Why the outlook for Latin American stocks is improving
Pablo Riveroll discusses the risks and rewards in Latin American equities, and explains their attractiveness compared to other regions.
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Latin American equities have made a strong start to 2019, with the MSCI Latin America Index returning 13.1% year-to-date in US dollar terms, as at 26 February.
It follows a disappointing 2018, which saw the index retreat 6.5% in US dollar terms, weighed down by double digit declines in Chile, Colombia and Mexico. In Chile and Colombia, negative returns were primarily linked to commodity price weakness. Meanwhile policy concerns weighed on the performance of Mexican assets with the election of a new president and left leaning government. These effects were not offset by Brazil, where the market was marginally lower, as uncertainty in advance of elections stymied the economic recovery and weighed on the currency.
Argentina is not currently included in the MSCI Latin America Index; it is due to re-enter in June of this year. 2018 was nonetheless a torrid year for Argentine equities and the peso, which fell sharply as the government’s gradualist approach to economic adjustment was derailed by US dollar strength and the prospect of higher US interest rates. The country subsequently agreed an International Monetary Fund support package, including a $50 billion loan with a further discretionary credit line of $7 billion.
Nevertheless, when compared to wider emerging markets (EM) and developed markets (DM), Latin American stocks held up relatively well in 2018. The MSCI Emerging Markets Index declined 14.6% and the MSCI World was down 8.7%.
Why Latin American economies are improving
The outlook for economic growth in Latin America this year is positive, led by a recovery in growth in Brazil, the region’s largest economy. The acceleration in regional growth may be modest, but compares favourably with other regions of the world, where growth is slowing. Historically, an accelerating growth differential vs developed markets has supported the relative outperformance of Latin stocks, as highlighted in the chart below.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Brazil is expected to lead the acceleration in activity this year, with GDP growth forecast to rise to 2.5%, up from an estimated 1.3% in 2018. Following the election of Jair Bolsonaro, uncertainty over the policy outlook has eased and liberal economic management should boost confidence. The new government’s plans include the privatisation of some state companies, in addition to other business friendly reforms. Accommodative monetary policy should also help support credit growth and the slack in the economy (low capacity utilisation and high unemployment) should keep inflation low.
Argentina’s economy is estimated to have shrunk by 2.6% in 2018. This year, the pace of contraction is forecast to ease to 1.6%. Tight monetary and fiscal policies will remain in place, given the need to remain compliant with IMF conditions. However, the economy should gradually pick up from Q2, supported by a recovery in agricultural output and as inflation eases, spurring some recovery in real wages. Stronger growth in Brazil should also be beneficial. The extent and sustainability of Argentina’s economic recovery is likely predicated on how the political outlook evolves, ahead of general elections in October.
In Colombia, GDP growth is set to accelerate to 3.6% this year, up from an estimated 2.8% in 2018. This should be underpinned by investment which continues to gather momentum following the election of Ivan Duque last May. Private consumption is also expected to be supportive and corporate profits should be helped by the recent fiscal reform.
In Peru and Chile, 2019 GDP growth is projected to be 4.1% and 3.4% respectively, relative to the 4.1% and 4.0% estimated for last year. External weakness, linked to global trade uncertainty, accounts for some moderation in Chile, but growth should remain at healthy levels for both economies.
Mexico is expected to post GDP growth of 2.1% this year. This is in line with the figure estimated for 2018, but there is a risk of downside to this year’s forecast. Despite signs of a more rational approach post July’s election, there are rising concerns that President Andrés Manuel López Obrador (AMLO) and his MORENA party have changed tack. The cancellation of the Norman Foster-designed new Mexico City airport, following a controversial public consultation, is emblematic of these worries. Consequently, business confidence has deteriorated, with negative implications for private investment. This may be partially offset by greater consumption, helped by government transfers under AMLO’s planned social programmes.
The outlook for interest rates
With the notable exception of Argentina, inflation remains low and is controlled across much of the region, and the outlook for this year remains benign. In Mexico, inflation is slightly ahead of the central bank’s 2-4% target range, but this should ease by the end of the year. For a number of countries in the region, monetary policy is likely to remain accommodative and actions this year are therefore likely to be biased towards a slow normalisation.
Brazil’s central bank maintains a key policy rate of 6.5% - one of the lowest on record. This supportive stance is likely to extend through 2019, aiding the economic recovery. Brazil has not had a sustained period of low inflation and low interest rates in its modern history, so the current environment is ideal for businesses to fund long-term investments.
Chile’s central bank began to normalise its policy rate in October and in January it continued this process, hiking rates by 25bps to 3%. Despite some moderation in economic growth, this is expected to sustain above potential, which should support further rises to 3.5% by the end of the year.
Peru is likely to begin an interest rate hiking cycle this year, with three 25bps rises expected to take its headline policy rate to 3.5%. As growth picks up, Colombia’s central bank may also move to tighten monetary policy. It currently maintains interest rates at 4.25% but two 25bps rate rises are anticipated later in the year, which would take the headline rate to 4.75%.
