By Joseph Hogue CFA
As first quarter data starts to come in on corporate profits and economies, investors may want to reevaluate their positions within emerging markets.
Dark times looming for Buenos Aires?
Volatility in markets dependent on exports looks to remain high, while domestic growth should remain intact. Funds should continue to flow into Latin American currencies and bonds as developed markets offer little in the form of yields. Returns for retailers and other companies servicing domestic or regional demand may do well against commodity exporters as global demand looks to continue its sluggish growth.
It is beginning to look like the Brazilian economy bottomed out in the fourth quarter and may have increased by as much as 1.25% in the first quarter. An aggressive series of rate cuts has brought the benchmark SELIC (Special Clearance and Escrow System) overnight interest rate close to record lows. The government has actively managed the real through market intervention and taxes on foreign funds.
Were the SELIC to be lowered further, investors may be tempted to move money out of bonds and into savings accounts which, by law, must pay a minimum interest rate. There has been talk that the government may change the law to allow for more flexibility in rates. This led banks down strongly last week and may continue to pressure financials over the quarter.
Domestic demand has held up fairly well with manufacturing being the culprit behind weakness. Other than Mexico, which has enjoyed strong industrial production growth due to a rebound in the United States, the one-sided nature of economic growth is a trend throughout much of the region. Retail sales and services have performed well given strong domestic consumers and increasing credit growth, but exports and industrial production have been very weak due to slowing growth in China and Europe.
Retailers and consumer services like TIM Participacoes (NYSE:TSU) and Net Servicos de Comunicacao (NASDAQ:NETC) should do well as the government intervenes to support domestic demand and currency manipulation makes import products relatively expensive.
The Mexican economy has been more balanced than others in the region, benefiting from strong manufacturing growth in the United States. The overall economy probably grew around 4.75% in the first quarter with private consumption growing about 4% on a year-over-year basis.
The labor market is still fairly weak at 4.6% unemployment as net migration to the United States falls to zero. This is keeping consumer pricing pressures subdued even in the face of strong economic growth. Core inflation (3.7%) is just below the central bank's upper range of 4.0% but could increase in the second half due to higher food prices.
Low inflation and a stable economy look to help Mexican banks off fixed-rate home loans next year. The increased access to credit markets, partially funded through peso-denominated mortgage backed securities, could help the country conquer its lack of housing and will help drive asset prices in construction. Cement and concrete distributor, Cemex (NYSE:CX) stands to do well as both the U.S.and Mexican economy pick up over the next year.
I am generally of the opinion that returns to the markets in the relatively stable countries of Latin America are sufficient without having to chase returns from high-risk countries like Venezuela and Argentina. Granted, Venezuelan bonds offer a sizable return and Argentine equities may rebound significantly, giving investors a windfall. For most investors however, the risks far outweigh any possible returns. It is incredibly difficult to forecast the performance of local markets due to the day-to-day whim of politicians and any profits are as much blind luck as anything else.
The government continues to ignore structural problems and is relying on expropriation to keep a positive trade balance. Since bond markets are closed to the country, the government must maintain a surplus in its trade balance. As economic fundamentals look to continue their unfavorable trend, the government will have no other choice than to aggressively 'renegotiate' contracts and trade to maintain the surplus. Inflation remains firmly hyper-inflationary at +20%, though officially reported statistics maintain that it is only around 10%.
Despite the most active rate increases in the region, the central bank has not been able to cool credit growth in excess of 20% per year. This is contributing to retail sales increasing more than 7% on a year-over-year basis and a strong appreciation in the peso. While the central bank may hold rates at 5.25% this week, they are expected to announce some form of currency intervention.
Industrial production has been somewhat weaker, but still relatively healthy around 3%, while inflation seems to have moderated to around 3.4% in March. The country stands to benefit this year from the start of the free trade agreement with the United States, though most exports already had duty-free treatment. The Global X FTSE Colombia 20 (NYSEARCA:GXG) offers one of the few focused funds on the country's market while the Global X Andean 40 (NYSEARCA:AND) offers a diversified exposure across Colombian, Chilean, and Peruvian equities.
Chile, like Brazil, stands to bear the brunt of globally-induced volatility as the country is relatively more dependent on commodity exports. GDP growth may beat expectations slightly in the first quarter with about 5.4% on an annualized basis, but will probably slow to around 4.5% for the year.
Manufacturing output surged by 13.3% in March, but largely due to seasonal factors and widespread vacationing holding down February data. An increase in the unemployment rate in March to 6.6% and a 2.6% reduction in copper production is driving fears of a second half slowdown.
The government has recently buckled to student protests and promised an increase in corporate taxes to offset more spending in education. Also proposed are cuts to personal income taxes and fuel surcharges partially paid for by an increase in taxes on hard alcohol.
The outlook for Latin America for the rest of the year largely depends on your view of economic and political events in China and Europe. The recovery in the United States seems to have built enough momentum that it will continue regardless of external events. GDP growth of around 2.5% means the Federal Reserve will most likely announce some form of additional easing over the next couple of months which should help support commodity prices. The recovery in the U.S., combined with public spending and strong consumer confidence ahead of the Mexican presidential elections, should drive growth in Mexico, though it will still underperform others in the region.
The outlook for China looks incrementally better than current sentiment with GDP growth probably topping 8.5% for the year. The government and monetary authorities are just getting into their stimulus measures after a policy of aggressive restriction last year. Cuts in the reserve requirement as well as possible rate cuts will act to boost emerging markets over the year. This will have a greater effect on Brazil and Chile due to their higher reliance on commodity exports to the country.
The outlook for Europe remains much less optimistic as nearly every election over the last few years has resulted in significant changes in power. These shifts are increasingly starting to bring in those less willing to continue fiscal austerity and yields on sovereign debt are showing investors' growing impatience. French and Greek elections on May 6th will most likely bring regimes less favorable to the status quo and upcoming German elections will be a test of Chancellor Merkel's authority. Odds are good that the situation will get worse into the second and third quarters with headline risk driving volatility in emerging markets. Again, countries like Brazil and Chile, with relatively higher dependence on global markets, will feel the brunt of this volatility.
The unknown for the region is inflation, specifically in food prices. Consumers in the region spend a relatively larger proportion on food than in developed markets, so any rise in grain prices can spike consumer inflation and shake the markets. While prices have eased since the second half of last year, stimulus programs in China, especially those geared to the domestic market, could reignite inflationary expectations. Over the longer-term, grain imports into China and India will certainly keep upward pressure on prices. Investors looking to hedge the risk to emerging markets should carry exposure to agricultural-related companies or within some of the commodity-related ETFs.
Investors may want to take profits in commodity plays after any quick upticks following a Chinese stimulus announcement. Retail and other companies servicing domestic demand should outperform on an absolute and risk-adjusted basis.