Much like the rest of the world, Latin America (LatAm) bounced back sharply from the March 2020 lows. The rally, driven by foreign liquidity initially, was later picked up by improving fundamentals. In 2021, however, LatAm markets have been volatile due to political tensions in Brazil, a surge in Covid-19 cases and the weakness in LatAm currencies as a result of the rise and rise of the US dollar.
This has triggered outflows from foreign investors and raised concerns in investors’ minds about the attractiveness of the region. However, the LatAm regional bloc, one of the world’s largest producer and exporter of commodities, is particularly sensitive to global economic growth conditions. The ongoing boom in global demand for commodities and expected steady post- pandemic economic recovery in the region itself, indicate that the impact of the near-term headwinds may be short lived.
The Brazil effect
Brazil comprises roughly 65% of the MSCI LATAM Index and events in the country have an outsized impact on the performance of the region as a whole.
Jair Bolsonaro, the current President of Brazil, has been out of favour with masses courtesy his decision to sack the chief of Petrobras (a state-owned oil and gas company), and the sub-par handling of the Covid-19 crisis. As foreign investors sensed trouble, withdrawals made by them triggered a fall in the Brazilian Real and stocks of state-run companies.
Brazil’s ex-president, Luiz Inacio Lula da Silva, has also been in the limelight after his criminal convictions were annulled by the Supreme Court in March 2021. He is now eligible to contest the 2022 presidential elections against the increasingly unpopular Bolsonaro, making for a very uncertain political scenario in the country.
The raging Covid-19 outbreak (third highest in the world) in Brazil weighs heavily on the region too. However, we believe much of these negatives have already been priced in, opening room for the positives to play out.
Coming up against the dollar
Of late, USD has been strengthening on the back of a robust economic rebound in the US. A strong USD makes commodities expensive, thus denting demand for LatAm’s primary export. It also makes USD-denominated loan repayments costlier for borrowers in the region.
However, the relative strength of the dollar is likely to be temporary. Even though the US is registering healthy growth, the rate is unlikely to be at par with Asia Pacific (APAC) and LatAm, which have a higher percentage of exposure to cyclicals. They are therefore likely to attract higher institutional cash flows from developed markets, including the US.
Furthermore, monetary and fiscal stimulus packages announced by the US thus far, totalling to 57 5 of the country’s GDP have been the highest in the world. This will cause fiscal and current account deficits to widen, thus causing the USD to retreat off its highs by the second half of 2021.
A weak USD will help offset the impact on commodities prices and loan repayment stress for LatAm companies.
Commodity play in global recovery
The current reflationary global scenario hints at improved sentiments, regularization of supply chains and a pick-up in demand. US and Europe have committed to spend USD 2.25 trillion and Euro 1.8 trillion, respectively, to modernize infrastructure.
Among major nations, China has been at the forefront of economic growth by virtue of its emphasis on fiscal spending and capex. It is a dominant consumer for base metals as well and accounts for more than 50% of the world’s iron and copper demand.
Demand for industrial metals is also slated to improve structurally owing to thrust towards electric vehicles. A combination of these developments bode well for exports of commodities from the LatAm region.
Earnings and valuation opportunity
Mining and energy companies comprise more than 30% of the MSCI LatAm index. Earnings growth of the region is thus highly synchronised with rise in commodity prices. Commodity prices have risen 13% year-to-date so far, causing an upward revision in earnings estimates for LatAm equities.
Also, in the last few years, capital expenditure by commodities businesses in LatAm has been limited due to global slowdown and low utilization levels. A combination of robust demand and limited supply will therefore boost commodity prices, further aiding margins and earnings of LatAm equities.
In terms of valuation, the MSCI LatAm Index is trading at lower than its ten-year average valuation of 11.9X, making it favourably poised for a re-rating because of the fundamental drivers for the region.
To sum things up
Our analysis shows that the impact of an appreciating USD and a volatile Brazil domestic scenario seems to be priced in the MSCI LATAM Index as of now. That said, we foresee continued volatility and see-saw movements in sentiment in the near term.
With its fundamental drivers intact, however, and the current undemanding valuations, LatAm offers a high-risk, high-reward opportunity to investors who can handle the volatility. Investors with a high risk appetite can allocate up to 10 percent of their global equity exposure to the region via mutual funds.