By contrast, policy in Mexico has been tightening since late 2016 and headline rates are among the highest in the region at 8.25%. Despite a decline in inflation last year, monetary policy has remained tight given upside risks to inflation stemming from macroeconomic uncertainty. The chance of further rate rises this year has diminished given the recent peso strength.
Controlling inflation remains a significant challenge in Argentina. Last year inflation rose to 47.1%, with the acceleration driven primarily by the sell-off in the peso. As part of the agreement with the IMF, the central bank took measures to tighten monetary policy more meaningfully, including material interest rate hikes; the policy rate peaked at just over 70%. This has helped to stabilise the currency and interest rates are receding, most recently to 46%. We expect inflation to moderate to below 30% this year, with stabilisation in the currency quelling the pass-through inflation felt from peso depreciation. The central bank’s policy to intervene if the peso moves outside of its defined trading band should also help.
Fiscal consolidation to continue
For the broader region, further consolidation of public finances is expected this year, with the exception of Mexico which is aiming for another year of a primary surplus (excluding interest payments).
The contraction is likely to be led by Argentina where under the terms of the IMF programme the government is targeting a primary deficit of 0%. It follows a better-than-expected fiscal performance last year which saw the primary deficit narrow - the overspend stood at just 2.4% of GDP.
In Brazil, putting the fiscal accounts on to a more sustainable path is a key priority for the Bolsonaro administration and will be closely watched by investors. The primary fiscal deficit fell to 1.6% in 2018. For 2019, privatisations and concessions should provide one-off additions to public revenues. However, medium-term stability is centred on social security reform, the outlook for which is uncertain. The president has presented a comprehensive fiscal reform proposal which is likely take longer to pass in congress than using his predecessor Michel Temer’s version. The new plan is ambitious and would result in a greater saving than under the Temer proposal, allowing room for some dilution in negotiations. But it likely means a delay in the legislation of at least six months.
Colombia has made progress in reducing its fiscal deficit, which is estimated to have eased to 3.1% in 2018. However, revenue shortfalls have maintained pressure on the government to reduce spending and the target of a 2.4% deficit for 2019 may be harder to achieve. Corporate tax reforms were passed in December, but only after the measures were watered down, with the removal of tax unification and VAT simplification. Consequently, the legislation raises just over half of the targeted figure. In Chile, the fiscal deficit is projected to have narrowed to 1.7% in 2018 from 2.7% in 2017. Further consolidation is forecast for this year, albeit modest. Peru’s fiscal deficit has expanded in recent years as the government provided support to the economy. This is expected to peak at 2.7% this year, before the government passes measures to reduce the deficit to 1% of GDP by 2020.
In Mexico, there is a risk that the more orthodox fiscal management under previous governments is undone by the AMLO administration. Nonetheless, the government has reiterated its commitment to a 1% primary surplus in the 2019 budget. However, campaign commitments to deliver higher social and infrastructure spending, the costs to cancel the new Mexico City airport, and the need to support Pemex, the sate-owned oil company, have raised doubts over the feasibility of current plans.
External outlook
From an external accounts perspective, the region as a whole has a current account deficit, although this has meaningfully narrowed. Financing needs for the region as a whole are only modest but understanding the dynamic at a country level is important.
In Argentina, the measures adopted under the IMF agreement should help to facilitate further reduction in the current account deficit, which is forecast to fall below 2%, helped by a sharp contraction in imports and a more competitive exporting sector. The outlook for Mexico and Brazil is reasonable. Both countries run small current account deficits, even after accounting for some expected widening this year. In Brazil, expectations for a pick-up in foreign direct investment (FDI) flows should be supportive, balancing the impact of stronger growth, which may boost demand for imports and push the current account deficit modestly higher. In Mexico, expectations are for only a modest widening in the current account deficit to around 2% of GDP, with remittance flows and high local interest rates likely to continue to provide support. Recent signs of a deceleration in FDI bears monitoring, given the deterioration in the policy outlook.
In Chile, Peru and Colombia, the current account deficits are funded by FDI flows. Peru and Chile may see some widening in the current account deficit this year.
The improving outlook for economic growth is being reflected in expectations for higher corporate profits growth. However, despite the more attractive outlook, aggregate valuations do not appear to be stretched.
The table below provides a snapshot of forward price-to-earnings (P/E)[1] and forward price-to-earnings growth (PE/G)[2] ratios for Latin American equity markets, as well as for the region as a whole, EM and DM.
For the region as a whole, based on the MSCI EM Latin America Index, the P/E multiple shows a discount of close to 11% to developed markets, as measured by the MSCI World Index. Relative to the MSCI Emerging Markets Index, Latin American equities trade at a 14.5% premium. However, adjusted for earnings growth, the PE/G ratio suggests that Latin American equities are undervalued when compared to both EM and DM.
