Sharp appreciation of the dollar and falls in commodity prices have hit Latin American equities. But vigorous domestic and infrastructure spending indicate fundamental strength in the region.
This year began strongly for Latin American markets, which were buoyed by the strength of commodity prices and the award of investment grade status to Brazil in April. This was despite the backdrop of increased global economic uncertainty as the credit crunch deepened, and the greater volatility in the world’s leading equity markets.
However, the past three months have proved more difficult for equities after the sharp appreciation of the dollar and the falls in global commodity prices. From the beginning of June to the end of August, the MSCI Latin America index posted a negative return of 22.2% in dollar terms. Nevertheless, the economic fundamentals for Latin America remain positive.
With sentiment towards the region largely driven by moves in global commodity prices, it is important to recognise that while Latin America’s overall exposure to commodities is relatively high, there are marked variations between countries. For example, Brazil is a net exporter of oil, which represents about 8% of total exports, whereas Chile has to import all its oil. Conversely, metals account for just over 50% of Chilean exports but slightly less than 18% of Brazil’s.
Within the region, commodities represent the smallest percentage of Mexican exports at 21%, although here oil is a key contributor. So Latin America is far from being a homogeneous region and the impact of the recent falls in commodity prices differs between countries because of major variations in their resource base. Overall, a further fall in the oil price poses the key risk but there are structural reasons why the price of oil is likely to stay at historically high levels.
Brazil is Latin America’s biggest economy and the world’s largest exporter of orange juice, ethanol, soya beans, sugar, beef and coffee. Strong commodity prices are therefore positive for the economy. To help highlight Brazil’s resource base, Vale is the world’s largest producer of iron ore and a major beneficiary of increasing demand from steel manufacturers in China. Economic growth in China is expected to remain robust, with GDP forecast to grow by 10% this year and 9.2% in 2009.
Overall, Brazil continues to enjoy strong fundamentals, including a healthy trade surplus and a balanced current account. Brazil has no external debt and this year became a net creditor nation, having built up more than $200 billion (£110 billion) in international reserves. In comparison, Turkey, South Africa and India are running deficits of between 5% and 7% of GDP.
As part of the global trend, Brazil has seen a marked pick-up in inflation. In July the annual inflation rate reached a three-year high of 6.37%, which was close to the upper limit of the central bank’s target of 6.5%. The bank targets an inflation rate of 4.5% plus or minus 2%. However, inflation remains lower than for many emerging economies, and there has recently been an easing of food prices, particularly for meat, fruit and vegetables. Energy costs have also fallen back.
Additionally, Brazil’s central bank has been pre-emptive in raising interest rates to help anchor expected inflation. Since April the bank has raised the benchmark rate three times, from a low of 11.25% to the current 13%. Consequently, unlike many countries, Brazil has positive real interest rates; real yields on domestic bonds therefore look attractive.
It is also encouraging to see that economic activity in Brazil remains robust, with GDP growth of 5.0% forecast for 2008, falling moderately to 4.0% in 2009. Not only is the country continuing to benefit from historically high commodity prices, but growth is being driven by rising levels of consumption and investment.
The strength of domestic demand is one factor fuelling inflation. The sustained growth in consumer demand, as disposable incomes continue to rise, is highlighted by the sales of new cars, which rose by 32% in July compared with the same month last year, while retail sales in general have been rising strongly.
Looking further out, there should be scope for the central bank to begin lowering interest rates next year as inflationary pressures ease. This should help to underpin economic growth, along with an increase in employment and real wages, and the rise in investment.
Industrial activity remains an important driver of economic activity, and the latest figures for industrial production proved better than expected, with output up 8.5% from a year ago, and capacity utilisation at a record high. So while commodities continue to play a vital role in the Brazilian economy, this is not the whole story and there are other central drivers of economic activity.
Mexico is another positive story. Oil is particularly important to its economy, accounting for about one third of government revenues, but the picture is not clear cut. In comparison to Brazil, Mexico has forged stronger links with America so that any developments that bolster American economic activity are likely to improve sentiment towards Mexico. This is because about 80% of Mexican exports are destined for America – and a fall in the oil price is helpful for the American economy.
Encouragingly, government spending in Mexico is being directed towards measures that support economic activity. For example, over the next five years a total of $250 billion is earmarked for infrastructure spending. Although inflation in Mexico has crept up, it is still relatively low and the central bank was pre-emptive in raising interest rates. On the stockmarket, the valuations of several large Mexican stocks look particularly attractive.
The outlook for Latin American economies and stockmarkets remains closely tied to the fortunes of commodities, including oil. However, there are other important themes such as the strength of domestic consumption and infrastructure spending.
Moreover, looking further out, the prices of commodities needed for infrastructure development in emerging markets, such as iron ore and copper, should continue to be supported by the positive demand/supply dynamic.