Given the strong performance of Latin America's stock markets in 2003 and 2004, Schroder's James Gotto examines whether the region's rally can continue
Latin American equity markets have delivered strong gains for two consecutive years, helped by factors including lower risk aversion among investors, improvements in the outlook for global growth, higher commodity prices and strong domestic and corporate profits growth. In the wake of this strong performance, it is likely 2005 will offer more moderate returns although robust economic growth across the region and the high profitability of Latin American companies should support equity market performance. It is likely Brazil offers the best investment opportunities in the region although there are a range of companies with good investment potential in Mexico, as well as in smaller markets such as Argentina, Chile and Peru.
The driving forces behind Lat AM
In 2003, the main drivers of Latin American equity markets were lower risk aversion among investors, allowing risk premiums across Latin America to fall, better than expected reform progress from the new Brazilian government and an improving outlook for global economic growth. This strength was sustained into 2004, helped by factors including strong domestic and corporate profits growth, commodity price strength and reduced investor fears about the likelihood of a substantial tightening in US monetary conditions, which is of concern in Latin America given its high levels of US dollar-denominated debt.
Is this strong performance likely to be sustained in 2005? Latin American markets had a weak start to the year, driven by renewed investor concerns that the US Federal Reserve could tighten monetary policy more aggressively than previously hoped, and the consequent rally in the dollar. However, they have recovered well, particularly as fears of a medium-term strengthening of the dollar have eased. Looking forward, it is expected the external environment to remain reasonably benign and believe that robust economic growth across the region and the high profitability of Latin American companies should support performance over the year. However, it is possible that, following the strong gains seen in 2003 and 2004, this year will see moderate performance from the continent's stockmarkets as economic growth will moderate and interest rates are set to rise. Nevertheless, the strong fundamentals, combined with relative share price valuations that continue to be attractive, provide some reassurance that the potential downside for these markets is limited, should global investor risk aversion rise in the course of 2005.
But where do some of the best investment opportunities lie in these markets? Brazil is the largest equity market in Latin America and, at present, it has the best investment potential, offering the most attractive combination of good value stocks and strong corporate profits growth. The market has seen strong performance, meaning that share price valuations have generally become less compelling when compared to their own history, although they remain cheap based on international comparisons. However, concerns include the fact that Brazil's current account surplus has recently narrowed and real interest rates are also rising. These are likely to remain high as the Brazilian Central Bank focuses on reducing inflationary expectations - the interest rate rises implemented so far have yet to slow down the rate of GDP growth. Overall, the macro-economic environment is being underpinned by solid domestic consumption and we are emphasising beneficiaries of this growth in the banking and telecoms sectors at the expense of more cyclical steel and paper stocks.
A stock that has good prospects is Banco Bradesco, Brazil's largest private bank in terms of assets, which has commercial, investment and international banking operations. The shares are trading at a substantial discount to fair value and the company recently reported results that were stronger than expected. The bank is likely to benefit from its focus on profitable businesses such as consumer loans and from growth in fee income. Banco Bradesco's efforts to reduce costs, which have already improved returns on equity to some extent, are set to be a further positive going forward.
Another stock is Coteminas, which is an integrated textile company with activities ranging from the production of yarns and fabrics to the manufacturing of t-shirts, socks, bed linen and brushed towels. The company is changing its strategy from one that was centred on intermediate products to one focused on more added-value consumer goods and the shares are attractively valued. Coteminas is also set to benefit from domestic economic strength, with expected income per capita and purchasing power increases likely to be positive for demand for its products.
Mexican economic growth has improved
The second largest equity market in the region is Mexico and although we are not currently finding as many good opportunities as in Brazil, there is good investment potential available. Economic growth has improved, helped by the strength of the US economy which is a major market for Mexican exports, with retail sales and capital investment up relatively strongly recently. Monetary policy tightening is near to its peak although domestic political uncertainty ahead of the presidential primaries in May is a negative. At the corporate level, pension fund investment appears to have been driving the market recently and although overall company fundamentals are positive, they seem to be largely reflected in valuations.
However, one example of a Mexican stock which has good potential is Grupo Aeroportuario del Sureste (ASUR). The company operates nine airports in the South East region of Mexico, the most important of which is Cancun, and was privatised in 1998 by the Mexican government. ASUR recently reported a strong set of results, helped by strong passenger and commercial revenue growth numbers which bode well for the company's prospects in 2005. The shares are also trading at a substantial discount to our estimate of fair value.
Corporate earnings likely to surprise
Of the smaller Latin American markets, there are some investment opportunities in Argentina. Its economy is now recovering from the devaluation in late 2001. This is being driven by domestic consumption, which is being helped by low real interest rates. However, investors remain focused on Argentina's public debt restructuring, in the wake of the country's economic crisis. The recent restructuring package presented by the government has now been widely accepted and we believe that the Argentine equity market is under-owned by other investors and that corporate earnings are likely to surprise on the upside. The problem is liquidity as many Argentine companies were bought by controlling foreign investors prior to the crisis and exchange controls remain in place for the local market.
In Chile, there are also some attractive potential among selected utilities, telecoms, banking and materials stocks. The economic growth outlook is good, with consumer confidence, retail sales and industrial production rising although full share price valuations are limiting the number of investment opportunities and the country's gas supply from Argentina remains subject to disruptions. Finally, the Peruvian economy is performing well, underpinned by domestic demand. However, the market is 70% exposed to commodity prices. Following weakness in the price of gold and given that there is expected to be dollar weakness in the medium term, there are positive prospects for Buenaventura, which has a stake in one of the world's lowest cost gold mines.
Given the excellent performance of Latin American stockmarkets in 2003 and 2004 it is possible that this year is likely to offer more modest returns. However, solid growth across the continent and the high profitability of Latin American companies should underpin market performance. Brazil offers the best investment potential among these markets in our view although there are good stock specific opportunities in Mexico, Argentina, Chile and Peru.
Latin American equity markets have delivered strong gains for two consecutive years. This year returns will be more modest but still attractive.
Brazil offers the best investment potential among these markets followed by Mexico, Argentina, Chile and Peru.
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