Still riding high
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Emerging Markets

Still riding high

Latin stock markets have turned a blind eye to the credit crunch

Judging by the apparent state of Latin stock markets, investors in the region haven’t yet heard about the global credit crisis. Or if they have, they’re really not that bothered. By mid-March, the region was down just 2.5% from the global market high at the end of October, compared to losses of 13% for the US and 19% for Japan.

In other export-led emerging regions, valuations have been stretched lower on fears of corporate earnings downgrades in the wake of a US recession. But Latin America has outperformed other emerging bourses in the same period, with EMEA stock markets down 10% and Asia 20% since October 31, 2007.

The scale and duration of the Latin stock boom – driven largely by a global rally in commodity prices – is phenomenal: whereas MSCI Latin America rose by 45% in 2005 and 39% in 2006, it was up 692% by mid-March from its low in September 2002.

Peru is up an eye-catching 91% year-to-date, and global exuberance over cyclical stocks means commodity equities now account for 60% of Brazil’s weighting in the MSCI, and a quarter of the entire region.

Many reckon the good news will last, so long as the commodity rally – propelled largely by China’s growing demand for natural resources – continues. “High commodity prices are here to stay, and this will continue to support the region’s equity bull run in the near term,” says Evandro Pereira, head of LatAm equity capital markets at UBS.

Correlation

Yet despite improving economic fundamentals across the region, Latin stocks are hardly immune to global swings.

A Citigroup study last November showed that the correlation between US equities and MSCI Latin America has risen to 0.7–0.80 – the highest of the past 16 years of available data. The figure is highest for Mexico (0.8) then Brazil, and the lowest for Peru, Argentina and Colombia with less foreign penetration.

“How can Latin American equity markets hope to decouple from the US equity market, when correlations are so high?” says Geoffrey Dennis, Latin American equity strategist at Citigroup.

Indeed, when volatility returned to global markets last February – triggered by a sudden sell-off in Chinese equities – Latin stock markets dropped 12.5% from February 22 to March 5; as the subprime crisis exploded last summer, LatAm equities shed 23.1% between July 23 and August 16; following Q3 write-downs and crisis in the US leveraged loan market, the index lost 13% between October 29 and November 27.

“The short run for Brazilian and Mexican stocks has been the push for commodities, while the appreciation of exchange rates has sent equities higher,” says Marcelo Salomon, chief economist at Unibanco.

If record commodity prices persist, many believe that the headline performance of the region’s stock markets will remain positive. But analysts fear that other sectors will nevertheless suffer this year.

“Brazil looks overbought near-term and expensive, as it continues to ignore risks of any sort (earnings, domestic interest rates),” Dennis observes. “If you strip out commodity plays, you will see in the second half of the year an index that struggles as the impact of the US recession kicks in. Brazil and Mexico indices are a play of only a couple of names,” says Salomon, noting that Petrobras alone accounts for 28.7% of the Bovespa, Brazil’s stock index.

Consumer stocks have underperformed as risk-averse fund managers have increased cash redemptions, despite improved macroeconomic fundamentals. But with the declining cost of capital, it’s a different story for financial institutions: Brazilian financial heavyweights such as Bradesco and Banco Itau are now valued higher than Citigroup and combined with Banco Brasil comprise 10% of the country’s index.

Vulnerable floats

Yet valuation levels across the region are vulnerable to “a sharp correction in commodity prices and – less so, in our view – to weaker growth in the internal economy, which hurts earnings growth of domestic stocks,” says Dennis.

For Brazil, this means the headline performance of Bovespa is at the mercy of largely exogenous risks. In practical terms, with the return of global risk aversion and tightening liquidity, this has meant that plans for several Brazilian IPOs have been shelved in recent months – including a $764 million float for healthcare company Amil Participacoes and a planned $529 million listing for materials firm Paranapanema.

“The IPO market is weak, and the negative environment is putting pressure on local stocks. But as the year progresses and sentiment calms, we will hopefully see new listings,” says Josef Schuster, chief executive of IPOX Schuster, an equity research firm which runs IPOX Latin America 20, a non-tradable index of the top 20 companies in Latin America.

Schuster warns that investor fatigue could also set in this year following a record $47 billion in IPOs in 2007, up from $16 billion the year before.

For IPOs and new issues, volatility is the main problem at present – a fact that’s “frustrating efforts to price new transactions as markets fall globally,” says Bernardo Parnes, head of equities at Banco Bradesco. “Companies need to reduce their expectations in terms of the number of multiples they price at ... Most companies that went public last year are trading below their issue price, and this is hurting international investors, and valuations may have to correct themselves.”

Pricey, dicey

But Latin American valuations by and large have converged with developed markets – a complete turnaround from the 50% discounts in terms of price-earnings ratios seen among Latin stocks as recently as 2003.

“Perhaps all asset classes globally were overvalued,” says Cristiana Pereira, an adviser to Bovespa. Although she admits that prices for new company listings in Brazil last year “might have been over valued”, Pereira adds that in the long term, valuations are fair because of Brazil’s promising growth patterns. “Of course all markets are connected, but I think growth is sustainable because of our major structural changes. It’s not like the past when liquidity dries up and Brazil is hit.”

While the prospect of overvaluation clouds Brazil’s outlook this year, Mexico’s acute correlation with the US business cycle has sent equities lower but may present opportunities, observers note. Exports to the US account for 24% of Mexico’s GDP – a fact which has dragged down consumer and construction stocks.

Citigroup, however, is now overweight Mexico: “The market is attractively valued at current levels (12.9x forward earnings), while earnings downgrades are already being absorbed. The market should have strong upside as the end of the US recession approaches,” says Dennis.

Elsewhere, Chile and Colombia have performed modestly well despite a rise in inflation, while the lack of foreign participation may have served to insulate these markets from external volatility. In Chile, for example, at least half the equity portfolio allocations of local pension funds must be invested in domestic stocks. This means that they suffer from “unattractive valuations relative to the rest of the region, which makes finding compelling investment opportunities difficult”, says Will Landers, senior portfolio manager at BlackRock.

This year’s regional laggard, Argentina, has lost 4% year-to-date, on the back of high inflation and investor fears over the economic policies of president Cristina Fernandez de Kirchner. Still, as the commodities story is unlikely to be derailed any time soon, the impact of global credit volatility on the region’s equity indices looks set to be anything but severe.

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