Mapped out

Latin America’s wealth of natural resources, a hike in export demand, improved fiscal policy and burgeoning domestic economies add to the region’s strength and entice investors with even more choice. Frances Hughes reports.

The Latin America stockmarket has more than doubled in value over the past three years and increased more than six-fold over the past five.

Global demand for, and price of, commodities, such as copper, oil, and iron – which Latin America has in abundance – has rocketed. And changes to fiscal and monetary policy has also boosted economies in the region.

In addition, the domestic economies are growing stronger, a middle class has emerged and the consumer market is coming alive.

However, when emerging markets are discussed Latin America is often overlooked, because the focus tends to centre on the rise in prominence of India and China. Indeed, the projected GDP growth for India and China for 2008 is forecast by the International Monetary Fund (IMF) to be 8% and 10% respectively, compared with a prediction of 4% for Brazil and 3% for Mexico.

Nonetheless, over the past two and three years the Latin American market has kept up well in performance terms with India and China. Over five years, it outperformed them both.

Over three years to November 26, the MSCI Latin America index returned 235% compared with the MSCI India return of 264% and MSCI China return of 246%, according to Morningstar. Over five years the MSCI Latin America returned 659% compared with 541% and 627% respectively.

In terms of UK-registered Latin America funds, of which there are more than 20, the top performer over five years to November 26, was the £193m Invesco Perpetual Latin America fund, according to Morningstar. The fund, managed by Dean Newman, returned 547% compared with an average Latin America fund return of 464%.

Newman says free market economic policies are more prevalent in Latin America than in the past. “Now Latin America has its economic house in order,” he says. The most important factors are contained inflation and lower interest rates.

According to the IMF Latin America has been growing at its fastest rate in the past three years, at more than 5% on average, since the 1970s. Previously the region suffered from ‘boom and bust’ cycles where high inflation and high levels of external debt cut short periods of growth. Now lower inflation, falling interest rates and current account surpluses are working together to provide increased economic stability. As a region it has gone through major structural improvements.

The boom and bust cycle associated with the region in the 1980s and 1990s has gone, with domestic finances having been firmly addressed over the past decade.

Several factors have come into play to make Latin America, especially Brazil and Mexico, which together account for more than 85% of the MSCI Latin America index, a more stable and sustainable investment opportunity.

The rapid growth of India and China has contributed hugely to the demand for commodities and hence Latin America’s export earnings. Large trade deficits have turned into strong surpluses. The terms of trade in Latin America improved on average by more than 20% between 2002 and 2006 according to the IMF. In addition, private transfers, mainly reflecting workers’ remittances, contributed to stronger current accounts, particularly in Mexico and Central America.

Brazil in particular has significantly changed its debt profile. It converted its floating rate debt to fixed rate debt and built up foreign reserves, estimated at $170 billion (£83 billion). Now it has no dollar exposure in its debt.

“The debt profile is a key point,” says Katy Dobson, manager of the largest British registered Latin America fund – the £1.08 billion Threadneedle Latin America fund.

“High levels of debt in US dollars have been vulnerable to exchange rate fluctuations,” she says. “Brazil doesn’t have exposure to the dollar in its debt. It also has a low inflation environment, about 3.5%. In the past that would have been thought impossible.”

“Brazil has taken advantage of [the increased demand for] commodities and improved its debt profile,” adds Dobson. “Hyperinflation has gone and real wages have increased significantly.”

In 1994 inflation was 2,076% in Brazil. Ten years later, in 2004, it had fallen to 7.3%. The projected figure for 2007 is 4%, a huge reduction from 13 years ago. Likewise, Mexico has seen a large drop in inflation. In 2004, it stood at 15.5%, while the projected figure for 2007 is 3.6%.

Indeed, five years ago, the average rate of inflation across Latin America was in double digits. But now Argentina, Bolivia and Venezuela are the only Latin American countries to retain double digit projected inflation figures.

After years of hyperinflation Brazil’s central bank’s containment of it has led to higher employment and real wage growth. Salaries have been going up more than inflation over the past four years. Meanwhile, lower interest rates have resulted in greater credit availability.

