CAPITAL MARKETS: Throwing caution to the wind

21/03/2010 | Sid Verma

The investment case for Latin America has never looked sounder, but the rally is resting on a knife edge

The global financial crisis has turned the conventional investment proposition for Latin American assets on its head.

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 world assets.

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 $228 billion.

BUBBLE TROUBLE

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 prices.

“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 Investment.

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 155%.

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 prices.

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 create bubbles.”

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 today’s global asset bubbles.

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 Bank’s 1% policy rate.

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 exchanges.

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 country’s 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 the year.

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 0–5% 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 10–15% returns if interest rates are hiked by 0.5%, while corporate default risks have eased. Credit Suisse predicts 14–15% returns for Latin high-yield debt on the back of resilient capital inflows and the economic rebound.

POLICY CONUNDRUM

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 it’s 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 equity.

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 region’s 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.”

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László Andor, European Commissioner responsible for employment