The global financial crisis has turned the conventional
investment proposition for Latin American assets on its
Latin markets, once seen as inherently volatile due to poor
fiscal and monetary policies, mismanaged financial systems and
high government debt, now offer both high return and, to some
extent, less risk relative with the notable exception of
Ecuador, Venezuela, Bolivia and Argentina to developed
Proponents of the Latin investment story argue that asset
prices have naturally rebounded to pre-crisis levels and
are sustainable thanks to the regional economic upturn
and strategic real money inflows. Moreover, they argue that
this year there will be strong relative growth, consumption and
investment for regional equity, debt and currency markets.
According to the Institute of International Finance (IIF),
net private inflows to the region will hit $176 billion in
2010, concentrated in Brazil, Chile, Colombia, Mexico and Peru,
compared with $136 billion in 2009. At the height of the 2007
bull run, net private flows in the region were estimated at
Yet renewed enthusiasm for emerging markets
especially Latin assets sits awkwardly with growing
uncertainty over the global markets rally. Fear is growing that
the policy-led stimulus and the rush of global liquidity have
overstretched both commodity and emerging market asset
Money supply is running at a rapid pace and,
therefore, there is huge demand for different assets... and if
this monetary expansion continues, there is a 70% possibility
of a global market bubble, says veteran equity investor
Mark Mobius, executive chairman at Franklin Templeton
The explosion of global credit over the past year has led to
widespread global asset price reflation. HSBC estimates that
global money supply exploded from $24.4 trillion in December
2000 to $62.3 trillion by end-2009, an increase of more than
It found a strong correlation between money supply and
rising valuations for externally issued bonds from emerging
market issuers on the JP Morgan EMBI+ indices, global equities,
using the MSCI All Country World Index, and commodity
Mark Dow, investment manager at Pharo Management, a
multi-asset global macro hedge fund, says: There will be
a bubble somewhere because it is in the nature of markets to
Ultra-easy US monetary policy and the cheap cost of dollar
funding what New York University economist Nouriel
Roubini has famously called the mother of all carry
trades is at the heart of todays global
Since the US Federal Reserve lowered interest rates to
near-zero in late-2008, the so-called dollar carry trade
where investors borrow in dollars and invest the money in
high-yielding assets of another country is now the
easiest and most popular investment strategy.
This has sparked a portfolio shift where investors borrow
dollars to fund long investments in Latin American local
currency government and corporate bonds, equities, currencies
and commodities. The strategy is appealing, given higher
growth, inflation and interest rates in the region that will,
in theory, deliver higher returns on financial assets. For
example, even though Brazil has cut interest rates to a record
low in the crisis, the base rate is still high at 8.75%,
compared with the European Central Banks 1% policy
But it leaves open the possibility that interest rate hikes
in the western world could savage developing market assets.
Capital flight would see bond prices and exchange rates
plummet, while triggering a collapse in corporate earnings
across Brazil, Colombia, Chile, Mexico and Argentina.
Any dip in Chinese demand for commodities if, and
when, stimulus measures are eased back could also
puncture sky-high valuations in equity markets, where
resource-related stocks have a large weighting in regional
A growing number of economists is also warning of an
impending China shock in the medium term. Former IMF chief
economist Ken Rogoff last month forecast that Chinese growth
will collapse to 2% in the coming years, as the countrys
credit and real estate bubble bursts a cataclysm with
global consequences, not least a slump across
commodity-exporting Latin America.
END OF THE ROAD
Analysts increasingly point to 2010 as the end of the road
for record-low interest rates. HSBC marks the end of the first
quarter as the turning point. It calculates the current global
policy rate, weighted to purchasing power parity, is 2.9%, and
forecasts that this will rise to 3.4% by the fourth quarter of
Given the high positive correlation between global asset
prices and money supply, choking off liquidity could adversely
impact so-called risk assets. High-grade external debt would be
hit hardest as the rally in the asset class left investors with
little compensation for interest rate risk.
According to Anne Milne, head of Latin American corporate
bond research at Deutsche Bank, a US rate hike of 0.5% will
result in returns on high-grade Latin corporate paper to drop
to 05% in 2010, even accounting for coupon payments. A 1%
hike would cause investor returns to fall to zero, or in some
cases negative territory, Milne notes.
Nevertheless, high-quality Latin debt is still projected to
outperform investment grade US debt, according to JP Morgan.
