Latin passion could set investors' hearts racing

Emerging markets seemingly offer a textbook reflation trade and cheaply rated Latin America in many ways has compelling prospects. Economies in the region, which is rich in natural resources, will surely benefit if commodities truly are on the up leg of a supercycle.

Furthermore, as the value stocks in developed markets that have done well since the turn of the year rerate upwards, investors will look farther afield for bargains. In a risk-on environment, countries that are extremely cheap could be a real opportunity.

Yet any optimism must be tempered. Tragically high excess death tolls in the pandemic and the misery of the past 18 months is already spilling over into unrest with combustible election campaigns fought in Mexico and Peru, and an election in Brazil next year. Add in environment, social and governance (ESG) concerns and you can argue that Latin American countries fully deserve their lowly rating.

As in the rest of the world, public finances have been strained in the crisis (to breaking point in the case of Argentina which defaulted on government bonds last year). Fiscal risk hovers over all the nations in the region and the weight of debt denominated in foreign currencies, especially the US dollar, provides further reason for caution.

Volatility in bond markets feeds through to equities. Still, for bulls who believe that economic recovery will drive earnings for Latin American companies, shares are the way to invest in the region. At the moment, shares are cheap but so are bonds and, in some cases, there have been negative recent equity premiums (the excess implied future return from shares compared to bonds).

Rises in local government bond yields imply that unless expectations for company profits rise, shares must fall in price to offer fair compensation for being riskier assets. Société Générale’s Cross Asset Research team estimates spikes in 10-year government bond yields for Brazil this year and lesser increases in Mexico.

Société Générale says that assesses both countries’ stock markets are among the most sensitive to bond yields fluctuating, with Brazilian and Mexican shares potentially losing around 30 per cent and 20 per cent, respectively, if their model scenarios play out. So despite economic growth forecasts for a strong recovery the low equity prices have scope to get cheaper.

Currency weakness weighs on Brazil and Mexico

Adding to the pressure on Brazil and Mexico is the weakness of their currencies. Société Générale also forecasts that the real will drop around 15 per cent against the US dollar this year and a fall of around 5 per cent fall for the Mexican peso versus the US dollar. Both estimates were made before the Federal Reserve indicated it would tighten US rates sooner than expected, which has strengthened the dollar.

Interestingly, a more technical aspect of Société Générale’s equity premiums, which are largely the work of analyst Praveen Singh, is that the long-term growth phase of the calculation accounts for roughly two-thirds of present value (the worth of future growth in today’s money) priced by most equity markets. Most growth for Brazil is expected in the near-term part of the economic recovery from the pandemic.

Without long-term growth forecasts being revised upwards significantly, the big driver of Brazilian share prices will be the fluctuations in the required potential rate of return, which is influenced by bond yields. In any case, short-term growth isn’t certain.

Investment managers at Brooks Macdonald have questioned how sustained commodity demand will be. Chief investment officer Edward Park cautions that structural shifts in demand are overstated and the current surge in prices is due to supply constraints that “will begin to dissipate as the global recovery becomes more synchronised”.

China’s infrastructure spending has slowed and Park points to the reluctance of Chinese local authorities to issue debt to fund new developments. The counter to this point would be that nations such as Brazil and Argentina depend far more on exporting soft commodities, and global demand for food will continue to rise.

Also, the US is spending, with President Biden’s plans involving $1.5tn (£1.08tn) to $2tn on rebuilding America’s neglected infrastructure. World Bank figures for 2018 show that 45 per cent of Latin American and Caribbean exports went to North America, versus 18 per cent to Asia Pacific. This suggests that a slowing pace of demand from China (while undeniably a risk) should be offset.

What’s more of a worry is political instability in the region, which may adversely affect the outlook for growth and cause bond yields to spike and local currencies to weaken. The campaign for the Mexican legislative elections was one of the bloodiest in years. Horrifyingly, 91 politicians were killed, including 14 candidates. The result was largely stalemate and there are fears of protests and more violence.

Covid-19 has exacerbated the trends of populism and polarising candidates around the world, with Brazil’s President Bolsonaro a divisive figure. He most likely faces a fierce 2022 election battle with former president Lula da Silva. In Peru, a judicial ruling will be called between right-wing candidate Keiko Fujimori and socialist rival Pedro Castillo after their June run-off.

Many of the attractive elements offered by Latin American economies primed for recovery are also present in other emerging markets with less political risk. Furthermore, as Société Générale points out, regions such as emerging Asia combine the value of high implied forward returns with a wider equity premium over local government bonds.

Funds which track MSCI Emerging Markets index have around 80 per cent of their assets in Asian stocks - China alone makes up 40 per cent of this index. Brazil is the most represented Latin American country at around 5 per cent, so a small part of a more general emerging market exposure seems like the best way for investors to play Latin America for now.

Still, at some point when a bit more political certainty exists, these very cheap stock markets may be the place to seek growth at a reasonable price. Until then, the region is a fascinating sideshow with funds targeting it to be kept on the watchlist.

Funds for Lat Am exposure

The simplest way to get equity exposure to Latin America is via an exchange traded fund (ETF), such as iShares MSCI EM Latin America UCITS ETF (LTAM). True to the index, the fund is geographically concentrated with 57 per cent in Brazil and 22.5 per cent in Mexico. It has significant exposure to cyclical sectors, with financials and materials making up half of the fund and healthcare and information technology combined under 5 per cent. Brazil’s Vale (US:VALE), the second-largest mining company in the world, makes up as much as 13 per cent. The charges are quite high for an ETF with a total expense ratio of 0.74 per cent.  

For exposure via an active fund, there are two investment trusts that specifically focus on the region. BlackRock Latin American Investment Trust (BRLA) had assets of £194m on 24 June. Its peer Aberdeen Latin American Income Fund (ALAI) is very small with assets of only £43m and low liquidity in its shares. BRLA is a pure equity fund with a yield of 4.8 per cent, whereas ALAI has 28 per cent in fixed-income according to its June factsheet and yields 6.1 per cent. BRLA’s portfolio is well-diversified across both value and growth-type stocks and sectors, whereas ALAI's equity component has a greater growth bias.

While both trusts currently trade on double-digit discounts to net asset value, BRLA has a discount control mechanism. This includes a tender offer to buy a quarter of the shares in 2022 at close to net asset value if: 1) the trust underperforms the benchmark index by more than 1 per cent per annum over the four financial years to 31 December 2021 or 2) the discount has on average exceeded 12 per cent over the same four years. This mechanism should help to put a floor under the discount in the near term.   

In the open-ended fund arena, Gordon Smith, head of research at Killik and Co, likes Brown Advisory Latin American Fund (IE00BFZ0XJ95). Rupert Brandt has managed the fund since 2006. He focuses on the small and mid-cap segments of the market and has a value-oriented approach. Smith says: “There is a preference to buy less glamorous stocks and into sectors that are currently out of favour.” The fund, which is a concentrated portfolio of 28 holdings and has a high net ongoing charge of 1.6 per cent, has performed well recently but struggled over the longer term.    

Darius McDermott, managing director of Chelsea Financial Services, rates ASI Latin American Equity Fund (GB00B4R0SD95). It has assets worth £102m and a historic yield of 1.18 per cent. The fund is managed by a six-person Latin America team and has 42 holdings in large-cap companies.