LATIN AMERICA´S TUMBLE PUTS DECOUPLING THESIS TO TEST / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

Latin America’s tumble puts decoupling thesis to test

By John Paul Rathbone, Latin America editor

Published: November 18 2010 18:21

Is it time to revisit the notion that emerging markets have decoupled? Maybe, at least in Latin America.


The old investment rubric used to be that when the US caught a cold, Latin America came down with pneumonia. That the region emerged largely unscathed from the financial crisis shows this no longer holds true – but only because Latin America has coupled itself to China instead, via the continent’s growing commodity and trade links with Asia.


During the past week, for example, it was not a stuttering US economy that sent Latin American markets tumbling.


Rather, it was the prospect of higher Chinese interest rates, combined with eurozone worries, that saw Latin American equities drop for eight straight sessions. Bond yields rose and currencies drooped as investors pulled money out of the region.


Few believe, though, that this marks the start of a bigger Latin American downward shift.


Even if Chinese economic growth slows, world demand for commodities remains strong and extremely loose monetary policy in the US looks set to last.


The International Monetary Fund estimates that Latin America’s $5,000bn economy will grow 6 per cent in 2010, and more than 4 per cent a year until 2015.


“We still think the long-run picture for Latin America looks benign,” says John Lomax, HSBC’s head of global emerging market strategy. “The recent setback was just due to investor repositioning.”


Certainly, the recent correction blew some of the froth off a stellar run. This year, the Chilean, Peruvian and Colombian stock markets have each risen about 40 per cent in dollar terms, and Mexico’s has risen 18 per cent. The only laggard has been the market’s supposed “darling”, Brazil, up just 3 per cent.


Bonds have also rallied and debt issuance ballooned. Corporates have sold a record $40bn of bonds this year, according to Dealogic, and increasingly exotic structures have become common, such as Mexico’s recent $1bn century issue and several offshore bonds denominated in Brazilian reals.


At the same time, rising local interest rates have sucked in footloose international capital, strengthening currencies to levels that threaten the competitiveness of businesses in the region.


Since the start of 2009, the Chilean peso and the real have risen more than 30 per cent against the dollar. Those gains have prompted Brasília to impose a 6 per cent tax on foreign bond buyers. “One of emerging equity investors’ bigger worries is that Brazil extends its bond tax to equities,” says Mr Lomax.


Indeed, reflecting this concern, policymakers in the region fear future asset bubbles far more than a large market shake-out.


On Wednesday, Agustin Carstens, Mexican central bank chief, was the latest to warn of the bubble effects of US quantitative easing. According to the World Bank, capital flows into Latin America are running 15 per cent higher this year than they were in 2007 at the peak of the credit boom.


Such capital flows “carry the risk of undermining long-term growth, through currency overvaluation, or giving rise to financial excesses at home”, says Augusto de la Torre, World Bank chief economist for Latin America and the Caribbean.


If the latest correction takes some of the steam out of the rally, that might even be a good thing. Moreover, the Chinese scare could provide attractive re-entry points for investors. The question, though, is into what and where?


“The problem is that after a good year, nothing looks that cheap,” says Kieran Curtis, emerging markets fund manager at Aviva investors.


Stocks remain above their five-year average on a price-to-earnings basis, according to Capital Economics. But, with the exception of Colombia and Peru, at 27 and 22 times earnings respectively, these are still below previous bull market peaks.


Brazil looks attractive, with the Bovespa trading on 12 times 2010 earnings. However, a bet on the Bovespa is a bet on commodities, given that natural resource groups make up about half the index. Meanwhile, other sectors, such as consumer staples, look richly priced at 17 times. “We prefer Mexico,” says Mr Lomax.


In currencies, “Latin American forex is likely to continue to do well, so long as monetary policy remains so loose in the west”, says Maarten-Jan Bakkum, fund manager at ING Investment Management.


However, the Brazilian real is 32 per cent above its trade-weighted 15-year average, which suggests further gains are unlikely. The Mexican peso, by contrast, is 7 per cent below its long-run average, the Peruvian sol is in line and Chile only 7 per cent above.


“One problem is capital controls, but I think they’re unlikely in Peru, Colombia and Chile, although Brazil could do more,” says Mr Bakkum.


Finally, there is fixed income. Sceptics point out that emerging bonds are trading, in aggregate, at just 250 basis points above US Treasuries, close to their 2007 record low.


Yet low western interest rates make it hard to envisage a sell-off given that, say, investment grade long-dated Mexican peso bonds yield 7.5 per cent.


“The problem for all bond investors is that no one knows what they should take as their benchmark. It may no longer be US Treasuries, although if 10-year yields rise by a percentage point in a week, it makes you reassess your other positions,” says Mr Curtis.


“Still, if the US 10-year settles at where it is now, below 3 per cent, that is probably a buying opportunity.”


Copyright The Financial Times Limited 2010.