Up 60% This Year, Should You Invest In Peru?

| About: iShares MSCI (EPU)

Summary

Up 60% This Year Should You Invest In Peru.

Government spending is boosting the local economy.

External trade has enormous potential.

This is the first in a series of articles that takes a very fundamental macroeconomic sectoral flow analysis of the economies of key countries across the globe to see if the local stock market is worth investing in via electronically traded funds ((ETFs)). These are commonly available to all investors even though not resident or normally able to trade on the stock market of that country.

Details of the methodology employed to analyze these opportunities is located in the sectoral analysis section later in this article.

Which Countries are Doing Well?

The first port of call is the ETF page at Seeking Alpha (SA) and a look at country ETFs and how they are performing.

One notices from the list:

  1. Latin American countries head the list, what are they doing right?
  2. No European countries head the list?
  3. Only three "developed" countries are near the top of the list being New Zealand, Canada and Australia, what do they have in common?
  4. The U.S.A is green and showing promise, though far down the list. Why?
  5. Mexico, a Latin American country, is near the bottom, why? What is it doing wrong?

All these questions are more will be addressed in forthcoming articles.

Most countries on the list are performing in the red and are of no further interest, though we could learn from them what to avoid, as could their governments and politicians, but as investors, we will leave that to them.

The iShares MSCI All Peru Capped ETF (NYSEARCA:EPU) is the first fund on the list, after a very good year is it still a buy?

PERU

Government Sector

Peru is at the top of the SA ETF list, and Fitch provides a snapshot of Peru's current fiscal situation:

"Peru's fiscal deficit will widen over the coming year, as President Pedro Pablo Kuczynski pursues an economic agenda centred on public infrastructure investment and tax reductions. We expect Kuczynski's forthcoming budget to reflect his campaign's expansionary fiscal policy platform, calling for a series of tax adjustments and debt-financed investment. While he will face resistance from the more fiscally conservative Fuerza Popular (FP), which dominates the legislature, key elements of his agenda, particularly infrastructure investment, are likely to advance in the coming months."
Source: Fitch

The Peruvian Government is net spending into the Peruvian private sector at present. Net spending is labeled as a deficit; it is however very good for the private sector as it leads to expansion, and even better if the spending on durable assets such as the education and health of the workforce, roads, bridges, and airports, etc.

The Peruvian government does promise future contractionary surplus budgets but is for now running a government budget deficit. Given that the mainstream political agenda is so against government spending it takes a strong political will, majority and conviction to start it and to keep it going into the long term, Peru does not have that.

The Peru ETF has lost ground recently no doubt due to opposition to the government spending programs from the fiscally conservative FP party who believe that draining money out of the economy will help it grow as will not building infrastructure.

The fact that the legislature is dominated by a fiscally conservative political party is not good and shows that government spending will not have an easy path and could well be reversed into austerity which is in trend at present across the world.

External Sector

As the charts show, further headwind comes from the external sector which is draining money out of the private sector, and any compensating government expenditure has to be significant to both make good this loss and also expand the economy.

History shows that Peru has had a healthy and positive balance of trade adding valuable income to its private sector which then finds expression in a rising local stock market.

Over the last few years and into At present Peru has a negative balance of trade and so no great help for the private sector can be expected from this quarter, though the potential for income is enormous in boom times.

The next section explains the logic behind this analysis.

Sectoral Analysis Methodology

Each nation state is composed of three essential components and these are:

  1. The private sector
  2. The government sector
  3. The external sector

The private sector contains the people, business and community and for us most importantly the stock market. For the stock market to move upwards, this sector needs to be growing. This sector by itself is an engine for growth and innovation however only it needs income from one or both of the other two sectors to grow.

The government sector contains naturally the government with its judicial, legislative and regulatory power. Key for the stock market is that this sector can be both a source of funds for the private sector through spending and also drain funds through taxes. The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange.

The external sector is trade with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.

For the stock market in the private sector to prosper and keep moving upwards income is required to be put into the flow. Otherwise, the sector can only circulate existing funds or is being drained of funds and is in decline.

The ideal situation is that the private sector has a net inflow of funds and is constantly growing thus giving the stock market headroom within which to expand in value. For this to happen one or both of the other sectors has to be adding funds to the circular flow of income.

This relationship can be expressed by the following formula:

Private Sector = Government Sector + External Sector

This can be further broken down as follows:

(Savings-Investment) = (Government Spending-Taxes) + (Imports-Exports)

In English we could say that:

The private financial balance equals the sum of the government financial balance plus the current account balance.

We can re-write Expression in this way to get the sectoral balances equation:

(S - I) = (G - T) + CAD (current account balance)

which is interpreted as meaning that government sector deficits (G - T > 0) and current account surpluses (CAD > 0) generate national income and net financial assets for the private domestic sector.

Conversely, government surpluses (G - T < 0) and current account deficits (CAD < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.

In summary, our interpretation of the sectoral financial balances is as follows:

  1. (S - I) is the private domestic financial balance of the private domestic sector. If it is in surplus, then that sector is lending funds to the other sectors. If it is in deficit, then the private domestic sector is borrowing from the other sectors or running down its net financial position in other ways (such as liquidating past wealth accumulation).
  2. (G - T) is the government sector financial balance. If it is in surplus, then the government sector is spending less than it is taking out of the economy in taxation and undermining the capacity of the two other sectors to accumulate net financial assets and vice verse.
  3. CAD is the external sector financial balance. If it is in deficit, then the national economy is borrowing from abroad or running down its net financial position in other ways and foreigners are accumulating financial asset claims and vice verse.

These are accounting statements. They represent a closed system that sums together. The component responsible for creating the medium of exchange that enables the others to function is the government. The government, to use a physiocrats analogy, can be likened to the bones of the economy, it gives the economy infrastructure bones, and the marrow within the bones provide the lifeblood in the form of the medium of exchange. The marrow must produce enough blood to sustain the economy at full employment. Notice that the medium of exchange is created, not borrowed or earned.

Government $deficit = non-government $surplus (net financial assets)

If government net spending is increasing, then private sector wealth must rise by exactly that amount, and this can be most readily seen in the GDP and stock market of the land in question so long as the external sector is neutral to positive.

With this fundamental accounting fact in mind, one then looks for investing opportunities that fit the search criteria, being countries where the circular flow of income is expanding from government spending and or external income flows from trade.

Recommendation

Peru, despite topping the SA ETF list is not recommended as a buy because both sectors that support the private sector and thus the local stock market cannot be relied upon to provide the necessary income to allow it to continue expanding. The government sector is facing internal headwinds that might lead it to contract the economy by net draining it of financial assets via taxes and government spending cuts while the balance of trade has been weak for many years and is at best neutral to negative at present.

Peru is one to watch when commodities improve and the balance of trade improves and when this happens I will report back on this opportunity.

In my next article, I will examine Brazil to see if it is worth investing in at present from a sectoral analysis perspective.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here