Latin America: A Bet On China's Rise

| About: iShares Latin (ILF)

By Samuel Lee

Latin American stocks are an indirect bet on China's infrastructure boom. Let me explain: China's mandarins pumped credit into China's economy during the financial crisis to ward off the effects of collapsing global demand. Latin America's commodity exporters have reaped the fruits of the resulting construction boom, tying the region's fortunes to China's fiscal and monetary policy via commodity prices. The correlations are telling. In the two decades before 2007, the S&P Latin America 40 Index's rolling three-year correlation to commodity prices, proxied by the Goldman Sachs Commodity Index, rarely rose above 0.30. Rolling correlations have since shot up to 0.80.

Granted, rising commodity prices have helped set off a virtuous cycle of credit expansion and asset appreciation, lending internal momentum to the region's growth. Despite it, Latin America hasn't decoupled from the West's woes. Witness how the region's equity markets have cratered during the eurozone crisis. If anything, Brazilian stocks behave like turbocharged exposure to world markets in part, thanks to a vibrant carry trade (in addition to the Chinese export link we mentioned). Even after recent cuts in Brazil's benchmark SELIC interest rate to under 10%, Brazilian bonds are among the highest yielding in the world. The high rates have attracted a lot of foreign capital from low-yielding markets, elevating the real to one of the priciest currencies on a purchasing-power parity basis. Dents to Brazil's economic outlook will hurt equities and spur further rate cuts, which in turn will hurt the real and wallop equities again.

Beyond these considerations, Latin America seems attractive because fundamental reforms that have led to macroeconomic stability and relatively stable public debt. However, an investment thesis can't rest on a simplistic narrative that a rampant growth will take equity investors on a ride to the stratosphere. History suggests high growth may be a curse for investors.

Driving Factors
The bull case for Latin America rests on several trends pointing to strong future growth for the region. First is China's rise. The expectation is that the hundreds of millions of Chinese entering the middle class will continue to vacuum up the world's scarce natural resources, providing a windfall for commodity-exporting countries like Brazil. The second is improved economic management. Investors expect Latin America's public debt ratios to fall and its central banks to maintain and buttress the hard-worn credibility they've earned. The market hopes Latin America will avoid the debt crises and inflation that have wracked it in the past. (There have been at least two in the past few decades.) The third leg rests on demography. Europe, the United States, and even China are on the cusp of a rapid graying, suffering a demographic penalty--a problem compounded by massive welfare promised to the elderly. Latin America, on the other hand, is enjoying a demographic dividend as its young population enters the workforce and accumulates human capital. Finally, many expect pre-sal, or pre-salt, oil deposits to turn Brazil into a major oil exporter. According to The Economist, Brazil's Tupi oil field, reckoned to contain between 5 billion to 8 billion barrels, is the second-largest discovery in two decades; many more may come.

Then again, if you believe in mean reversion, Latin America may give you pause. The S&P Latin America 40 Index returned 21.7% annualized for the period 2001 to 2010, putting it among the decade's best-performing asset classes. This wasn't just a growth story, but one of redemption. In the early 2000s, Latin America was an economic and political basket case. Brazil's exchange rate and stock market had collapsed; the government was broke. The International Monetary Fund had to bail out both Brazil and Argentina within a year of each other. Despite Latin America's steady strides toward fiscal health and well-diversified economic growth, those risks never disappeared. They came to the fore during the financial crisis when the Latin American stock market lost almost 60% in six months. The high returns investors earned in the past were in part compensation for buying a beaten-down, unloved asset class. Latin America looks a lot healthier now, and investors have bid up its equity prices. Don't bank on the region's stock market to repeat its hot run.

We say this despite Latin America's rosy growth prospects. The bulls argue strong economic growth will translate to strong equity returns. But stock performance and GDP growth have been uncorrelated throughout the 20th century. Emerging-markets recent run of fantastic equity returns and economic growth haven't upended this counterintuitive relationship. From 1999 to 2007, GDP growth and stock market performance among 21 emerging markets had a correlation of negative 0.30. Investors do a good job of anticipating and impounding future growth into current prices. In fact, they have tended to pay too dear a price for growth.

Bad debt that has scuppered emerging markets in the past may do so again. Latin America has at least twice in the past few decades defaulted or inflated its way out of them. Bulls point to stable or declining public-debt-to-GDP ratios. But leverage has shifted to the private sector. According to Brazil's central bank, as of the end of September 2011, the household-debt-to-yearly income ratio has doubled to 42% over the past five years. And even if Latin America remains a paragon of fiscal prudence, the region's balance sheets can deteriorate if China's debt-driven infrastructure boom pops and takes down with it commodity prices. Of course, this time may be different. We doubt it.

How to Access the Market?
IShares S&P Latin America 40 Index (NYSEARCA:ILF) is any easy, liquid, and inexpensive fund that provides access to this market. The fund tracks the S&P Latin America 40 Index, a curated collection of 40 stocks domiciled in Brazil, Mexico, Chile, and Peru. Like many S&P indexes, a committee considers a variety of factors when selecting stocks. Investors need not fret much over underrepresentation. The stocks are market-weighted and replicate the sector and country weightings of the Latin American stock market. Many of the companies are among the region's dominant players. For example, America Movil (NYSE:AMX) controls much of the Latin America wireless market and 90% of Mexico's landlines. Vale (NYSE:VALE) is the world's largest iron ore and nickel miner. Our analysts think many of the ETF's holdings have economic moats, by dint of scale or regulatory barriers.

The fund levies a 0.50% expense ratio, a steep charge for a small basket of liquid stocks.

Like almost every iShares ETF, the fund engages in securities lending and returns 65% of the resulting income to the fund's shareholders. In the past fiscal year, ended March 31, 2011, ILF earned enough securities-lending revenue to offset about 7 basis points of the expense ratio. The practice introduces some counterparty and collateral reinvestment risk, but they should be de minimis, provided iShares sticks to conservative industry practices.

SPDR S&P Emerging Latin America (NYSEARCA:GML) covers the same markets as ILF but holds about 3 times as many securities. The added diversification comes at the cost of wider bid-ask spreads.

IShares MSCI Brazil Index (NYSEARCA:EWZ) is another good proxy, despite its single-country exposure. Over half of ILF's portfolio is dedicated to Brazilian equities. EWZ is the biggest Latin American equities ETF, and it levies a 0.59% expense ratio.

Investors can gain similar risk exposure for less through Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO), which charges a 0.20% expense ratio and maintains high secondary-market liquidity. This recommendation may seem odd in light of the MSCI Emerging Market Index's modest 20% weight in Latin America. However, since China's fiscal and monetary policy has been driving emerging-markets returns for the past few years, broad emerging-markets exposure can serve as a plausible, low-cost alternative for the time being.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.