Within Latin America, Argentina and Colombia stand out as relatively undervalued markets on a P/E basis. By comparison, Chile, Peru and Mexico look to be relatively expensive. In Mexico, this is despite some de-rating over the past year, which means the market trades close to the bottom of its historical valuation range. Brazil too is relatively expensive on a P/E basis, particularly when considered in relation to its long-term average multiple.
Focusing on PE/G ratios, valuations in Brazil appear more reasonable, adjusting for forecast earnings growth of 17.9% this year, the strongest in the region. On this measure, valuations in Colombia and Mexico also appear attractive. However, in our view, earnings growth expectations in Mexico may see further downward revisions while the outlook in Colombia is also less certain given the slow pace to economic recovery.
The key risks
Politics
Argentina will hold presidential elections on 27 October. In addition, half of the seats in congress and a third of the seats in the senate are also up for election, while 22 provincial/city elections will also be held. The official presidential candidates are yet to be confirmed but it is likely that President Macri will stand for re-election. The outcome of the vote will define the outlook for government policy and economic management for the next four years, with significant implications for financial markets. Provided that the economic recovery is on track, it is likely that President Macri is re-elected. But uncertainty remains and Q2 activity data will be closely monitored, given expectations for the economy to exit recession. External factors remain a risk, and much uncertainty remains. From an election perspective, the key dates are 22 June, the deadline for candidate registration, and 11 August when primaries take place. The latter should be a litmus test as to the scale of support behind each candidate.
In Brazil and Mexico, the focus is on the government’s capability to execute policy. In Brazil, President Jair Bolsonaro has so far made orthodox ministerial appointments, and the respected Chicago trained economist Paulo Guedes is his finance minister. The degree of cohesion in his ministerial team will be an important aspect in delivering on his campaign promises. The key test will be whether he can deliver social security reform that is sufficient to put public finances on a more sustainable path. At the same time, he is also seeking to slim the size of the government. These reforms will require the support of other parties, and the president’s relationship with congress bears monitoring, given that his party does not have a majority.
By contrast, President AMLO’s MORENA party has a majority in both congress and the senate. This should aid passage of legislative change. However, a series of unconventional public consultations, together with congressional proposals, has served to alarm financial markets. The president has sought to alleviate uncertainty by affirming previous policy to target a budget surplus this year. Nonetheless, significant uncertainty within the business community remains. If confidence in the government’s policies is not restored, there is a risk of a further drop in private investment. The government’s capacity to meet its fiscal target will also be scrutinised, particularly in light of its commitment to large spending increases through social programmes, the airport cancellation costs and Pemex’s financial difficulties.
A stronger US dollar
The extent of US dollar strength and Federal Reserve interest rate hikes will be fundamental for appetite for investor risk appetite in general, including in Latin America.
We expect the US dollar to depreciate in 2019, led by a closing growth differential to Europe and a pause or slowdown in the pace of US monetary tightening. The US dollar impacts financial conditions in emerging markets and dollar depreciation is highly correlated with the fortunes of EM equities - it typically benefits local currencies and yields while easing pressure on EM central banks. One caveat is that US growth is expected to continue to slow into 2020 and if it slows more rapidly than expected and the Fed response lags, then global growth concerns may be a more dominant driver of EM performance.
Trade
The ramifications of US-China trade tensions have put downward pressure on commodity prices in the past 12 months. Deceleration in domestic growth in China may further undermine spot prices. Latin American exporters most at risk include Chile, Peru and Brazil.
For Mexico, commodities exports, notably to China, account for a relatively small share of total exports. Manufactured goods are far more important. Indeed, exports to the US represent over 70% of total exports, meaning that US demand has an significant bearing on economic growth in Mexico. The path to the official ratification of the US-Mexico-Canada Agreement, which replaces NAFTA, will also be closely followed by investors, as will the extent of economic slowdown in the US.
Healthy economic growth and attractive valuations – but being active is important
We have started 2019 with a clear economic recovery underway in Brazil, and with early signs of a recovery in Argentina. Valuations in Argentina are close to multi-year lows.
For Colombia, Peru, Chile, and to a lesser extent Mexico, economic growth looks set to remain at healthy levels and while valuations for the markets as a whole are not cheap, we continue to identify attractive stock opportunities for investors.
Longer term, the case for investing in Latin America remains strong, supported by a growing middle class, relatively low labour costs and rich natural resources.
Maintaining an active approach to investment will in our view be key to navigating these opportunities. This is particularly important in Latin America, where one can take advantage of countries being at different points in their economics cycles – through time correlation between country equity returns has been historically low.
Pablo Riveroll is Head of Latin American equities within the Schroders Emerging Markets strategic capability. Read more of our Emerging Markets insights
Developing markets generally carry greater political, legal, counterparty and operational risk. Investing in a concentred geographical region, may result in large changes to the value of investments.
The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue.
[1] The forward price-to-earnings ratio is derived by dividing an equity market’s value or price by the total expected earnings per share of all the companies over the next 12 months. A low number represents better value.
[2] The price-to-earnings growth ratio is calculated to take account of each market’s growth prospects. A reading below 1 is typically indicative of an undervalued market.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.
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