Brazil has seen interest rates fall significantly in the past two years. They peaked at 19.5% in 2005 and are 11.25%. This has increased demand for credit and created a domestic consumption boom. Consumers are also more willing to take on credit because inflation is contained.

Both contained inflation and lower interest rates have encouraged more banks to lend and more people to borrow. Companies are prepared to invest in their businesses, while consumers are more able and willing to borrow money and spend it on themselves and their homes.

Floris Kleemans, senior economist at ABN Amro, says lower interest rates in particular are helping Brazil’s domestic economy. “Lower interest rates create credit [and] that’s good for companies,” he says. “Domestic demand fuels growth for credit and lower interest rates make lending money a feasible proposition.”

According to the IMF, in the first half of 2007, lending to the private sector was up by more than 40% from a year earlier in the seven largest Latin American countries. It was up by more than 20% in the region as a whole.

Dobson of Threadneedle says there is a definite increase in investment because of lower interest rates. “Interest rates have declined so much you are starting to see a pick up in investment,” she says. “Companies are starting to invest more in their businesses. [With] high interest rates there was no investment at all.”

Newman at Invesco, says lack of access to capital tends to breed fragmented industries. He expects to see more consolidation of such industries, particularly in Brazil.

One area that is seeing particularly strong growth because of lower interest rates is the mortgage industry. Over the past two years it has grown by almost 200%. Last year mortgages in Brazil accounted for only 1% of GDP, now it accounts for 2%.

“The mortgage market has been booming,” says Luiz Ribeiro, manager of the $189m HSBC Latin American Freestyle fund. “It has been growing close to 100% a year in the last two years because of lower interest rates and a change in regulation making it easier for banks to recover the houses. [But] it still represents only 2% of GDP. There is still room for it to grow.”

Kleemans of ABN Amro agrees. He predicts that mortgage growth will “continue for some time.” “Domestic demand is becoming more important,” he adds. “Domestic demand is a factor to drive growth and investment.”

Indeed, the boom in domestic demand across the Latin American region is what fund managers are focusing on now and it is adding fire to the argument that Latin America is more than just a commodities play. Consumer discretionary stocks in particular are featuring more prominently in Latin America portfolios now.

With unemployment falling, wages increasing and the availability of credit widening there are more people able to buy houses, televisions and refrigerators, says Chris Palmer, manager of the $1.2 billion Gartmore Latin American fund.

“What do all those employed people do with their wages?” he asks. “There is demand for housing and quite a lot of buying for the home. Very rapidly, with the pick up in the domestic economy, you get a pick up in real wages. There are many more signals that the consumer is coming alive. There is much more spent on discretionary items. In Chile shopping malls are going up all over the country,” he adds.

However, it is not only the fact that people have more money that makes them spend. An increasingly stable economy makes them feel better about making the decision to buy a television or a car or even a house.

A more stable economic environment and increasing consumer demand have both contributed to the rise in the number of companies listing on the stock exchange. The number of initial public offerings (IPOs) in Brazil in particular has risen dramatically this year. In the first half of 2007, there were 27 new listings on the Sao Paulo stock exchange, more than the total number for 2006.

“Because of monetary stability it makes more sense to list companies,” explains Kleemans. “It’s very difficult to launch a product if liquidity is not there. [But] External debt is no longer an issue. The probability of crisis has come down throughout the region and they operate in quite a stable environment. There is a lot more liquidity in these markets now. Now you get a different way of operating,” he adds. “It’s an interesting market to be in [and] it’s an additional argument for people to get in.”

The increase in IPOs is a significant step forward for Brazil. It has broadened the equity market, making it more diversified, and it gives investors further exposure to Brazil’s domestic economy. Five years ago the market consisted of mining, oil, banks and telecoms. But now there are many more choices. For example, two years ago there were no companies listed in the housing sector. Now there are more than 20.

Indeed, nearly all of the new IPOs are linked to the domestic economy, whether it is healthcare, real estate, insurance, retailers or IT companies.

