we are among the top three equities traders in Mexico, although our Mexican business has predominantly been in FICC — or Fixed Income Currencies and Commodities.
In Brazil, the business is much more broadly diversified. The equity markets until a few months ago were very strong. A lot of revenues could be generated through IPOs, privately placed equity, private equity. The fixed income markets have developed nicely. We’ve built a large, growing and stable fixed income currency commodity business.
In Argentina, the complexion of the businesses is different. We have an equity broker dealer and a fixed income and investment banking business that all do well, but not on the scale of Brazil. What we have in Argentina — and we don’t have in many other places – is a high net worth wealth management business that has been very successful.
Chile is a sophisticated market. We have an equity broker dealer there with financial services capability, but it’s very over-banked, and margins are very tight. Our Santiago office is the launching pad for Chile and Peru. We use Panama as a jumping point for the Caribbean Basin in Central America where we’ve identified 95 companies that we bank from the investment banking side.
Knowledge at Wharton: How do you approach investment banking in Latin America?
Quigley: That’s a good question. There is a divergence of opinion in the industry on how to do that. Wall Street’s standard operating model for Latin American investment banking is to cover the large-cap multinational companies and capture the cross-border flows that are emerging between Brazil, India, China, Russia, and the Middle-East. We do provide relationship management coverage of a subset of those multinational companies that we’ve deemed as priority clients.
What is truly an opportunity in Latin America, in my view, is finding a way to competently and sustainably bank the small to mid-cap sector in these economies. This is where the emerging leaders across various industries are going to be. Of course, it’s easy to identify these companies in a strong market when lots of successful IPOs are going on; it’s less obvious to sort through them in a market where there’s lots of inertia, as there is these days. But the SME sector in Latin America will be a potentially large pool of profitability going forward. It also serves to plant the seeds of future large cap client growth.
Knowledge at Wharton: Could you explain your wealth management strategy for the region?
Quigley: Right now it is predominantly an offshore wealth management model. We have about $60 billion in assets of high net worth money that is managed out of New York, Miami, San Antonio, Houston, San Diego and a few other places. We need to develop local private client delivery systems that can enable us to capture a larger share of the high net worth wallet. It’s a growth sector and I see a compelling need to offer local products as a complement to the offshore model. I view this as our strongest growth opportunity in Latin America. Latin America is one of the regions of the world where the year-over-year degree of wealth creation exceeds most other parts of the world. That general trend is in place. I believe it will only accelerate in the future.
Knowledge at Wharton: What worries you about investments in Latin America?
Quigley: One of the things that has worried me a little is the love affair the world has with Brazil. Of course I will qualify what I am about to say with the following statement: There is no question that within the context of Latin America, Brazil is the number one opportunity. It is the largest component piece of everybody’s business. For us last year in Latin America, Brazil was about 35% to 36% of the total revenue pool. For most of our competitors, it was well more than 50%.
When you travel to the Middle East, China, Singapore, Japan, Russia, or other growth markets, and they talk about wanting to increase asset allocation to Latin America, that leads to an immediate conversation about what can they buy in Brazil. So in the eyes of many people, the Latin American investment thesis has meant putting a stake in the ground in Brazil. This worries me because this has created distortion in the market.
Knowledge at Wharton: One final question: What advice would you give your clients today?
Quigley: It is easy in an environment like this to curl up under a desk and get very conservative. The first job I had at Merrill Lynch when I joined in January 1983 was taking home a portfolio of bonds that a U.S. insurance company owned. They were called Original Issue Discount Bonds, because the coupons were so low…the prices were very, very low. They almost traded like zero coupons, and this was at a time when the long bond was trading at 14% and the 10-year note was trading at 12%.
I went home and started flipping through this catalog of bonds with coupons of 2%, 3%, and 4%, and 5%. I remember scratching my head, and saying to myself, “Why in God’s name would anybody have ever bought a bond with a 2%, 3% or 4% coupon?” And yet here we are, and coupons of government securities and other securities are down around those levels. The visceral reaction right now is to get super conservative, put your money under your pillow, and go hide.
Empirically, if you look through investment cycles over time — even though I would agree that this is different than anything I have seen in 26 years on Wall Street — I think putting some money out there is a good idea for the long term. There are tremendous values to be had.