Latin America to Rise From the Ashes of the Credit Debacle

I believe that God favors those who try to help others. When people want to buy, I try to help them out by selling. When people want to sell, I try to help them out by buying.

(Sir John Templeton)

There are various reasons to be upbeat on Latin America’s prospects in the wake of the global credit-induced meltdown. The actual trigger for the current rough ride in Latin markets has virtually nothing to with the Latin economies. The US housing industry is just not relevant except as a source of remittances for some countries in Central America. If anything has relevance it might be the yen carry-trade but even that is mainly reflected in Brazil and scarcely relevant to the other markets including Mexico.

It has been convenient for lazy minds to attribute the robust Latin American markets in recent years to amorphous culprits like “hedge funds” and “the yen carry-trade”. But to base the regions move back to livelier trading upon these factors is to ignore a number of key internal dynamics in the region that have been the real reason for the sound economic performance, the improved finances and commensurately the healthier capital markets. The foreign hedge fund participation and/or carry trade phenomenon has been mere icing on the cake.

The hedge funds may not have been responsible alone for the rise but they had proportionally more to do with the decline. Local investors knowing how flighty the foreigners are, suffer from nervousness in turn and second-guess by dumping everything in the hope of bottom fishing. They are almost all subscribers to the philosophy of Sir John Templeton that we quoted at the start of the note. Its not exactly a bad strategy if they can catch the moment of most despair for the foreigners and relieve them of their holdings 15% down from where they were a week before. This phenomenon has been seen twice in recent weeks. As most domestic investors in the region aren’t leveraged, there is seldom a compulsion to sell, just a strategic withdrawal. The foreigners are the ones with guns against the head.

The powers that be are not particularly concerned. Most leaders or Central Bank heads have kept “stumm”. Luiz Inácio Lula da Silva was quoted in last week’s Economist saying, “Brazil is not afraid of this crisis”. It is, he insists, “an eminently American crisis” caused by people trying to make a lot of “third-class money”. And Nestor Kirchner is on record as being scathing about the effect of hot money. In the latest rout it was locals selling off in a second-guessing of foreign investors who weren’t even in the Argentine market (except in a handful of ADRs).

Looking past the current fluctuations we can see a scenario of a slowing US economy and a slightly more subdued Europe and Asia. Of course, Asian growth rates are a matter all of their own. “Subdued” there may mean 7% growth instead of 12% and the end effect is that robust demand for agricultural and metals products out of the Latin American countries should continue at the current pace. So robust domestic activity helped by relatively benign internal economics will then be overlaid by ongoing export growth at sustained decent (we don’t use the word “high” for current values) commodity prices. There is still inequity, inefficiency and relatively primitive capital markets with low levels of middle class participation however the next ten years look better than the last ten years.

The keys to improved Latin American perspectives have been:

The commodity reflation

More disciplined fiscal policies leading to better debt servicing abilities

Strong reserves giving a cushion against crises

Investors would probably want more assurances than a mere three but the key here is that these are the nub of previous dilemmas in the region. With these solved (or at least in good health) a lot of other good things start to happen. A virtuous circle starts to take effect after so many stalled attempts.

The Commodity Reflation

We are now five years into the reflation in basic commodities. It gives a certain schadenfreude to note that the commodity reflation has brought so much benefit to Latin America after it was treated as essentially a cheap quarry from the end of the 1970s until the new century. It is useful to note that commodities (particularly base metals) are not even back to their late 1960s purchasing power by a long way. Ironically back in those days, whatever significant extraction was going on in the region was happening under the aegis of multinational miners, mainly based in the US. The circle has turned and now the US is a mere taker for the products (though in a distinct second place to China) and the mining assets are almost exclusively OUT of the US control.

Disciplined policies

The commodities supercycle might be termed an embarrassment of riches if there weren’t so many underfunded and neglected causes requiring government attention across the region. Despite the superfluity of export revenues, it only goes part of the way towards getting infrastructure and social conditions into desirable shape. This naturally puts the pressure on the government to pass along some of the benefits. After the many traumas of the last fifteen (or should that read 50?) years the temptation to recycle surpluses into the economy is very strong. The tendency is largely being resisted, except in the case of Venezuela, which can be good and bad. In Chile for instance the parsimoniousness is totally inexplicable due to the Goldilocks-like economic scene it has enjoyed for so long. As we recently wrote elsewhere Peru is potentially playing with political fire by not having more trickle-down from its commodity bonanza. In Argentina the government is only just starting to loosen the purse strings (ahead of October’s Presidential election) with pay hikes for teachers and benefit boosts for pensioners. Finding the right balance is the key. The existence of fiscal surpluses (and strong reserves) has as much psychological effect as real. This is particularly manifested in debt issuance and restructuring. The absence of deficits allows debt reduction or at least a stay on new issuance for anything other than roll-overs, this feeds back into a certain hunger amongst banks for paper, lower yields are a corollary and a virtuous debt circle comes into existence. This has been evident in recent years in most LatAm issuers.

