Petrobras has come to be one stock that equity investors pride themselves on not holding. For years, the Brazilian company’s shares have trod a steady path lower, and last year the stock fell off the proverbial cliff.
Many of the best long-term equity investors have steered clear, and for that they have, typically, been rewarded with benchmark-beating returns.
Early 2015 was different. The oil and gas company’s shares rallied sharply from mid-March through presstime in May. Investors who had once happily avoided the stock now lament the gaping hole in their portfolios.
Petrobras’ slump and sudden rally has been emblematic of Latin American investing in the past 12 months, say fund managers. The normal rules of engagement were tossed out.
“This was one of the years where our process doesn’t necessarily work,” says Luis Carrillo, head of the Latin America Group in JPMorgan Asset Management’s emerging market equities team. “Brazil’s market was driven by who was going to win the election. It was one of those years where you had to be diversified, without taking enormous risks.”
For BlackRock, it was similar. “Typically we do well in years where stock picking is the most important thing,” says Will Landers, emerging markets fund manager. “It hasn’t necessarily been that type of year, but we’ve been able to weather it okay.”
Bond investors are similarly downbeat. As the commodities cycle ground to an abrupt halt, Mexico’s much-awaited moment never quite materialized. Andean exchange rates plummeted, and fixed-income managers struggled to find the value of years past. On top of everything else, portfolio administrators have had to keep up with the quickly changing signals from the US Federal Reserve over interest rate increases.
“Latin America has been a significant underperformer in the last 12 months against the rest of the EM asset class,” says Steve Ellis, fixed-income portfolio manager at Fidelity Worldwide. “I’m talking about hard currency sovereign debt, EMBI Global-type of mandates. Spreads have widened pretty aggressively in Latin America in the past 12 months.”
Despite the pessimism, most bond funds managed to post one-year gross returns in the low-single digit range — keeping their heads above water if not coming close to long-run averages.
Equities fared much worse, though. Even the best performers suffered double-digit losses (see table, page 15).
Overall, rather than a year for picking winning investments, 2015 could be characterized as one for avoiding figurative banana peels.
The cycle turns
In the lead up to the global financial crisis, and the first years after, emerging markets were investors’ shining star, providing returns unavailable anywhere else. Suddenly, the asset class has experienced a sharp fall from grace. Today, returns are damned with faint praise: “If we look at emerging market dollar debt returns from 2000 to the financial crisis, there were 10% per annum returns,” says Sam Finkelstein, head of macro strategies in Goldman Sachs Asset Management’s global fixed income team.
“Those lofty return days are over, but on a relative basis in a fixed income portfolio we think that emerging markets are okay.”
Emerging markets, particularly those that depend on exports of oil or other commodities, will pose difficulties for yield-hungry investors until China stabilizes say some.
With the cloud of negativity settled over the region, fund managers are also grappling with serious portfolio outflows. In bonds, the trend can be dated to May 2013, according to data from EPFR Global, which predominantly focuses on retail investor flows.
The market souring began two years ago when Fed chairman Ben Bernanke suggested the end of asset purchases was in sight, causing investors to shuffle some of their holdings to the US. Ever since, international investors have shunned Latin America’s debt in increasing numbers.
Investors pulled $3.69 billion of cash from LatAm debt funds in 2013, according to data from EPFR, abruptly ending several years of steady, if not spectacular, inflows. Last year, the outflows deepened, reaching $4.49 billion.
The trend has kept up this year, although at a much slower pace. From the beginning of the year to April 24, investors had pulled $20 million from LatAm bond funds.
In equities, the volumes have been higher, and withdrawals started earlier.
“It is an industry-wide phenomena for most asset classes within emerging markets,” says Fiona Manning, senior investment manager at Aberdeen Asset Management’s Global Emerging Market Equities team. “But Latin America does seem to be particularly hard hit.”
JPMorgan Asset Management picked up some market share as investors departed emerging markets, a fact that has helped its resilience, says Carrillo. “We were prepared for much worse outflows than we got. We were looking at 2008, 2009 to see what we could expect and we definitely did not get that bad.”
The question of fund flows is less gloomy, however, if one considers portfolio flow estimates from the Institute of International Finance. Its data, derived from country-level portfolio flows as well as capital markets issuance, risk appetite, and Fed expectations, offers a bigger-picture view than that of EPFR data.
The IIF estimates more than $9 billion went into Latin American bond portfolios, and close to $5 billion into equities, in April. Even the IIF data has a bearish slant, however: the Institute expects that inflows of capital will slow this year compared to last.
