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Magazine Issues » May 2009

BRICS: A Tale of two countries

What does the future hold economically for Latin America's heavyweights Mexico and Brazil? Mexico has more hurdles to overcome, but both countries are attractive to investors in the current global climate, says Jeff Casson of SWIP...

The first months of this year have brought very different fortunes to Latin America’s two most important stock markets. While Brazilian equities have delivered positive returns, the Mexican market has remained under pressure. 

The reasons for this might seem obvious at first glance. As a major exporter to the US and an oil producer, Mexico is reliant on the foundering US economy. In addition, the recent surge in drug cartel-related violence has led to panicked pronouncements that the country is set to become a failed state. 

By contrast, Brazil is benefiting from political stability under President Lula, the relative stability of the banking sector and commodity prices and its strong financial position. 

But is the distinction between these two countries really so stark, and how are they both placed to weather the global downturn?

Of the two, Mexico clearly faces some of the most significant short-term challenges. The recent headline-grabbing drug-related killings, followed by the swine flu outbreak, have certainly cast a pall over the country and unsurprisingly made investors wary. However, improvements in the Mexican political system and the ability of the ruling party to govern effectively mean that the country is a long way from approaching ‘failure’. 

Mexico has a strong three-party political system involving regular federal, state and municipal elections, which are widely held to be free and fair. Furthermore, the ruling party is clearly capable of effective policy implementation, which would not be the case in a state approaching failure. In recent years, the government has made significant strides in improving access to public services, including transport infrastructure, social and housing programmes and school-building projects, all of which have been funded by a robust system of tax collection.

The anti-drug measures undertaken by President Calderon bear comparison with the policies of Colombian President Alvaro Uribe, which have led to a dramatic improvement in law and order. Meanwhile, the US is stepping up its efforts of help. The Obama administration recently announced it would spend $700m (€525m) to provide extra personnel and equipment to help Mexico’s military in the battle against the drug cartels. 

Many of these measures remain at early stages, and there are few signs that the violence will decline significantly in the immediate future. But in the longer term, Mexico has the political and legal infrastructure to deal with the problems associated with these drug cartels. Mexico still has the 12th largest economy in the world and is committed to eliminating the country’s drug problems. 

Importantly, this view was also recently reflected by credit rating agency Moody’s, which maintained its investment-grade rating on the country’s sovereign debt, stating that Mexico’s profile did not match that of a failed state.  

Global challenges
The political threats appear overdone, but what about the arguably more powerful forces of the global recession? Mexico certainly faces a number of challenges. These include: a collapse in its major export market (the US), the lower oil price level, a currency that has dipped to historic lows and a fall in remittances from Mexican workers abroad. 

There is no denying that Mexico faces a number of issues that need to be addressed.  But the situation is not necessarily much worse than in many global economies. 

Looking at the currency, the peso lost more than 53% (against the US$) at the height of concerns and is now trading at 43% below the high in August 2008 amid pessimism that the US downturn will push Mexico into recession.  The drop was exacerbated by concerns about the state of the country’s balance of payments.  But the fall in exports has been almost matched by a decline in imports and at current price levels, Mexican products are now much more competitive in export markets. 

A drop in oil revenues is another major concern. However, this is partially compensated for by a fall in gas imports and the fact that Mexico has hedged the majority of 2009 oil production at approximately $70 per barrel.  Recent signs that global oil prices are stabilising should also prove helpful. While still a long way from its peak, having rebounded from a low point at the end of last year, the oil price is now back above $50 a barrel and trading at levels close to its five year average.

The fall in the level of remittances from workers abroad is also having a negative impact on the economy. Thousands of Mexicans are legally or otherwise employed in foreign countries (mainly in the US) and regularly send part of their earnings home. This forms a vital component in the economy. The global downturn has seen many of these workers lose their jobs, with the result that remittances are falling. However, although the total dollar value of remittances has declined, the weakness of the peso against the dollar has enhanced the value of those funds that are sent home.

Investors, though, may remain wary of the country until they can be assured that some of these difficulties are being overcome. While steering clear of Mexico, many investors have been focussing their attention on its larger neighbour, Brazil. The MSCI Mexico index has fallen around 10% between the start of the year and the end of March, but the Brazil MSCI index is up by a similar amount.  

Robust banking
One of the main reasons for Brazil’s outperformance is that its banking sector is benefiting from a robust regulatory framework and high reserve requirements. This discouraged the country’s private banks from taking some of the wilder risks that brought down their peers in Europe and the US. 

This lack of debt is reflected throughout the country and gives authorities much more leeway in dealing with the current economic crisis. During the boom years, Brazil built up $200bn in reserves and its current account deficit is relatively low by global standards.

The central bank recently enacted a series of bold policy moves, such as lending $36bn from Brazil’s foreign currency reserves to companies, providing scarce and much-needed liquidity. As soon as the crisis hit, the central bank began intervening strongly in foreign exchange markets and providing liquidity to banks that lend to the most troubled sectors of the economy, such as exporters and heavy industries.

The other area in which the government is continuing to provide stimulus is in infrastructure spending. Significant airport and port building projects are on the increase, while major improvements are also being made to the country’s road and networks. These present investment opportunities in themselves, but will also help boost future economic growth. 

Importantly, the current crisis is not pushing up inflation, whereas historically a depreciating real has triggered a rebound in domestic inflation. This is partly due to the country’s improved financial integrity and was recognised in 2008 when Brazil had its sovereign debt upgraded to investment grade. This improvement in creditworthiness helps the Brazilian government by cutting the cost of issuing debt and is testament to progress than has been made in improving the country’s financial credibility. 

The taming of inflation has also allowed the Brazilian central bank to be more aggressive in its monetary policy for virtually the first time in its history. Rates were recently cut to 11.25% and are forecast to fall significantly further.  That might seem high by Western standards, but should be viewed in a historic context. A decade ago rates were nearer 60%, as inflation soared into triple digits. In contrast to the US or the UK, where authorities have had to resort to additional monetary stimuli, such as quantitative easing, Brazil’s central bank has scope for further cuts, assuming inflation remains well behaved.

For these reasons, both Brazil and Mexico should be able to see out the current global downturn. But perhaps the most compelling incentive to invest in either country at the moment is provided by equity valuations.  

PE ratios fall to single digits
The recent market sell-off has dragged share price valuations to historic lows, with the PE ratio of both countries’ stock markets now in single digits. In 2008, when the commodities boom was reaching a peak, the discount traditionally associated with investing in emerging markets had all but disappeared. In some Latin American markets, valuations were at a premium to those in developed markets.

When analysing the performances of individual companies though, it is clear that in a large number of cases, the sell-off has not been justified. Many companies, and particularly banks, are not saddled with the levels of debts and toxic assets that have plagued their Western counterparts. Company valuations in many sectors do not currently reflect the strength of company balance sheets, nor the quality of their management teams, who have run these businesses through several domestic crises. As a result, there are now an increasing number of attractive investment opportunities.

Looking at the prospects of both Brazil and Mexico, it is clear that neither will emerge from the global downturn unscathed. Although they have succeeded in becoming more self reliant and boosted domestic growth, exports still form a large part of these economies. The next twelve months will be a challenging time, but the fundamentals of both Mexico and Brazil – low debt, a relatively robust financial sector, particularly in Brazil, a growing consumer base and a host of infrastructure developments – underpin some very strong long-term opportunities for investors.

Jeff Casson is investment director global emerging markets at Scottish Widows Investment Partnership

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