21st July 2016
Jan Dehn, head of Research at Ashmore, and Gustavo Medeiros, FI Portfolio Manager at Ashmore, believe that Latin America offers the best investment proposition of any region in the world. They explain how Latin America offers the cheapest valuations in all of EM, and how recent headwinds are turning into tailwinds; the economic cycle is improving after weathering recent shocks, governance is improving as discredited populists are voted out, and a cyclical upswing is about to take place.
Latin America was more severely impacted by the recent external shocks than any other Emerging Markets (EM) region. The QE program in developed countries triggered a giant global portfolio shift that strongly favoured financial assets in developed countries, while exerting a chilling effect on asset prices and currencies across EM. In addition, there were adverse indirect consequences for EM local markets due to the sharply rising Dollar and falling commodity prices. Latin America’s particular vulnerability stems from its greater dependence on commodities and disproportionately larger reliance on foreign savings and portfolio flows.
To add insult to injury, a number of Latin American countries had gradually become more populist over the last decade. Hence, when commodity prices dropped and foreign money pulled out there was little to keep them afloat. Even Latin American countries with good policies, which is the majority, in fact, were adversely impacted by the general bearish sentiment towards the region.
Sentiment is now changing. Today Latin America offers the best investment proposition of any region in the world. The case for investing in Latin America rests on the region’s resilience during the recent headwinds, the nascent cyclical upswing, a more benign external environment and genuinely attractive valuations of asset prices. Latin America is today the cheapest market in all of EM. This opportunity, however, will not last forever. Investors should allocate now in order not to miss this once-in-a-decade opportunity.
Cyclical downturns and institutional resilience
Despite the plethora of headwinds, Latin America’s fundamentals in the end proved far more resilient than anyone had expected. The evidence of resilience is particularly evident in three areas, namely the economic cycle, default rates and institutions.
Cyclical downturns were unavoidable. Widespread capital flight caused tightening of financial conditions locally. Large currency moves also forced resources to move across sectors. However, Latin America’s sizeable economic buffers ensured that these cyclical downturns did not morph into major structural malaise. Pass-through inflation from weaker currencies was relatively well contained without major damage to long-term inflation expectations in most countries. Eventually the weaker currencies and softer domestic demand began to help restore external competitiveness. Low starting levels of government and private sector debt helped limit the damage as did sizeable stocks of FX reserves and healthy banking systems. Some Latin American economies suffered quite severe recessions, but flexible credit lines with the IMF did not even have to be activated.
Latin America’s institutions generally held up well in the face of a considerable populist onslaught. Democracy survived, even in the most extremely mismanaged economies of Venezuela and Argentina and somewhat less badly managed Brazil. These three countries all saw their central banks become less independent and the free flow of cross-border capital impeded. The quality of fiscal policy deteriorated as government policies also became more interventionist at microeconomic level. But this meant that, as soon as commodity prices dropped, these populist governments came under immediate and intense pressure, which soon translated into political transition and better policies. Brazil and Argentina have already adopted far more orthodox policies, while Peru has also become more orthodox. Venezuela may yet follow suit.
It is important to recognise, however, that the descent into populism was far from uniform across Latin America. Most of Central America as well as Chile, Mexico and Uruguay stayed entirely committed to open markets, inflation targeting and sensible fiscal policies.2 Peru, Colombia and Panama launched major infrastructure investment programmes. Mexico and Colombia pursued serious economic reforms, including constitutional change.
The investment case for Latin America
Having weathered the global shocks without sacrificing the basic pillars of stability, where is Latin America heading today? We think the region offers the most outstanding investment opportunity in EM, possibly in the world. The investment case rests on the following four pillars:
We expect Latin America to deliver the strongest fundamental improvements and the best asset price performance in EM over the next two years. Latin America was hit harder by external shocks in the past few years than other EM regions, but Latin America’s economic and institutional buffers protected the basic economic and political fabric. The economic cycle is now beginning to turn and external drags are fading. Additionally, the policy environment is improving in a number of highly influential countries in the region. As developed economies turn ever more populistic Latin America is heading in the opposite direction. All these factors add up to an attractive investment proposition.