The rush of global capital into Latin America in recent years has been a striking sign of confidence in a region long known for political and economic instability. Even more striking has been the equanimity of investors amid the recent emerging-markets turbulence. Latin American stocks tumbled and bond yield spreads widened in May and June as fears of higher U.S. interest rates rocked global markets.
But in contrast to previous incidents when turmoil in global markets hammered Latin securities, the declines have been in line with those of most other emerging markets in Europe and Asia — and less than losses in such countries as Turkey and Saudi Arabia. Structural improvements, such as debt reduction and the introduction of floating exchange rates, have left many countries better placed to ride out today’s storm, say analysts and fund managers. As a result, rather than rushing for the exits, many investors are looking to buy on the dips.
“In general these countries are in excellent condition and there’s no real reason for the region to have undergone this rather crazy crisis,” says Raphael Kassin, head of London-based ABN Amro Asset Management’s emerging-markets fixed-income group, which manages $4 billion.
Indeed, some seasoned investors welcome the declines, saying they have brought prices down to more-attractive levels and may drive out short-term momentum players. “We see this as positive because we have seen these nondedicated investors coming in with huge amounts of money and distorting the valuations,” says Carolyn Kedersha, senior portfolio manager for Dreyfus Service Corp.’s Premier Emerging Markets fund. “To the extent that this volatility shakes them out, that will be good for us as a value investor, and indeed for the region.”
To be sure, there are risks aplenty across Latin America. Some investors worry about a further leftist tilt in the region following the victory of Bolivia’s first indigenous president, Evo Morales, at the end of last year and efforts by Venezuelan president Hugo Chávez to support left-wing parties in the region. Mexican stocks fell 3.4 percent in one session at the end of May after Andrés Manuel López Obrador, the center-left candidate, regained the lead in opinion polls from his conservative rival Felipe Caldéron, ahead of the July 2 election. Brazilians will go to the polls for a presidential election in October.
Many Latin American economies continue to depend heavily on commodity exports and remain vulnerable to swings in prices of copper, soybeans and other raw materials. And the high tide of global liquidity that has lifted virtually all emerging markets since 2003 appears to be receding, giving way to a more volatile environment. Investors will need to differentiate carefully between countries and companies.
In short, Latin American markets are returning to more-normal conditions after an extraordinary, three-year bull-run. The MSCI EM Latin America index surged 411 percent between September 2002 and May 10, 2006, when it hit an all-time high, before plummeting 29 percent over the following five weeks, in the sixth-biggest sell-off to hit the region in the past 15 years. By comparison, MSCI’s EM EMEA index and BRIC index each dropped 28 percent and the EM Asia index fell 21 percent.
Yield spreads on Latin American bonds have also risen in line with other emerging markets. The spread over U.S. Treasuries for Mexico’s benchmark long bond, due 2033, widened by 50 basis points, to 189 basis points, between early May and late June; and the spread on Merrill Lynch & Co.’s emerging markets bond index widened by 47 basis points during the same period, to 201 basis points.
“People were quite invested in Latin American equities, liquid domestic public bonds and even external debt,” says Felipe Illanes, senior emerging-markets fixed-income strategist at Merrill Lynch in New York. “When this sell-off began, a lot of people basically had the same trade, and there weren’t too many people on the other side to receive it.”
In the past, external shocks have caused major damage to Latin American economies. Contagion from the Asian crisis caused equities in the region to plunge 40 percent in 1997–’98 and sent several countries, notably Argentina and Brazil, into recession. But this time around, Latin America is in much better shape to weather storms in global markets, analysts say.
Many governments made fundamental economic reforms in the wake of previous crises, such as Mexico’s Tequila crisis in 1994–’95, Brazil’s 1999 devaluation and Argentina’s debt default in 2001. Countries have abandoned fixed exchange rates, which exacerbated many previous calamities, and have floated their currencies, making their economies more flexible. Central banks have adopted inflation-targeting regimes and brought down the rate of price increases to low single-digit levels. And governments have trimmed deficits, paid down external debt and built up significant foreign exchange reserves.
Argentina and Brazil agreed to pay off their debts to the International Monetary Fund ahead of schedule in December 2005, and Colombia swapped out its dollar-denominated debt for obligations in its own currency. Brazil’s external debt-to-export ratio now stands at its lowest level in 25 years.
Those efforts paid off in June. In the midst of a general widening of credit spreads in emerging markets, the Brazilian government offered to buy back up to $4 billion in foreign bonds to lower its debt and market volatility. It succeeded in buying back only $1.1 billion as most investors chose to hold on to their positions. Treasury Secretary Carlos Kawall said the results showed investors were willing to keep Brazilian paper even during turbulent times. The yield spread on Brazil’s long bond compared with U.S. Treasuries widened by 50 basis points between early May and late June, to 267 basis points, effectively moving in step with other emerging-markets spreads.