The big step is to then be able to issue paper in local currencies and eschew the treacherous waters of international exchange ebb and flow. Even Argentina has been able to start issuing in local currency. We would note that a key to this development, beyond improved fiscal discipline, has been the evolution of domestic pension funds that make a captive market for local issuances with long maturities. Improved trade and current account balances mean that debt issuance is going primarily towards domestic uses rather than funding of the current account deficits (a common flaw in the 1990’s scheme of things). This trend could eventually result in the shift over from non-domestically denominated debt to a profile largely in foreign currencies that can then decouple from international crises. It is interesting to note that while Latin equity markets got buffeted by the subprime credit crisis it was widely conceded that it had little or no relevance to the region. The Financial Times even went so far as to speak of a flight to quality INTO emerging market debt as a possible outcome from the whole schemozzle. Flattering indeed…

Bulging Reserves

As Argentina showed in 2001, having decent reserves is no protection is other things are awry (and if policymakers refuse to pull levers at their disposal). However, the commodity reflation has interacted with sound fiscal and exchange rate policies (mostly) to lead to a burgeoning in the reserve cushion across the region. Amongst notable reserve holders are of course, Brazil, but Venezuela, Chile, Argentina and Peru are all healthily padded in their Central Banks at this time. Rumour also has it that they are getting smarter in the management of these reserves. They do not want to be the last ones left holding the dollar as it goes down. Frankly we think more could be done to diversify away form the US currency at this point. That of course runs foul of some of the more folksy political and Central Bank figures of the region who count dollars in their dreams.

While hefty reserves are desirable in a crisis the extra heft they have acquired in recent years has given governments more room to manoeuvre. The best examples are in Argentina where the IMF was finally sent packing with a total payoff that shocked the global financial community. It’s akin to the junkies running the biggest pusher off the block. Then the recent decision to pay down a partial line of maturing Bodens using reserves shows that the government didn’t have to tap the credit markets in a week of extreme fluctuations. Bankers were miffed that they didn’t get their pound of flesh at higher rates, but they shall just have to get used to the new reality.

Amounts are now reaching a critical mass that could hold out against the worst imagined scenarios. The key to preserving the stash is exchange rate policy. This has not been so well played in places like Venezuela and Argentina. Venezuela has recently acted to close the exchange rate gap that was encouraging capital flight and creating multiple distortions across the economy. Argentina though is stuck with the Kirchner “babushka” school of economic thinking where an artificially low currency allows him to stash away dollars for a rainy day. He fails to realize that the distortions of the low currency make the onset of the rainy day even more imminent.

However, having bulky reserves is never a bad thing. As yet they are not at the levels that governments are tempted to do dumb things. As they continue to grow on the back of the commodity/fiscal interplay then wider horizons on financing start to open up as we mentioned when discussing evolving debt issuance trends.

Portfolio review

Our last major portfolio overhaul was in late July (on the eve of the market meltdown). This seems like an eternity ago in light of the events in the markets since then but the number of changes we would make in light of this is actually quite few. In any case, we have also made some published twiddling of the knob in the interim in a variety of names, these being:

Gol Airlines (GOL): closed 22nd of July

TAM (TAM): added a Long position on XXX

Crystallex (KRY): closed June 15th

Aurelian (ARU.to): opened a Long position on 25th of May

Gold Hawk Resources (CGK.v): opened a Long position on 22nd of July

Northern Peru Copper (NPUCF.PK): opened a Long position on August

We take this opportunity to take the following actions:

Banco de Galicia [GGAL]: We are dropping this leading Argentine bank. It is still labouring after all these years under the weight of the problem loans and the enforced pesoisation of 2001/2. While the market has recovered well, nimbler new banks (created out of older competitors owned by foreigners or the State) have stolen market share from the slow moving Galicia.

