Fund manager's comment/Michael Dow
Latin American equities have been one of the best-performing assets in US dollar terms so far this year. Mexico has been the best-performing market in the region and Brazil the worst ' a fact that has been mirrored in the performance of their respective currencies.
Many Latin American countries are heavily indebted. When economic activity or government income drops for any reason, servicing this debt can become problematic. When such an event happens, it is even worse if your currency is pegged to the US dollar at a time when neighbouring countries have devalued theirs. Unfortunately, both parts of this scenario have been in place in Argentina over the past few years.
So, Argentina has little or no growth and too much debt. Since most of the debt is owed to foreigners, interest and debt repayments flow out of the country, putting pressure on the peso to fall. As it is fixed to the dollar it cannot do so, which puts pressure on the government to default or reschedule the debt. Since Brazil also has US dollar denominated debt, currency weakness increases its debt service costs. So, as Argentine contagion hit the Brazilian real, the Central Bank was forced to increase interest rates to shore up the currency.
This is taking place at a time when the country is dealing with a power shortage. Brazil relies heavily on hydroelectricity for its power supply and a drought this year has led to a shortage. Prolonged power rationing could constrain economic activity and lead to a reduction in foreign direct investment.
As the difficulties for both Argentina and Brazil have developed, Mexico has stood out as the preferred market for investors. The transition to the new government led by Vicente Fox has gone smoothly, the economy has adapted well to the US slowdown and inflation and interest rates are falling.
The fact that Moody's raised Mexico's debt status to investment grade last year and that Standard & Poor's is likely to follow suit will provide support to the market going forward.
The global background for Latin American equities still looks positive. Central banks are cutting short-term rates, growth expectations look like they are bottoming out and valuations remain attractive. The main risk for the region lies with Argentina. While uncertainty surrounds the outcome in Argentina, the current trends in the market will remain in place.
Mexico is our preferred market in the region and the portfolio is biased towards the strength of the domestic economy with heavy positions in the banks and telecom companies. We are light in Argentina and given the continued uncertainty, we are likely to remain so. Even if Argentina avoids default or devaluation, growth in the economy remains a long-term problem.
Michael Dow is head of emerging markets at Standard Life Investments
• Global background positive for LatAm.
• Strength of Mexican economy.
• Mexican debt status now investment grade.
• Many countries heavily indebted.
• Power shortage in Brazil.
• Countinued uncertainty in Argentina.
Despite improved risk appetite
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