Newman at Invesco says a large proportion of his exposure to Brazil is in what he calls “new Brazil companies”. “In the past the equity market was limited to a big cap stocks in telecoms, resources and utilities sectors,” he says. “[But] there’s been an IPO boom in the past two and half years. There’s something exciting there.”

Urban Larson, manager of the £38m F&C Latin American Equity fund, says the increased trading volumes means stocks are much more liquid now. “It’s been an amazing development,” he says. “Two years ago, there were one or two equity offerings a year, if that. Now there is one or two a week. It’s a big change. There were no healthcare companies two years ago. Now there are six. Trading volumes are much higher [now] and stocks are more liquid.”

In addition to that, the Brazilian derivatives market went public two weeks ago, further increasing the choice investors have in Latin America. And because the new IPOs are domestically orientated, the market is becoming much less weighted towards commodity stocks.

A stronger and more diversified domestic market in Latin America makes it less dependent on commodities and its relationship with America and other trading partners. Kleemans of ABN Amro agrees this increased diversification is making Latin America more independent.

“Latin American economies are becoming more diversified with domestic economies growing,” says Kleemans. “They are becoming less dependent on export production and export partners,” he adds. “Access to finance, credit growth, domestic demand growth and lower interest rates are very important factors.”

As well as driving a consumer boom, it is hoped the fall in interest rates will encourage more domestic investment into equities. Extremely high interest rates have encouraged a fixed income culture in Brazil. More than 85% of the mutual fund industry is in fixed income. But now that rates have fallen it is hoped the pension market will start investing more of its assets into equities.

The main problem in having little domestic investment into equities is that the market is left vulnerable to foreign investment outflows.

“That’s one of the characteristics of the Brazilian market that is a problem,” says Ribeiro of HSBC. “There is no strong base of domestic investors. That is a risk. But it is changing. As long as interest rates keep coming down investors will be forced to invest in equities,” he adds.

The mutual fund industry in Brazil is $587 billion in size, according to Larson of F&C. One year ago 7.6% of it was in equities, he says. Now it is 11.1%. “It’s a clear trend,” says Larson. “But it’s still a low allocation.”

Newman at Gartmore says investors should be aware of the large fixed income market in Brazil and the possibility assets could move into equities if interest rates continue to fall.

“The fixed income market in Brazil is massive,” he says. “The argument is, at some point there will be a wall of money into equities. Its something to be aware of.”

The burgeoning domestic economies across Latin America makes it more resilient to outside pressures and the influence of America has diminished.

“There is a lot more emerging market to emerging market trade,” says Kleemans of ABN Amro. “The engines of growth are for emerging markets in emerging markets.”

However, America is still a driver in the region, especially in Mexico. The country is a competitor to China rather than a large commodities producer, whereas most Latin American countries have increased their exports to Asia.

More than 70% of Mexico’s exports go to America, compared with only 20% of Brazil’s. Most of Brazil’s exports go to Europe and then Asia. Furthermore, Mexico’s GDP is closely linked to American industrial production.

“Mexico will suffer the most,” says Ribeiro of HSBC, “because of the manufacturing sector but also because of Mexican people in the US sending money back. There is still a strong link, but GDP is still expected to grow 3% this year, which is nothing too worrisome.”

But Kleemans is more upbeat about the country’s prospects and says it is not as close to the American economy as it used to be. People are spending more money and banks are lending more so the domestic economy is more important than it was in the past.

“Mexico will be most vulnerable to [an American slowdown],” he says. “But we are quite pleased to see what’s happening.”

Likewise, Larson of F&C says Mexico’s domestic economy is more resilient now. “The jury is still out if Mexico can avoid a slowdown if the US slows down,” he says. “But now the government is flush with cash [from] oil revenues and is accelerating infrastructure spending.”

Indeed, infrastructure spending is a big theme in Latin America. Brazil plans to invest $280 billion in infrastructure between 2007 and 2010. In September Mexico gained approval for tax reforms to pay for investment in infrastructure. It has a $235 billion infrastructure investment plan for ports, railways, roads and energy over the next four years.

