Having escaped the shackles of their stereotypes, Latin American countries today present to investors an attractive mix of low budget deficits, low public and private debt, and prudent monetary policy. Gail Moss reports
As the ‘old world' is rocked by debt problems threatening to engulf the entire euro-zone, Latin America - having long ago thrown off the stereotype of army coups and exotic investment punts - is increasingly being seen by managers as a model of political and monetary rectitude, if not quite yet the safest bet on the planet.
"What makes the region more attractive is that in the past 20 years, countries have gone through a lot of economic reforms, curbing inflation to make them more open to foreign direct investment, " says Mario Felisberto, CIO, Latin America, HSBC Asset Management. "Many countries could now be considered true democracies. And demographic conditions there are generating huge potential in terms of consumption."
While Latin America still benefits hugely from its abundant natural resources, the careful management of most of its national economies has strengthened governments' ability to cultivate sustainable growth. Central banks, having tightened monetary policy, can now judiciously unwind it in order to soften the impact of a slower global economy.
"Central banks hiked interest rates earlier last year, and inflation appears to be falling across the region," says Urban Larson, director, emerging equities, F&C. "All these countries have very large pools of domestic institutional money. In particular, pension funds in Chile, Colombia and Peru are providing net inflows into the stockmarkets every month. This makes markets less sensitive to volatility in the current global environment."
Brazil has an even larger pool of domestic institutional assets but it is primarily invested in fixed income, providing ample liquidity to the domestic debt market.
All this compares favourably with the profligacy eagerly pursued - until recently - by some European governments, says Larson.
"Most South American countries have very small budget deficits, which are shrinking further, and low levels of public and private debt," he says. "Brazil and Chile are net external creditors, with reserves much greater than their foreign debt. In fact, Chile is legally required to run a structural surplus."
In recent years, the strengthening of regulatory frameworks has made these countries even more investor-friendly. Chile now has the most advanced regime, while Larson rates Colombia as the "most improved" in recent years.
As a consequence of all this, Latin America - with the notable exception of Argentina,
which might be moving closer to another debt crisis - is enjoying substantial foreign direct investment.
If the fiscal and regulatory environment is benign, the single most important business case for investing in the region is the growth of the middle classes, now making its mark on the continent's economies.
Brazil - whose economy dominates the continent, with over 40% of GDP - is the biggest beneficiary. Contrary to its once-popular stereotype as nothing more than an exporter of coffee beans and other commodities, around 80% of its economy is now driven by domestic consumption from a population of 190m, 45m of whom have moved up from poverty over the past decade.
"Government measures to reduce social inequality are finally having a tangible impact," says Carlos Scretas, manager of Schroder ISF Brazilian Equity fund. "More and more people have crossed the line between having just enough money to survive on a daily basis, to having the money and the credit to buy things they have never bought before, such as TVs and cars."
All this has fed into expected growth figures for 2011 which are healthily above developed market averages, while not so high as to be unsustainable.
Consensus figures suggest that Brazil's GDP grew by 3.5% in 2011, while the estimate for Chile was 4%-plus, and upwards of 5% for both Colombia and Peru.
Having previously turned off the growth of credit in the economy, the Brazilian Central Bank is now trying to boost motor car sales, one of the country's key economic sectors; in July it allowed banks to increase leverage slightly on some types of credit, including credit cards, and loans for buying cars.
"Brazil still has the weapons to fight recession - such as cutting taxes - while keeping some anti-inflationary measures in place," says Scretas.
Commodities still play an important role in the Brazilian economy, however, making up half of all exports, and including iron ore, soya, sugar and hardwood pulp.
But manufactured goods such as commercial and military aircraft from Embraer, steel exports from the likes of Gerdau, CSN and ArcelorMittal Brasil, as well as autos and other products, also feature significantly.
For institutional investors, the economic case is strengthened by the depth and liquidity of capital markets and the quality of companies on the Brazilian stockmarket BOVESPA.
Julian Thompson, head of global emerging markets, AXA Framlington, likes Petrobras, the oil giant that is 51% owned by the state, which recently made huge discoveries of oil below a salt line (so-called ‘presalt' deposits) requiring a great deal of investment with a high-risk, high-reward profile.
"If China has a hard landing, that could affect the oil price," admits Thompson. "But we don't think that will happen, and we believe global demand will remain relatively resilient."
AXA's other favourites at present are retailer Lojas Renner - whose 20% per annum top-line growth mirrors Brazil's domestic consumer boom - and Cetip, the electronic trading platform for fixed income securities and OTC derivatives. Cetip has now bought a car-registering business.
"As interest rates come down, loan finance becomes more affordable, so the company should grow in line with the increase in auto loans," says Thompson.
"Despite its export trade, Brazil is a fairly closed economy, giving it partial protection against the global slowdown," says Carlos de Leon, analyst and portfolio manager of RCM's global emerging markets team. "Its long-term drivers for growth are access to credit for the consumer, loan growth in the banking sector and total payroll growth."
He says: "Brazil is much better placed to survive the global financial crisis than the last time, in 2008. It was the first BRIC country to cut interest rates, at the end of August last year, and can accelerate this if it has to."
Brazil's interest rate at end-November had been cut by 150bp to 11%, from its peak the previous July, and de Leon was expecting a further 1% cut over the next few months.
But can Brazil's government provide the right policy framework to underpin its long-term economic growth?
Dilma Rousseff, the country's first-ever woman president, has impressed locals by pursuing a clean agenda, sacking a handful of ministers for alleged corruption in her first year in office, but has also led an increasingly interventionist government.
"Politically, we are in good shape," says Scretas. "Rousseff is a tough lady and, with a weak opposition, doesn't have problems in passing legislation."
That said, Latin American equities posted a pretty weak performance for last year.
