Brazil hosts the FIFA World Cup in 2014, and millions of ordinary Brazilians are praying their nation will score its sixth victory in the contest. International investors are also wondering what the future holds for the Latin American markets and whether they too can repeat some of their past successes.
After years of stellar double-digit returns, Latin American equity markets have lost 2% of their value over the last three months. An improvement in developed markets and political instability in the Middle East have damaged sentiment towards the region.
“Clearly Latin America, in the context of the emerging markets, has been suffering from the improvement in outlook for the developed world,” says Claire Simmonds, portfolio manager for Latin America at JP Morgan Asset Management (JPMAM).
So far this year the FTSE All-World stocks index has risen by 4%, whereas Latin American stocks have dropped by more than the same amount. And $3.1 billion has fled Latin equity and debt funds since January, according to EPFR, a global fund tracker. “Political and inflationary risks in the emerging market world, especially in the Middle East and Africa, have affected sentiment and investment flows,” says Simmonds.
More bullish investors argue that recent setbacks do not alter longer-term arguments for Latin American investment. “It doesn’t change the long-term structural rerouting towards emerging markets,” Simmonds adds.
Despite recent sell-offs, the MSCI Latin America index has risen more than 120% over the last five years, more than doubling the money of anyone astute enough to invest in the region in 2006. Such strong recent performance is what has made Latin American stocks vulnerable to profit taking, argue investors.
The Brazilian economy has grown to rank as the world’s eighth largest. In contrast to lacklustre (or negative) growth in developed markets, it is forecast to grow a further 5% this year. Strong fundamentals support the long-term investment case. “Interest in foreign capital investing in emerging markets is here to stay; people will go and invest in those stock markets,” says Alberto Ramos, chief Latin American economist at Goldman Sachs.
Emerging market equity funds saw outflows of $15 billion year-to-date; EM bond and equity fund outflows in February were as high as the record outflows seen in October 2008. Nevertheless, over the last year (to February 28) the MSCI EM Latin America index is up nearly 18%, while the JP Morgan EMBI+ Latin debt index is up more than 10% over the same period.
OPPORTUNITY
More recent setbacks may present nothing worse than an investment opportunity. “Recent underperformance relative to developed world markets creates an attractive entry point,” says Will Landers, US-based fund manager of the £371.87 million BlackRock Latin American Investment Trust.
“People will re-evaluate Latin America and begin to realize that 2011 will be another year of relatively good growth,” says Gray Newman, Latin American economist at Morgan Stanley. “Over the past 12 months markets have, if anything, become too cautious in thinking about the region.”
The region’s debt markets present a similar picture. Helene Williamson, head of emerging market debt at F&C Investments, says: “Despite the recent sell-off, emerging market fundamentals remain very positive. Last year perhaps investors were too euphoric on emerging markets and pessimistic on developed markets, so this is a readjustment. The fact remains that structurally people are too underinvested in the asset class.”
“So far, this is a muted sell-off,” says Brett Diment, head of emerging market debt at Aberdeen Asset Management. “What we are seeing is, in part at least, a more realistic reassessment of the US and Europe.”
Latin America may be in danger of becoming a victim of its own success, some suggest. Emerging market bonds were the most popular fund sector in Europe last year, attracting E39.1 billion in assets, according to Lipper Thomson Reuters, up from eighth place only a year earlier. Against such a background, recent performance downturns look less significant. Emerging market equities were the third most popular sector last year, according to Lipper Thomson Reuters, drawing more than E29.3 billion in investors’ money.
STRUCTURAL GROWTH
Structural changes are occurring in Latin America that support the region’s longer-term investment case. The work done by outgoing Brazilian president Luiz Inácio Lula da Silva, replaced in January by former Marxist guerrilla Dilma Rousseff, in reducing poverty is bearing fruit.
As recently as 2000 more than a third of Brazilian households were struggling to exist on incomes of less than $5,000. That proportion had fallen to just over a fifth by last year, according to JPMAM, and is expected to fall further by 2015 to just 16%.
“You’re talking about a truly middle-class economy,” says Landers, whose BlackRock Latin American Investment Trust is more than 70% invested in Brazil. “Sources of growth over the next few years should come from the burgeoning middle class and the associated pent-up demand in the areas of credit and housing.”
Rising affluence in Brazil means investors such as BlackRock are taking more interest in consumer stocks. “Latin America as a whole is experiencing major demographic advantages, with a growing and younger population being a significant driver of economic growth,” says Landers.
The region’s population of 559 million accounts for nearly a tenth (8.6%) of people in the world. It is also one of the youngest regions in the world, with more than half (55%) of the population abelow the age of 30.