“Infrastructure has been one of the problems to speed up growth in most of these countries,” says Ribeiro of HSBC. “It will have an impact.”

Efficient taxation and the establishment of infrastructure are key goals across the region. Years of underinvestment by governments has left infrastructure quite “tired” across the region, according to Palmer of Gartmore. But now governments have more money to be able to commit to it.

“All of the governments in Latin America will have to intensify this public spending [on infrastructure],” says Palmer. “That’s a big opportunity for investors. In the past most of the money went on public debt. Now that’s paid and the rates have come down, the capacity of these governments in terms of public spending is improving.”

In addition to pledges to spend on infrastructure Latin America is seeing a general improvement in its taxation system. Over the past year several Latin American countries have introduced fiscal reforms, focused mostly on the tax system. In Mexico fiscal reform is expected to raise about 2% of GDP over the next few years, according to the IMF. Brazil also announced a comprehensive reform of the indirect tax system and is aiming for a significant simplification in tax administration.

Although stronger domestic economies and the emergence of China and India has helped Latin America become more independent, a slowdown in the global economy will affect it. If the American economy slows down dramatically and starts to affect the global economy, Brazil and the rest of Latin America will suffer.

Likewise, if risk appetite declines sharply, Latin America, like all emerging markets, will be affected. Although Latin America is not directly linked to the subprime crisis or the credit crunch, for example, it is still vulnerable to sentiment.

Nonetheless, it cannot be ignored that Latin America has strengthened its domestic economies significantly, made the economic environment for its businesses and populations more stable and planned for reform and investment. Decreasing its reliance on America is an important factor. The investment landscape of the region has changed dramatically and if investors believe in the China story, the continuing demand for commodities globally and a fast developing consumer culture, the outlook for the region looks positive.

With more than 20 British-registered Latin America funds, British investors have a significant amount of choice when considering a Latin America investment. The most recent launch was last week, with the Neptune Latin America fund managed by Felix Wintle. Wintle, like Dobson, Larson, Newman, Palmer and Ribeiro, is focusing on consumer-related stocks and aspirational trends. That is where the growth is they say.

The main concern for the region will be to ensure that the good work of recent years is not undone and that growth is allowed to continue. Interest rates and inflation will need to be kept low. Unemployment will need to be closely monitored and domestic investors should start investing in equities rather than fixed income. If domestic markets remain strong and Latin American equity markets continue to broaden, there will be even more choice for investors.


Changing political landscape

In 1989 Brazil had its first directly elected president since 1960. Brazil overcame military rule in 1985 after more than half a century. Today Brazil’s leader is Luiz Inacio Lula da Silva of the Workers’ Party (PT), popularly known as Lula. He secured a second term in a landslide election victory in October 2006.

Mexico was a one party state for about 70 years. Only in 2000 was a president, Vincente Fox of the National Action Party (PAN), elected to office. The elections held in 2000 marked the first time since the 1910 Mexican Revolution that an opposition candidate defeated the Institutional Revolutionary Party (PRI).

Argentina was under military rule from 1976 to 1983. This week Cristina Fernandez takes office as president. She takes over from her husband Nestor Kirchner. In October Fernandez swept to victory in the first round of Argentina’s presidential election, a victory that many attribute to the popularity of her husband.

Hugo Chavez a former military officer, is president of Venezuela. He came to power in 1998. Last week he suffered his first electoral defeat. Voters in a referendum narrowly rejected proposals to extend his powers and accelerate a move to “democratic socialism”. Many Venezuelans feared he would use the new powers to impose a dictatorship.

Chile has been relatively free of coups and dictatorships apart from the 17-year rule of General Augusto Pinochet. Pinochet came to power in the 1973 coup, one of the bloodiest in 20th-century Latin America, against an elected socialist government. He stepped down as head of state in 1990. Now Michelle Bachelet is president of Chile. She took over in March 2006 and is the country’s first woman to be president.