“Our expectation is that the year as a whole, 2015 versus 2014, will show a decline of private capital inflows because the region as a whole is growing very little, or probably stagnant,” says Ramón Aracena, chief economist for the Latin America department at the IIF. “The main driver of portfolio equities is usually growth.”
Staying prepared
The EPFR numbers, which reflect day-to-day movements in many portfolios, concern many fund managers. Poor performance in regional equity markets can in part be attributed to investors being forced to sell assets at a lower price than they had hoped to cover fund redemptions.
Indeed, equity markets across the region have been highly volatile.
As a result, managers have had to address liquidity in their portfolios carefully, regardless of where they are invested.
“It’s obviously much tougher in some of the smaller markets,” says Manning at Aberdeen. “Somewhere like Peru, liquidity has been more of a problem. And equally somewhere like Brazil, whilst the market is very liquid, is also very much driven by foreign flows. Such a negative macro environment can have a big impact in terms of the moves that we see in the market.”
Landers says BlackRock is keeping 2% to 3% of its assets in cash, double or triple the amount of previous years. Staying more liquid is a response not just to outflows, but to heightened volatility in the markets.
“One of the things we’ve done this year is keep a little more cash so we can buy some stocks that fall more than they should,” says Landers. Holding a stash of cash also lets BlackRock deal with outflows “without being forced to sell in a market in which we may not be willing to sell.”
First movers
Much of the rush out of emerging markets stocks and bonds depicted by the EPFR data came ahead of sweeping changes in global economic and monetary policy conditions. In particular, investors jostled to be ahead of the crowd when it came to positioning for a normalization of US interest rate policy.
Similarly, much of the outflows preceded the crash in global commodities prices, the bedrock of LatAm expansion for years.
Such prescience opens the question: what happens when US rates do ultimately rise? Will the US’s economic recovery continue to lure global investors — or will investors who want to get ahead of the curve look at LatAm assets in a more favorable light again?
Investors and analysts are divided on where flows go from here. JPMorgan’s Carrillo says the market is close to a turning point when it comes to sentiment on Latin America.
“I was marketing with some investors in Europe two weeks ago, and you could sense that they wanted to become more positive on LatAm than I was willing to let them be,” he says. “That has to do a little bit more with timing than anything else. The move of the US market is a little bit ahead of itself.”
Once the dollar’s strengthening run wanes, investors could again turn their attention to Latin American assets, he says. For now, though, “we think the dollar can get stronger, not versus just LatAm but versus everything else,” says Carrillo. “Perhaps what we need to see is the first steps in US Fed rate policy normalization.”
The IIF is also optimistic on capital flows picking up. “All the Pacific Alliance countries, and now Brazil, are on relatively sound footing to continue to attract capital in 2016,” says Aracena. “Our expectation is that in 2016, inflows into the region are going to grow.”
But not everyone is so confident. BlackRock’s Landers says he has not seen a sign that fund outflows are close to flipping into inflows. That is unlikely to happen until regional growth improves sharply, he says.
“The outflows have moderated, but I think that dedicated funds are still suffering through small but steady outflows. You’ve got to have a much more positive story.”
Others note that the competition for portfolio flows is no longer about a question of developed versus emerging markets. “Now you have another competitor,” says Roberto Shinkai, an equities director at Bradesco Asset Management in São Paulo. “Right now, flows are going into Asia.”
Still Shinkai argues that portfolio flows are cyclical. “The main competitor in the last two years was the S&P,” he says. “So the developed markets outperformed the emerging markets, and they are showing a growth story that’s different from years before. I think the emerging markets will regain the growth story.”
For now, the top fund managers in Latin America are focusing on what they do best: taking a long-term perspective, looking carefully at each asset, and using market volatility in their favor as best they can. That won’t always boost returns month-by-month.
“I’m looking forward at some point to a stock picker’s market,” says BlackRock’s Landers. But he acknowledges a short-term hiatus still haunts the Latin American markets. “I think these top-down issues continue to dominate the discussions. The rally that we’ve seen in the region, especially the Brazilian market during the last month or so, has had much more to do with global risk appetite and global liquidity.”
But investors who have strong long-term convictions on some companies can find bargains at a time when others are heading for the exit.
“If you have confidence in the companies you invest in, there can be real opportunity in these volatile markets,” says Manning. “But you have to be very focused on the individual company, and in a sense try to look through the macro headwinds and take a long-term perspective.” LF
Additional reporting by Eduardo García