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The new hot pick?

Sep 9, 2016

Investors are beginning to embrace Latin America again, anticipating a turning point in the region's economies and financial markets

Katie Llanos-Small

When New York’s stock market opened on June 24 virtually no-one expected the day’s shock news to be a boon for Latin American investment.Cover2

Traders dumped assets, sold the pound, piled into US Treasuries. Ecuador postponed a bond sale. Mexico slashed 32 billion pesos from its 2016 spending plan.

But then the world’s central banks leapt into action, promising cheap money for longer in a bid to stabilize markets. Investors reacted in the same way they have since quantitative easing was first tested in 2009: they turned to emerging markets in search of yield.

The European Union, and indeed the world, is set for a long period of uncertainty after the United Kingdom voted to leave the trading bloc. But after the initial shock of Brexit faded, the implication for Latin America was a sharp rally in the region’s markets. The rapid reassessment of the risk-reward balance in LatAm came as economists began to see an inflection point in the economic cycle. After years of recession the region may, finally, be on the brink of happier economic times, they say. 

A move away from populism in Argentina and Brazil, a stabilization in commodities markets and the prospect of easier financing all point to better economic growth — and investment performance — across Latin America, says Jan Dehn, head of research at Ashmore Investment Management. "There’s going to be a strong and sustained performance coming out of EM investments, and within that, Latin America is the most interesting." Indeed, in July Ashmore proclaimed the region was "the best investment proposition in the world today".

But many remain cautious. If the anti-globalization angst that drove Brexit were to prevail in US elections in November, the region’s trade expectations could be rapidly rewritten, almost certainly spelling a return to recession.

"Latin America doesn’t operate in isolation from the rest of the world," says Michael Shifter, president of the Inter-American Dialogue. "There are a lot of ways in which they’ll be negatively affected. Just the heightened uncertainty in the global economy is not going to be helpful for the path that most of Latin America is wanting to pursue."

Indeed, major risks to Latin American growth lurk in the months ahead.

The biggest comes from the US election. Polls indicate that Hillary Clinton is likely to win in November, but the anti-globalization sentiment underpinning the popularity of Donald Trump is worrying for many Latin Americans.

"It is a risk not just for Peru, for all emerging countries," says Peruvian President Pedro Pablo Kuczynski. "We’ll see what happens. It’s a little bit worrying."

Trump’s pledge to rescind NAFTA is at the forefront of concerns for most LatAm-watchers. But the potential downsides go much further.

"Emerging markets lose under a Donald Trump presidency," says Kathryn Rooney Vera, head of macro strategy and EM research at Bulltick Capital Markets.

Re-risking

Trump's threats to replace Janet Yellen — although it is close to impossible for a US President to fire the head of the Federal Reserve — would likely push up interest rates and the dollar if he were to win the election, she says. That would be negative for emerging markets.

Additionally, the unpredictability of policy under a Trump government would also squash risk appetite among investors, she says.

"Markets hate uncertainty. Donald Trump has no record of voting on legislation so markets will dislike that."

Whether Trump would actually try to follow through on his promise to undo NAFTA is anyone’s guess. Whether he could is also complicated.

"In some areas, [the President] can renegotiate or reopen the treaty, and some need congressional support, which might be harder," says the Inter-American Dialogue’s Shifter.

Yet in some respects, Trump’s discourse on the campaign trail could have long-reaching consequences for Latin American economies — even if he is unsuccessful in his bid.

"Clinton is not going to renegotiate NAFTA," says Shifter. "But there will be enormous pressure within her own party and now part of the Republican Party on the trade issue and it will be harder to deepen some of the agreements that have been made."

The lack of repudiation to the rhetoric from official or popular quarters in the US — as much as Trump’s outlandish comments on trade and immigration themselves — has offended many Mexicans. That bruising could, in return, fuel support for more protectionist candidates at home.

"That could give ammunition to an anti-US political figure like [Andrés Manuel] López Obrador," says Shifter.

Happily for Latin Americanists, the prospect of Donald Trump winning the US Presidency was looking unlikely by late August. Without that risk, the forecasts for Latin America’s economies — and investment  flows — look decidedly rosier. 

