You will see more articles about South American equities this year because they have performed reall...
You will see more articles about South American equities this year because they have performed really well for the first time in a while. This performance has been lead by Brazil where the MSCI index was up nearly 103% in dollar terms last year. Mexico chipped in with close to a 30% dollar return and Chile an impressive 80%. The question is why? The answer is simple.
On the one hand, investors' aversion to risk collapsed following the Iraq war and riskier assets, of which South American equities and debt are a definite part, outperformed. Against this background investors in risky assets found themselves swimming with the tide irrespective of fundamentals - even Venezuelan equities delivered nearly 9% as measured by MSCI, despite the political and economic crisis taking place the country.
On the other hand outside of Venezuela, governments did themselves no harm in luring back risk-takers. Brazilian President Lula in particular proved to have a much more subtle understanding of policymaking than was initially feared by markets. The government has realised that it could not go on a borrowing and spending spree or undermine business interests in any significant way. On the contrary, it has sought to reform the amount wasted on a self-serving and often corrupt bureaucracy. Brazilian policymakers have correctly realised at this stage that growing the economic pie is much more important than deciding on how it is shared. The result has been falling inflation and interest rates and the possibility for the first time in years of some decent medium-term growth.
This does this mean that South American equities are an unqualified buy, however, for the very same reason cited at the start of this article - namely that they have already gone significantly in anticipation of these improvements. Venezuela is a basket-case at present with a president who is desperately holding on to power through massive spending of abundant oil revenues. Inflation is running at over 25% and economic activity has collapsed.
Risks include social chaos surrounding a further coup attempt, the emergence at the helm of someone even worse than Chavez and/or devaluation of the currency.
Perversely, this sort of situation is exactly what the best emerging market investors would look for because it tends to lead to bargain-basement panic levels of valuation in equity markets. Unfortunately, there is no indication that valuations are anywhere near panic levels in Venezuela at present, probably because locals are using equities as an inflation hedge.
Mexico and Chile are by comparison relatively boring places to invest and write about these days, which is reflected in their investment grade level of bond yields. Consequently you are unlikely to make big money here, merely because valuations are very cheap and this is certainly the case in Chile where PEs is in the high teens. Mexico fairs better from an equity valuation perspective as it continues to increase its exposure to the US economy, but there are also potential risks surrounding the government's low tax take in the economy and its reliance on oil revenues which are no longer reflected in bond yields there.
In Brazil, the major positive point is that inflation could be 6% this year while interest rates are 16%. This leaves scope for a further big cut in rates during the year. Analysts and economists usually underestimate the impact that a steep change in interest rates can have on demand in an economy because suddenly all kinds of investing and consuming activities become possible that was hitherto unthinkable.
This all suggest that earnings expectations for companies linked to the domestic economy could be way too low. If you are no longer buying Brazilian equities because too much risk is discounted and it looks too cheap, you should certainly be looking at it because of the potential for earnings upgrades as the economy picks up.
The risks to this positive scenario in Brazil are now all political; because interest rates will only fall this much if the government maintains its orthodox economic stance and manages to push spending reforms through congress.
It is worth betting on this simply because Lula is popular and has a mandate for change. In a few years time however, there is a strong likelihood that Lula will want to fulfil some of his social objectives through bigger spending.
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