INSIDE VIEW: The power of reform

Guido Giammattei of RBC Global Asset Management (UK) looks at Mexican and Brazilian equities and concludes that Latin American shares are likely at a cyclical, not structural, low. 

If we look at the MSCI Emerging Markets (MSCI EM) Index as the most common benchmark to measure the relative performance of emerging market equities, the picture for Latin America looks dire. Since January 2010, the MSCI EM Latin America Index has underperformed the MSCI EM Asia Index by 60%. This has resulted in the emerging market equity universe becoming more Asia-centric. The weight of Latin American stocks within the index has decreased to 14.5% – the lowest level since the index was created – from approximately 40% in 1998 and close to 27% in 2008. 

The whole Latin American region has performed poorly. This was expected in an environment characterised by a strong dollar and declining commodities prices in recent years but the Brazilian stock market has accounted for the lion’s share of this dramatic underperformance. 

The threefold structural drag on Brazil’s economic growth from high inflation, high interest rates and high exposure to commodities has been accentuated by political and macroeconomic mismanagement, which has had a substantial impact on corporate returns and profits. The average return on equity (ROE) of Brazilian corporates has halved, falling from 16% in 2010 to 8% today, and the country’s equity market has lost half of its market capitalisation since May 2010. As a result, the Latin American region as a whole underperformed by over 15%. 

From a portfolio management perspective, this is particularly unfortunate given that Brazil is not only the market with the strongest growth potential in Latin America, but that it also has the region’s largest equity market, with a number of companies with strong management and successful franchises. The macro political context, including the unpredictability that comes from a high degree of state interference, has in recent years become ubiquitous and pervasive in businesses, making it very difficult for global emerging market fund managers to invest in the country’s equity market, given the choice of better investment opportunities offered by other emerging markets. The cost of equity reached such a high level that fewer and fewer companies could generate adequate returns to make it into a bottom-up portfolio. 

Brazil is the most challenged economy in the Latin American region. The rise in inflation even during times of low growth reflects the fact that the country has reached, or perhaps exceeded, its current output gap. A major component of this is that most of the spare capacity in the economy, which was created by the numerous financial crises and the subsequent economic reforms, has now been used up. 

To attract private investment into its corporate sector, Brazil needs to focus on three key areas. First, it needs to address its chronic public-sector deficits (to some extent a reflection of fiscal framework weaknesses), which have contributed negatively to national savings and kept public investment low. Second, it needs to simplify and, with time, reduce the high corporate tax rates, which are seen as a way of paying to maintain a very large and bureaucratic government. Third, it needs to reduce the high degree of state interference against market forces and create a stable regulatory framework in key industries. These are structural factors that have discouraged fixed investments and damaged the country’s productivity and can only be addressed through policy reforms. 

Conversely, Mexico, the second largest economy in Latin America, stands at the opposite end of the spectrum. Mexico is part of a group of emerging markets that have passed significant reforms and has outperformed the rest of Latin America despite its commodity exposure, pointing to the benefits of reforming policy frameworks. The average ROE for Mexican corporates has fallen from 14% in 2011 to 10%, but the market stabilised significantly after the government passed historic reforms in the energy, fiscal and labour sectors. The Mexican equity market now trades at three times price-to-book value, up from 2.5 times in 2011. Although Mexico had disappointing growth in 2014 following a year of fiscal consolidation, the country should see an improved growth outlook in 2015, and even more so in the years to come when the benefits of the energy reform become fully apparent. 

While Brazil has its challenges, there is a silver lining. Historical evidence suggests that ‘big ticket’ reforms have been implemented only as a last resort, when the economic environment has deteriorated enough. 

The failure of the Brazilian government to push and implement structural reforms to address these issues has taken its toll on Brazil. The Brazilian economy is expected to contract this year and its current account and fiscal balance have moved into the red in 2014. Brazil’s credit rating has also been downgraded and the country is at risk of losing its investment grade status. 

However, there are signs that the government is trying to implement fiscal reforms. If further efforts are made to improve productivity and thereby help to anchor medium-term inflation expectations, then Brazilian assets, including equities, could see stronger performance. 

Within the emerging markets universe, India provides an interesting example to follow. The country had one of the strongest performing equity markets in emerging markets in 2014, which shows that a combination of credible monetary and fiscal policy, with efforts to improve long-term growth potential, can have a significant impact on the performance of the country’s assets. In addition to this, there are a few other factors that could positively impact Brazilian equities. 

First, there has been a significant adjustment in the Brazilian equity market in terms of valuations. 

Second, the currency, which was one of the most overvalued in emerging markets, has depreciated materially by more than 80% against the dollar from its peak in 2011, which improves the country’s competitiveness and outlook for earnings. 

Third, in terms of earnings for Latin America, the commodity sector produced 48.4% of MSCI Latin American earnings in 2008. This number has fallen sharply of late; it was 27.8% for 2014, and is expected to be just 15.4% this year. The share of earnings for energy and materials is expected to drop below 10% for each sector for the first time since at least 2008. Further declines in commodities should have much less of an impact on the region’s earnings and Brazil in particular, given the country’s high exposure to commodities. The key question now is whether the government is willing to persist with these reform efforts amid the growth slowdown.

The GDP for the MSCI Latin American countries is 17.4% of MSCI EM GDP, which is higher than the 14.5% market capitalisation weight of Latin America within EM. Conversely, in 2008, the region was 20.5% of EM GDP and 28% of EM market capitalisation. Brazil is just 9.1% of EM GDP, but this is also higher than the current market capitalisation weight of MSCI Brazil in EM (8%). In 2008 it was 11% of EM GDP but 17% of EM market capitalisation. 

Peaks and troughs are difficult to identify, but all conditions remaining equal, this could be a cyclical rather than a structural low for Latin American equities. 

Guido Giammattei is portfolio manager, emerging markets equities, at RBC Global Asset Management (UK)

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