When Brazil turned to the bond market for funding in late July, investors greeted it with an enthusiasm not seen for years. The operation offered a happy counterpoint to a dismal run for the country, which had been hit by recession, an ever-broader corruption investigation, a presidential impeachment process and widespread jitters about the hosting of the Rio Olympic Games in August. It also underscored debt investors’ growing confidence on Latin America.

Brazil borrowed $1.5 billion, paying less for the 30-year instrument than it had just months earlier for a 10-year bond. Investors have bid hard for the note in secondary trading, too, pushing its price higher still.

The deal is "emblematic" of a shift in market views toward emerging markets and Latin America in particular, says Matt Dukes, a director in the debt capital markets team at Deutsche Bank, who worked on the transaction.

"The investor appetite we’re seeing now is probably the best we’ve seen in quite some time," he says.

Brazil’s bond sale tapped into growing optimism about the country’s economic course, says Dukes. Additionally, investors are reassessing their views on emerging markets debt and are increasingly interested in long-dated assets. "It was perfect timing for Brazil. They were able to capitalize not just on the macro themes, but also the improving fundamental sentiment toward Brazil." 

The country took advantage of a wash of fresh funds coming into emerging market debt portfolios.

Over the course of July, $18.7 billion entered emerging market debt funds, according to EPFR. That was a sharp jump from the $2.3 billion of inflows in the preceding two months combined. Investors allocated a further $5.5 billion to emerging market bonds in the first three weeks of August.

While most Latin America allocations come from broader emerging markets funds, some $250 million entered regional-specific bond accounts between July and August 10, reversing outflows in May and June. 

It was a trend that BlackRock observed from its own clients in Latin America, as investors stepped off the sidelines in a bid to meet returns targets, says Armando Senra, head of Latin America and Iberia at the fund manager.

"In June, July we began to see pretty significant  flows into equities, back into risk assets, from our clients in the region. Are we back where we were last year? No. But we’re beginning to see that money flow back into investments."

Central banks lend a hand

Global monetary policy in the wake of the Brexit vote is widely seen as pushing investors back into the markets after a retreat.

"It has a lot to do with the posture of central banks," says Richard McNeil, head of the Latin American nancing group and co-head of Andean investment banking business at Goldman Sachs.

"In the aftermath of the [Brexit] vote, some of the world’s major central banks indicated they were prepared to step up and offer more liquidity. To some extent, this has induced a renewed search for yield, as market participants concluded that monetary policy was going to remain pretty easy and that there’d be a lot of liquidity."

Yet the flush of cash into emerging markets in July is not the only driver of better market conditions this year. In fact, the inflows catalyzed a trend in action since the beginning of the year — a growing interest in riskier assets in Latin America.

Latin American borrowers hit up the bond market for $83 billion of debt between January and the first days of August, according to figures from Goldman Sachs. That is already $3 billion more than the entire year’s activity in 2015.

A few factors have driven the frenetic pace. Brazil’s Petrobras and Argentina are two of the biggest. They were essentially locked out of bond markets last year; this year, they have borrowed billions.

Borrowers from Argentina accounted for 34% of the year’s bond sales so far — in 2015 they made up just 4% of the total, according to Goldman Sachs  figures. Similarly, issuance from Petrobras soared, from 3% of LatAm bond sales in 2015 to 12% in the year to date.

"When we say 'the markets are back’, we should take into account the addition of Argentina as a source of issuance," says McNeil. "There definitely was a big step change in how investors assessed Argentina’s prospects."

Bond sales from Argentine borrowers and Petrobras have also upturned the traditional balance of investment grade and junk-rated debt issued. High-yield bonds made up half of the $38 billion of international bonds sold out of Latin America in the year to August 15, according to Dealogic. Last year, just $7 billion of high-yield paper was placed internationally, compared to $31 billion from high-grade borrowers.

That speaks to another major factor propelling bond sales. "It feels like an environment where investors will be looking down the credit spectrum more aggressively than they previously have," says Deutsche Bank’s Dukes, as they seek yield to make up for returns lost in developed markets where trillions of dollars of investments are estimated to be drawing negative returns.

