The Reckoning

Receiving investment grade status is supposed to make you more attractive to investors, not less. But over the last few weeks institutional investors have been reducing their exposure to Brazil, with the Latin American indices giving up all their gains since the start of the year.

Patrice Lemonnier, head of emerging markets at CAAM, believes the sell off is linked to general risk aversion and inflationary concerns: “Flows are drying up everywhere in emerging markets – the environment is not too good for equities.” He points out that Asian valuations have halved over the last six months so their overvaluation problems have disappeared, whereas the valuations for Latin America have come off a bit but relative to developed markets they are still the same.

Will Landers, who manages BlackRock’s family of Latin American equity funds, believes profit-taking may also have something to do with it. “There was a very short sharp move upwards following the investment grade rating from S&P at the end of April, and as people were looking to raise cash they decided to take advantage of this. If you’ve been invested in Latin America for a while this is definitely an area where you would have had profits to realise.”

Inflationary pressures

Medium term, he believes investment grade status will help attract more conservative institutional investors to the region, but right now, inflationary pressures are making the region less appealing. “We do see a weakening in bank lending, and possibly some increase in non-performing loans, and as interest rates increase some of the real estate opportunities look less attractive,” says Stephen McCarthy, senior portfolio manager for emerging markets at SSgA.

He believes that Brazil’s central bank has been the most successful in signalling to the market that it will keep inflation down, but many countries have begun to tighten, including Mexico, Peru and Colombia. “Chile is lagging a bit behind the curve but it has been trying to offset the inflows of currency from the very strong copper price,” he says.

Indeed, many of these markets have benefited from strong commodity prices. Mexico has enjoyed a windfall as the price for Mexican crude is twice the amount it budgeted for. “Both Brazil and Mexico have programmes to promote infrastructure investment so ports and the transportation of goods and services should improve,” says McCarthy. “In the long run this should reduce inflation as this will lower the costs of production and make their goods more competitive.”

SSgA views Chinese demand for commodities as a long-term trend despite the fear of short-term pull-backs. McCarthy also doesn’t see the same huge systemic risks of the 1990s, as the LatAm economies are more integrated into global trading networks and fiscal and monetary policies have improved, with the exception of Argentina. “Rising inflation is a concern and loan growth to some of the lower income groups is excessive – there could be some set-backs there. But there is less risk of a foreign exchange crisis than in the past,” he says.

However, this remains a very narrow market, with the same stocks appearing in managers’ top 10 holdings again and again. Everybody loves Petrobras, CVRD (Vale), Banco Bradesco, and America Movil. Hexam Capital’s Bryan Collings, a global emerging markets manager, says he recently bought some of the latter, which he sees as a well-run, safe cash flow generator in the mobile space.

“It is not as exciting as some of the other mobile operators in India, Russia or Nigeria, but as the money comes into Latin America, this will be a beneficiary,” he says. “And it is probably one of the safest, most predictable earnings defensive plays, as so much of Mexico is dependent on what happens in the US, particularly the growth of the southern states.”

Don’t cry – there’s always Tenaris

Argentine pipe manufacturer Tenaris also turns up regularly, liked because it is a global player in the oil services segment, deriving few of its revenues from its troubled home market. Lemonnier says that it remains difficult to get access to markets like Colombia, whilst Chile is expensive due to the participation of local pension funds. Meanwhile Venezuela has disappeared from the investable map following a series of nationalisations – most recently those of its cement and steel industries.

“Latin America is basically Brazil and a handful of other stocks,” says Collings. “Of all the regions it is the smallest and it is shrinking in many ways, in contrast to EMEA where you’ve got other markets coming through. I don’t really think it’s necessary to have a Latin America fund – you can pick the eyes out of it and get exposure to other stocks elsewhere in the world.” 

Currently he prefers China, arguing that investors have missed opportunities by not being there. “People think that China has completely blown itself up. But if you look at it, it is only down 13 percent relative to the emerging market index this year, and the banking sector is up some 17 percent.”

He says that Bank of China is up 11 percent and China Construction Bank is up 12 percent relative to emerging markets, so these stocks are doing as well as, if not better than, Brazilian banking stocks. “In fact they have outperformed, year to date, one of the best iron ore producers in the world – CVRD.”

Disappearing act

Collings argues that investors need to dig a bit deeper and look for the inconsistencies in what people are saying: “There is no better example than the amazing Houdini-like disappearance of those people who last year said that when the China A-share market falls, which it has done massively, the China story and the commodities story will be badly affected. Well that just hasn’t happened, has it? But where are these people?”

He argues that the reason why both have been unaffected is because the size of the equity market in China is so small relative to the economy: “It wouldn’t make a difference if it fell 90 percent, in contrast to the size of the equity markets in developed economies, where it does affect your wealth. The Chinese still have well over a trillion dollars sitting in retail bank deposits.”

Collings believes that Brazil’s investment grade status overestimates its capacity for growth, and fails to take into account potentially negative surprises for investors. “Brazil is simply not as robust as people think, not as robust as emerging market funds’ positioning suggests and certainly not as robust as in recent years.”

If you want to read more about how regional specialists are trying to protect their portfolios against a backdrop of rising inflation, please go to:

http://www.thomsonimnews.com/story.asp?storycode=44601