"Brazil, in particular, suffered from the poor performance of global-related stocks, for example, Petrobras, and mining company Vale," says Mohamed Saidi, equity fund manager, Dexia Asset Management.
"This was partly because of worldwide uncertainty and increasing risk aversion. In addition, the government imposed taxes on foreign inflows which, combined with inflationary pressures, was very negative for Brazilian equities."
But stocks rebounded strongly in October, on the back of better-than-expected US economic figures and the short-term resolution of the EU debt crisis, according to Saidi.
In spite of this rally, however, some managers consider there is still good value on BOVESPA.
"Between 15 and 20 listed companies have instituted share buy-backs, so that suggests shares are cheap at present," says de Leon.
Like other managers, Saidi favours sectors - in this case, telecoms, consumer staples and utilities - which are exposed to domestic demand.
But he also likes stocks with diversified export markets, such as the brewery Ambev, which gets 30% of its revenues from other Latin American markets and 20% from China.
"Inter-emerging market revenues are becoming more and more important," he says.
"Emerging countries are able to generate more growth than the developed world. On the one hand they are producing more, and on the other, demand is coming mainly from other emerging countries. These countries are less indebted than the developed world, and consumers there have easy access to credit."
On a regional scale, he has, however, been reducing exposure to Mexico, Latin America's second-biggest economy. Saidi says that Mexico is also now the second most expensive country - with an average P/E ratio of 15 - in the emerging market sector as a whole.
A major factor making investors nervous is the general election to be held in July 2012, which has the potential to change government policies.
The biggest economic risk is the country's exposure to the US, its main export customer.
Saidi, however, has increased his weighting in Peru. "Fears surrounding the economic
direction of the new government have disappeared," he says. "Furthermore, they are taking market-friendly measures, such as cutting taxes for big companies and minimising state intervention. At the same time, there has been a fundamental strengthening of corporate sector revenues."
Other managers are more cautious, especially in view of last year's elections, when left-wing ex-army officer Ollanta Humala was elected president, with an agenda to redistribute wealth.
"The comfort factor is lower than it needs to be to make investments," says de Leon.
Peru's status as an exporter of metals such as gold, silver and zinc still provides something of a bedrock for the long-term investment case for an economy that is benefiting from free trade with the US and several other countries, rising infrastructure investment and strong consumer demand.
Similarly, Chile's fundamentals include its export trade, not only in copper but also in wine, fruit, vegetables, fish and pulp and paper, as well as an increasingly sophisticated domestic economy.
However, with over 30% of GDP represented by exports, half of which is copper, Chile is more vulnerable to the global industrial cycle. Its stockmarket, usually quite expensive, is more attractive at present.
In the current global uncertainty, external trade is a key risk factor for the short-term outlook of Latin American economies as a whole.
But in the medium and long term, managers generally believe that domestic drivers should prevail, leading to sustained strong performance.
"Overall, only about 17% of Latin America's exports go to the EU - which might be considered a risky market - and this is declining all the time," says Felisberto.
"Latin America will not generally be affected by the slowdown in Europe," says Thompson. "However, confidence will still suffer. And the region is exposed to Europe via China; if China's exports to Europe go down, that will reduce their demand for commodities from Latin America."
"Latin America is better placed than other parts of the world to weather any global slowdown, but it is not totally insulated," says Larson.
Interestingly, he says that Colombia - formerly one of the region's most violent countries - is better off than its neighbours in this respect.
"Colombia is coming out of its isolation and is still a relatively closed economy undergoing major structural improvements, so could be less affected by the current global problems than other Latin American countries," he says.
Having once been a significant exporter to Venezuela, Colombia successfully switched trade to the US and other Latin American countries when its neighbour closed the borders.
It is also getting investment from countries such as Canada to open up its undeveloped mining and oil reserves. Domestic infrastructure investment is booming after years of under-investment because of the security situation.
"Colombia is in a ‘strategic moment' when huge commercial opportunities for potential investors combine with a stable and advantageous fiscal/legal/regulatory environment," says Isabella Gandini, associate in the Bogota office of Norton Rose Canada.
"Last August, it brought into force free-trade agreements with Canada and the US, providing foreign investors with concrete tariff relief and long-term investment stability guarantees."
She adds: "Colombia has achieved dramatic results in internal security. The government calculates that the proportion of the country in which its civilian and military presence is ‘weak' has been reduced to 1.5%."
As a whole, Latin America's recent adherence to orthodox - and shrewd - financial management should help tilt the investment argument in its favour over the medium to long term, compared with other emerging markets such as Eastern Europe.
"Brazil's move back towards an easing cycle is likely to prompt interest rate cuts in Mexico, Chile and Colombia, which will help offset any slowdown," says Thompson. "In contrast, Turkey kept rates low to maintain growth, and is now struggling with inflation."
Thompson also notes the efficient regulation of the Latin American banking sector. "Debt ratios are relatively low for consumer and SME lending so, as central banks start to ease credit conditions, we should see an expansion of credit to the consumer and SME sectors," he says. "This contrasts with developed markets where commercial banks are deleveraging and are unwilling to lend at any price."
Another plus point is the region's lack of dependence on European banks. "There is not a great deal of crossover funding between European banks and their Latin American subsidiaries," says Thompson.
"By contrast, many East European banks are funded from, say, their German or Spanish parent. That funding is no longer available because capital requirements mean the banks have to deleverage. But we are not seeing any banking contagion in Latin America. So any slowdown is not likely to be exacerbated by a credit squeeze. On the contrary, it should be offset by the easing of interest rates."
"Ultimately, the biggest near-term risk is a slowdown in growth with an upsurge in inflation - in other words, stagflation," says Felisberto. "However, that has, to some extent, been priced into the market."