Despite popular stereotypes, consumption accounts for the majority (63%) of the Latin American economy, although it does not feature heavily in the region’s stock markets. “So although people associate Latin America with commodities, while that is true of the market and indices, it is not true of the real economy,” says Simmonds.
“We think the most interesting themes are structural growth stories in Brazil and Latin America,” says Simmonds, whose firm is looking at Latin American firms ranging from dentists to schools, retailers and credit card companies. “These opportunities exist because the market has deepened.”
STRENGTH IN OIL
Rising oil prices are strengthening Latin America’s investment appeal. Energy producer Petrobras, the largest company headquartered in the southern hemisphere, represents 14.5% of the entire MSCI Latin American index and more than a fifth of the Brazilian market. “Clearly, countries such as Brazil benefit from higher commodity prices because of the heavy weight of Petrobras in the index,” says Simmonds.
Brazil is well placed to benefit from rising oil prices, driven higher by Middle Eastern instability. According to BlackRock, the country is set to double its oil output from its current 2 million barrels daily to 4 million by 2020. Good news, “as long as oil doesn’t rise to levels that cause recession around the world,” cautions Landers.
“The region is rich in natural resources,” says Landers. “Oil, gas and mineral reserves are developing rapidly, and there is huge potential to become a major player in agribusiness.”
When the Latin American markets clawed back some of their losses last month, with the MSCI EM Latin America benchmark rising 2%, analysts said the rebound stemmed from the impact of the higher oil price on the heavyweight oil sector.
Together, Petrobras and iron ore miner Vale account for close to 40% of the MSCI Brazil. Apart from Chile and Central American nations, most Latin American countries enjoy the advantage of being oil producers.
However, higher commodity prices aren’t feeding too significantly into inflation or currency appreciation.
“So Brazil is a commodity-driven market,” says JPMAM’s Simmonds. “But it’s a domestic, demand-driven economy.” Exports account for only 10.5% of the Brazilian economy, and commodities are only half of that total. So, although the Brazilian real has appreciated by a third over the last two years, hurting exporters, its strength has not damaged the overall economy.
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BOND APPEAL Despite recent short-term losses, the JP Morgan EMBI+Latin debt index is up more than 10% over the past year, as investors respond to the lure of strong currencies and high-yielding bonds. The region’s more developed debt markets may have now reached fair valuations according to Hari Hariharan, chairman and chief executive of NWI Management, the New York-based firm specializing in emerging market debt.
“Latin American bonds are trading beautifully, and there’s not much of value left,” says Hariharan, adding that the exceptions were Argentina and Venezuela, both of which are rated well below investment-grade rating and continue to offer attractive risk premiums.
Evidence of the region’s changed status in the eyes of investors comes from the credit default market. Spreads for Brazil and Mexico (reflecting the risk investors attach to holding their debt) are only half that charged for Spanish debt. In other words, investors see Spain as a riskier credit than the two Latin American countries.
But the threat of inflation continues to prey on investors’ minds, with annual consumer price rises running in Brazil at just under 6%. However, JPMAM remains sanguine. “Inflation risks are selective, and only a handful of central banks risk falling behind the curve in terms of monetary tightening,” the firm said in a February research note. “When we consider relative valuations in the major markets, the inflation risk in India is arguably less discounted than in Brazil.”
In Latin America inflation remains in single digits and inside central bank targets, with the exceptions of Venezuela and Argentina. Central banks have raised rates in response to inflation fears.
Brazil now has among the world’s highest real interest rates. BlackRock’s Landers says the rate rises prove the Latin American authorities are serious about combating inflation. The Brazilian central bank has raised rates by 300 basis points in the last year, bringing them to 11.75%. “We should see this tightening cycle ending around 12.5% in the second quarter of 2011,” says Landers. Colombia, Chile and Peru have also raised rates over the past year.
In its attempt to combat inflation, the Brazilian government has also raised reserve requirements, forced banks to set aside more capital for lending and imposed a 6% tax on bond inflows and a 2% levy on equity investments.
Much in Latin America continues to depend on the direction of interest rates in the US. Unlike many houses, BlackRock is not sure of a US rate rise this year. “Economists are reducing their US GDP forecasts, so maybe that will take the pressure off the Fed to raise rates,” says Landers.
NWI’s Hariharan says that most investors are so sure of a US rate rise that they have already priced in the possibility of them rising from their current 0.25%. Ten-year US Treasury bonds have jumped up from trading at around 2.5% in October to 3.75% in early March. “A lot of any rate rise has been priced in,” says Hariharan. “By 2012, people are expecting a rate rise.”
Latin America may have proved to international investors that it is coming of age, but the region remains more dependent than it might wish on the decisions made by its more grown-up neighbour in the north.