The crisis has also shrunk the size of the levered investor
base in Latin markets, such as hedge funds and proprietary
traders, relative to real money investors. As a result, Latin
American-focused western investors, as buy-and-hold accounts,
are unlikely to unwind positions in Latin markets in the event
of higher interest rates, say investors.
High-yield Latin paper offers a cushion in the event of a
sell-off in US Treasuries. According to Deutsche, high-yield
bonds still offer 1015% returns if interest rates are
hiked by 0.5%, while corporate default risks have eased. Credit
Suisse predicts 1415% returns for Latin high-yield debt
on the back of resilient capital inflows and the economic
For now, though, emerging market policy-makers and exporters
particularly in Latin America are grappling with
the fallout of resurgent investor appetite: potential asset
bubbles and increasing currency strength.
Demand for emerging risk has meant that the so-called
impossible trinity the hypothesis that its
impossible to manage exchange rates, control inflation and
allow the free movement of capital at the same time has
returned with a vengeance.
Brazil is particularly vulnerable to large-scale capital
inflows due to its high interest rate environment and
the bullish sentiment toward domestically-driven economies
compared with its Asian counterparts. This has made it
costly for the central bank to sterilize capital inflows to
keep down the exchange rate.
Brazil announced last October a 2% tax levy on foreign
investors participating in local equity and fixed income
markets. Peru, Colombia and Chile before its devastating
earthquake have all raised the prospect of capital
controls if inflows continue to overwhelm local markets.
Peruvian finance minister Mercedes Aráoz said in
early March she was quite scared about commodity
price speculation and feared capital inflows were not targeting
long-term investments. Dow, at hedge fund Pharo, says the
strong emerging market investor firepower is
disproportionate to the investable opportunities,
citing Peru as an example of this.
TAKING THE SHINE OFF
Nevertheless, a higher global cost of capital is likely to
take the shine off Latin equities. Antoine van Agtmael,
chairman of Emerging Markets Management, which oversees up to
$14 billion of stocks globally, says: In the short term,
I see higher interest rates and less global growth than the
market currently assumes, and this will be negative for
emerging market stocks.
According to Citigroup, the MSCI Latin America index trades
around 17 times over the reported earnings of its companies,
more than the 13.7 monthly average of the past decade. Agtmael
argues that Latin equities are, in general, fully valued
that is, valuations are unlikely to rise further but are
not in bubble territory. This is due to the strong outlook for
corporate earnings that will boost investor returns on
But the rally in Latin American credit and equity may still
continue even if developed world interest rates shoot up, not
least thanks to the interest rate differential.
Will Landers, senior portfolio manager at BlackRock, notes
that Latin American current accounts are likely to deteriorate
as consumption rises, fuelled by cheap capital and the carry
trade. As a result, the regions central banks will be
among the first to tighten interest rates in the face of
inflationary pressures. Attempts to moderate currency
appreciation through sterilization, together with rising
interest rates, will lead to further capital flows and
exchange rate pressures, says Landers.
HEDGE YOUR BETS
The best hedge against global interest rate hikes could be
the local currency debt market, says Eduardo Câmara
Lopes, CEO of Ashmore Brasil.
For example, local currency bonds on the JP Morgan GBI EM
Global Diversified Index offer a yield over 7% with
exposure to appreciating currencies and higher local
interest rates, says Lopes.
Mohamed El-Erian, CEO at PIMCO, the global bond fund, notes
that Latin local currency bonds offer equity-like returns,
without equity risk. Latin American currencies tend to be
more flexible, so investors capture the repricing of credit
risk and currency appreciation, he says.
Meanwhile, fiscal stimulus measures and election-driven
spending in Brazil, Mexico and Peru will boost the industrial,
consumer and construction sectors. The region should grow 4.6%
in 2010, according to Credit Suisse. That compares with 2%
growth in the euro zone.
Latin stocks and bonds offer extra yield and exposure to
firms in a promising stage of the economic cycle compared with
the debt-ridden West. For example, ING estimates US bonds trade
200bp tighter than emerging market corporates while single-A
rated US firms are 58bp tighter than emerging market
sovereigns. This could attract new investor money in search of
yield, while Latin sovereigns and corporate creditworthiness
have greater upside.
But herein lies the problem, warns El-Erian. The
problem is capital tends to overwhelm emerging markets very
quickly, especially the most liquid asset classes. From a
tactical perspective, this may not be a great time to
accelerate exposure to big secular trades in emerging markets
as the global economy goes on a bumpy journey.