In another sign of economic strength, the Central Bank of Brazil took advantage of declining inflation to trim its key overnight interest rate by 50 basis points, to 15.25 percent, in May. The bank’s willingness to cut was striking, considering that the real was weakening at the time, emerging-markets stocks and bonds were falling sharply and other central banks, led by the U.S. Federal Reserve, were hiking rates.
“Unless the current global turmoil continues unabated or produces a calamity for the U.S. consumer, we suspect that Brazil’s central bank will continue to have room to buck the global tightening trend and reduce interest rates,” says Morgan Stanley Latin American analyst Gray Newman.
Bond managers’ confidence extends beyond Brazil too. “This is definitely the time to buy, especially for fixed income,” says ABN Amro’s Kassin. “I find Argentina a very interesting play. It’s politically stable, and I think the economy will continue to grow.”
Ashmore Investment Management, a London-based outfit that manages $20 billion in emerging-markets debt, has had inflows of about $1 billion a month recently because of a structural shift by institutional investors into emerging markets, says Jerome Booth, head of research. Those asset flows weren’t affected by the market turbulence in May and June, and Booth believes they will continue.
“When you get a problem with U.S. equities, pension funds are saying, ‘We’re not going to rebalance this time, and we’re not going to put money into U.S. equities,” he says. “They’ve got the liquidity, and they’re going to do other things with it. And emerging debt and emerging equity are on that list of things.” Ashmore’s biggest position currently is in Brazil.
Improvements in corporate governance have also boosted inflows in the region’s equity markets. Lewis Kaufman, who helps manage an $11 billion portfolio of international equities at Santa Fe, New Mexico–based Thornburg Investment Management, recently traveled to Brazil, Chile and Mexico and says he was impressed by the level of transparency. “The disclosure was excellent at many of the companies I visited, and my experience was pretty favorable relative to my expectations,” he says. His portfolio includes holdings of Mexican wireless giant América Móvil, Wal-Mart de México, the Brazilian jet maker Embraer and Southern Copper Corp., which operates mainly in Peru.
Now is the time for some “intense stock picking” in Brazil, particularly in the energy, consumer and banking sectors, which were hit hard in the sell-off, says Ricardo Kobayashi, head of equities research at São Paulo–based Banco Pactual, an investment bank that agreed in May to be acquired in by UBS for $2.6 billion.
Juan Bosch, a portfolio manager and strategist in Buenos Aires for Compass Group, which manages more than $300 million in Latin American assets, says one salutary effect of the recent sell-off was the depreciation of the Brazilian real, which has fallen by 8 percent against the dollar since early May. The currency had become overvalued in recent months, he notes, and its decline promises to give local exporters a needed boost. “When we see the currency shift around to the other side, we start looking at some of the export companies,” he says. Compass’s Latin American funds have added to their overweight position in Brazil by buying selected exporters as well as energy, mining and financial stocks, he adds.
Dreyfus’s Kedersha remains bullish on Brazil’s banking sector even after its strong gains in recent years. “We saw huge loan demand across all the different categories,” she explains. “If Brazil is able to continue to lower interest rates and doesn’t have to go into a pause because of what’s happening elsewhere in the world, that strong loan growth is only going to continue.” And Brazilian bank stocks are now cheaper, trading at an average price-earnings ratio of 11.3 in mid-June, compared with 12.8 in early May.
The positive mood among fund managers at a time of global weakness is a welcome departure for Latin American markets. Still, the region’s dependence on global commodity cycles leaves it more vulnerable. “South Korea and Taiwan are examples of bigger, deeper markets that are better equipped to survive a cyclical downturn,” says Arijit Dutta, who covers emerging-markets bond funds at Morningstar.
And everyone is keeping a close eye on the electoral calendar. Thierry Wizman, senior managing director and global emerging-markets strategist at Bear Stearns & Co. in New York, says concerns that López Obrador would eliminate special tax regimes that benefit certain sectors or companies have led some investors to pull money out of Mexico.
In Brazil investors generally believe that both President Luiz Inácio Lula da Silva and his likely opponent, Geraldo Alckmin, of the moderate Social Democratic Party, will continue to pursue market-friendly economic policies, but some worry about unrestrained government spending.
“Something needs to be done about the pickup in public spending, because this situation is one that is not sustainable for very long,” says Arminio Fraga, former president of Brazil’s central bank and currently head of Gávea Investimentos, a hedge fund based in Rio de Janeiro. “That’s the big question for the next president and the current one as well.”