Better growth expectations for China are another factor which, combined with strong global monetary conditions and a shift in perception of risks in emerging versus developed markets, have sharply altered forecasts for Latin American markets, says Will Ballard, head of emerging markets equities at Aviva Investors in London.

"It’s quite a change from where we were a year or a year-and- a-half ago: now you actually have three following winds for Latin America," he says.

"And that’s before you even start to think about portfolio positioning. So it’s not really a surprise that you’ve had a significant pick-up in equity markets and you’ve started to see inflows into Latin America."

Yet those indicators suggest that, perhaps, July’s rally is a kneejerk reaction to extra liquidity — rather than a response to changes in underlying conditions.

Weakening credit quality

An analysis of upgrades and downgrades indicate that Standard & Poor’s lowered its scores on South American borrowers roughly four times more than it moved in the opposite direction in the first half of the year.

"I don’t think the markets have been stronger due to evidence of improving credit quality in the region – if anything, quite the contrary," says Goldman Sachs’ McNeil.

"I think there’s a lot of liquidity about. Contrary to expectations, the Brexit vote ended up having the impact of calling forth more central bank liquidity into the markets, and of making Europe look a little riskier relative to some emerging markets and certainly relative to LatAm."

Dukes concurs.
"What we’re seeing in terms of the appetite is similar to what we saw when emerging markets were in vogue but fundamentals for emerging markets were arguably much stronger. So the fundamental backdrop isn’t necessarily as aligned with what we’re seeing in terms of valuations," he says.

The measure of a savvy investor, of course, is to buy before the fundamental indicators catch up — thereby taking advantage not just of the better conditions, but also of the corresponding market rally.

So is Latin America on the cusp of a prolonged rally today? Is the region set to see a sustained rebound in growth and investments? Or was the optimism of July a flash in the pan?

Improved expectations

Although regional growth remains underwhelming, expectations are growing that the economic cycle may be set to turn.

McNeil characterizes the activity as hunt for yield, but adds that, in spite of the region’s weakening credit profile, "it may be that folks feel that we’re at sort of an inflection point and things are about to start to get better."

Aviva’s Ballard is more cautious. The fund is a few points underweight Latin America versus its benchmark, the MSCI emerging market small cap index. "When we look at Latin America on a global emerging markets basis, we can see there’s a lot of reward there. If things go well, we think that Latin America could quite easily be the region that outperforms. 

"But already year to date it’s done very well. We think that there are significant risks associated with that outperformance. On balance it’s actually had a relatively strong move already.... We need confirmation that things are moving in the right direction," he says.

The base case for many economists is better macro-economic conditions for the region as a whole in 2017.

"Latin America is probably coming out of a two-year recession in 2017. The main reason is the turnaround in economic policy in Brazil," says Ramón Aracena, Latin America chief economist at the Institute of International Finance.

"Our expectation is that Brazil is going to have growth next year. It’s not going to be spectacular growth, but it’s going to be between 1% and 1.5%, which is not bad. If they continue the same course, you’re going to see around 3% in 2018. That tells you that the region as a whole is going to emerge from a two-year recession."

The Inter-American Dialogue’s Shifter also sees regional growth approaching an inflection point as policymaking in Argentina and Brazil becomes more orthodox and as commodities prices stabilize.

"Latin America is ready for a more positive cycle," he says.

Vanguard, which manages the world’s largest bond fund, is another optimist on the region’s path.

The likelihood of strong dollar liquidity and stable commodity prices in the years ahead gives some hope, says Roger Aliaga-Diaz, senior economist at Vanguard.

"Barring significant surprises, the outlook based on economic fundamentals should not be that negative, and compared to the last two years, it could be a little bit brighter."

More pro-market policies

Aliaga-Díaz expects Latin American economies to perform somewhere in between emerging Asia, which remains buoyed by China, and emerging Europe, which could suffer from volatility related to Brexit.

"Latin America is especially hit hard when the dollar moves significantly, because of the dependence on international funding," he says. "But if we have a more stable outlook for the dollar going forward, if the Fed moves very cautiously and gradually, you can think of a more stable outlook for the region over the next three to five years."

Stability in commodity prices and currencies and a weaker dollar are not the only reasons to be bullish about Latin American growth, however. New political administrations in Argentina, Brazil and Peru are also expected to prioritize economic growth and investment.