Banco Patagonia [BPAT.ba]: We are adding this newly listed Argentine bank to the portfolio. This bank was created out of the ruins of several other banks (most notably Banco Sudmaeris, Banco de Rio Negro and Lloyds Argentine branch network) by the enterprising Stuart-Milne brothers that owned the investment bank Banco Mildesa. It debuted in Sao Paulo with much fanfare back in late July, just in time for the market slump.

Capex [CPS.ba]: This stock now stands at over $17 with a 12 mth low of around $4. This is quite a stellar rise considering how tough the markets have been. Investors have clearly taken a shine to it. We would prefer to take profits on the name at the current time.

Petrobras Participaciones (PZE): This stock is off more than 25% from its year highs. It still represents the biggest oil and gas producing assets in Argentina after Repsol’s collection. The shedding of various utilities may have been a tad too early (valuation-wise) but has simplified the group and got rid of some non-performing distractions.

Cosan (CZZ): This Brazilian sugar/ethanol giant got off to just about the worst start anyone could hope for by launching on the day of the worst stock move on the 16th of August. The stock plunged and this only provides us with a better buying opportunity than the original IPO afforded. Cosan bills itself as the largest grower and processor of sugar cane in the world, generating a compound annual growth rate of nearly 16% in its crushed sugarcane volume. Its ethanol business has been growing at about the same rate. Sugar prices (shown below) have been falling in international markets due to supposed excess production but this will just have to be plowed back into more ethanol production instead of placed in sugar markets for disposal.

Ipiranga: This was one of our star calls. A takeover for the company was announced within weeks of initiating the new portfolio back in March.

Oi [TMAR5.sa]: A bid was announced for Oi and it is leaving the market. We feel rather pleased to have picked two of the biggest takeovers in Brazil this year for our model portfolio.

Vivo (VIV): To replace Oi, we have resolved to add a position in Vivo Participacoes S.A, a Brazilian telephony group controlled by the group Portugal Telecom and Telefónica de España. The company covers 86% of Brazil by geography, including all major population centers. They bought out our previous pick TMAR5.sa for R$1.2Bn as part of their aggressive growth strategy. As we did so well on Oi, this move is a logical step forward for our portfolio. We expect the Brazilian cellular phone business to turn into a veritable cash geyser in the years to come. Already VIV has added 300,000 GSM cellular services to its client list of 35 million subscribers and a 33% national market share:

Norwood Resources [NRS.v]: Closing our Long position. The company was drilling a prospective area west of Nicaragua's capital city, Managua. Seismics seemed to indicate substantial reserves of crude. However, the drill program discovered minimal amounts of crude oil and seawater. The drills were capped and Norwood declared the prospect non-viable. This was a great disappointment and good reason to leave this situation to its fate.

Mercado Libre (MELI): We are adding a SHORT position in this stock. This internet auction house made a stir in recent weeks. The debut P/E of 190 times is rich by any standards and holds out little prospect of dramatic improvement. The bulls hold out the hope of eBay (EBAY) buying up the 82% they don’t own. Why would they do that when they could have moved pre-IPO to bring the whole thing in-house. Of course, if it tumbles 50% they may be tempted but then again why hang around as a Long for a takeover 50% lower!? The true nightmare scenario is that eBay go after the market independently after selling down their stake (which is currently in a lock-up). In this scenario MELI is not worth a brass razoo..

Conclusion

We may have been hypercritical of investment styles in the region in the 1990s but at least there was less in those days of the ramp and dump tendencies that Brazil (and Mexico to a lesser extent) has seen in the last two years. While the local investors go accumulating stock either in their personal or pension fund guises, the interlopers have tended to be global hedge funds with little affinity for the region. Their prime investment criteria is liquidity, thus the most liquid stocks have been firstly beneficiaries and then victims of the vaivenes of the trading desk of the likes of SAC Capital. As we have often noted when talking about the various attacks on the new paradigm in base metals in recent years, the non-believers keep coming in to short (or at least sell) off these commodities and end up suffering perpetual attrition until they have no more wherewithal to play the game. The same is now true of Latin America. Those who wish to see it only as some sort of appendage to the US economy have got it severely wrong. Thus by inference if they tie their investment flows to this fallacy they shall again be proven wrong. Latin America has it way of “taking candy from babies”. Investors shall have to grow up in their view of the region or they will be left wailing by the roadside. The next year to eighteen months will be the period in which Latin America gets to shrug off some crucial old preconceptions and hit the high road. A “flight to quality” with Latin markets as the destination may not be the oxymoron it seems.