"The other positive thing from Latin America is this move away from populist economic policies," says Aracena. "You see that in Argentina with the new government, you see that in Brazil. And I think you’re going to start seeing that in Chile, because the popularity of President Bachelet is very low. So, slightly, the region is moving again toward more pro-market policies. That reflects the underlying, relatively solid foundations, of the checks and balances in these countries."

The brighter expectations are also reflected in official forecasts. Latin America and the Caribbean is projected to bounce back from a 0.4% contraction this year to grow 1.6% next year, according to IMF estimates. And in July, economists at the Fund said signs of improving confidence in Brazil were behind its forecast for 0.5% economic growth in 2017, a rebound from the -3.3% it predicts this year.

Stronger economic growth coupled with extensive liquidity in dollars sets Latin America up well to attract swathes of fresh investment, says Aracena.

"The region is coming out from the worst," says Aracena. "Now you see the situation in the mature economies, particularly in Europe, is less favorable than everybody was thinking. You still have a lot of liquidity in the system. So all this hunger for yield that’s going to prevail all across the globe is looking for a destination. One of the destinations is Latin America."

Aracena points to Colombia, following the peace agreement concluded between the government and FARC rebels, as a potential beneficiary. And across the region, strong interest rates compared to the developed world make an attractive carry trade, especially as investors judge the risks to be waning.

"In relative terms, the region should be able to attract much more capital in 2017, 2018. That’s my expectation," says Aracena.

'Substantial opportunity’

Aviva’s Ballard is cautious on the prospects, however. Already, inflows into equity portfolios have driven a sharp revaluation of stocks in Brazil. That means his fund is likely to keep its underweight position in the country for a while, says Ballard.

"You’ve already seen a very significant move in the Brazilian equity market," says Ballard. "On a price-to-earnings basis, it’s now starting to look expensive. So obviously with  flows coming in, people becoming more optimistic that things will pick up, the equity market has already started to move. But earnings haven’t picked up yet."

That poses a risk if the expected acceleration does not materialize, he says.

"The counter argument is if you look at the underlying book value of the companies — their asset base, the capital they’ve invested to generate returns — it still looks very cheap," says Ballard.

"If the economy does pick up, the opportunity for their return on equity to pick up is very substantial," he says.

Ashmore’s Dehn takes that analysis further, arguing that the inflows to emerging markets debt are just the tip of the iceberg, with much more to come.

"Latin America offers more value [than other emerging markets] because its asset prices have been beaten up more and will take time before the potential is realized: at the moment we’re looking at some markets there that are very cheap indeed."

The bounce back seen in July is "small fry" compared with the outflows of recent years. Dehn argues that the structural departure of investors seen in these years leaves ample room for a lengthy reversal. Many large pension funds have stopped allocating to Latin America despite their assets growing, leaving them underweight. Dehn sees a similar trend among central bank and insurance investors. "It’s an extremely positive technical situation," he says. "Because all the fast money, the potential sellers are already gone."

Beyond boom and bust

Regardless of how long central bank liquidity remains, or whether Chinese growth will slow again, the factors underpinning the mid-year market boost may be enough to give some of the region’s economies the lift that they need, suggests Aviva’s Ballard. 

"I wonder whether the question is more about whether it actually needs to be a fundamental change for Latin America to do better — or is it enough for Latin America that they get this breathing room?

"Brazil has had two years of very, very severe recession," adds Ballard. "If they end up with some breathing room, you’d expect the economy to be able to bottom out with it. It’s simply if external conditions continue to worsen that they’ll find it hard. You need them to exhaust inventory levels — then you should get a restocking cycle kicking in."

If the region is at an inflection point, it may offer an opportunity for more than just a cyclical turn. The global tailwinds and lurking risks could end up posing a "real test" of Latin America’s boom and bust "syndrome", says the Inter-American Dialogue’s Shifter.

"Thinking optimistically, there may be a combination of factors that may help many countries in the region to  finally overcome this boom-bust cycle that has benefited the region during good times, but causes real serious consequences when things go bad." LF 

This article was updated on September 22 to clarify that a US President cannot directly fire the head of the US Federal Reserve. 



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