Latin America's virtuous circle
For longer than most investors and hedge fund managers care to remember, the chief attraction of Latin America has been the kind of political and economic turbulence and market volatility that provides the brave with the opportunity to achieve outsize gains - or losses. Now, however, there is a danger of the region being characterised by a less colourful, more prosaic quality: stability.
Managers are quick to underline that there's no immediate danger of Latin American markets becoming so efficient as to squeeze out all interesting investment opportunities. However, the days of violent changes of government, monetary chaos, hyperinflation and wildly gyrating stock markets seem to be, if not definitively over, certainly numbered.
Says Florian Bartunek, a founding partner of Constellation Asset Management in São Paulo: "There's now a much better backdrop to investment in Latin America than 10 years ago. Most of the regimes in the region were elected; there are almost no dictatorships any more. You have a free press, free markets, and crucially, most currencies are floating - whereas a decade ago, Argentina and Brazil had pegged currencies. "Markets are much more open and liquid.
In the past, 90 per cent of what drove markets were political and macroeconomic issues, and now I would say it's 50 per cent. As more and more new companies come to the market, economic and political issues are becoming less and less important."
Ricardo Maxit, chief investment officer of Buenos Aires-based hedge fund manager Copernico, agrees. "The economic environment is very good, and the fundamentals have improved dramatically," he says. "Countries in the region are running much sounder fiscal and monetary policies. All countries are operating with floating exchange rates, commodity prices are booming, so the whole combination is very benign for the financial markets."
Maxit cautions that this does not mean that the boom-and-bust economic rhythm for which the region is notorious has been abolished for ever. "Are we entering a new virtuous cycle that will last forever?" he asks rhetorically. " I don't think so. There are good times, and we try to take advantage of them, while remaining aware that bad times will come again, whether that is two or four years from now."
He observes that although Copernico was formed as recently as 1999, it has already lived through events as traumatic as the implosion of Long Term Capital Management, Russia's default, and the Asian financial and economic crisis, as well as, closer to home, Brazil's devaluation and Argentina's default. But Maxit adds: "I do see a better environment. When bad times come, markets will do poorly, of course, but I don't get the sense that we will see in the future the volatility we have seen in the 1990s."
Gustavo Dominguez, a partner with Gottex Fund Management in New York and former head of Latin America for JP Morgan Chase, says an important sign of increasing stability is the lessening of contagion between markets and a new readiness of market players to take shocks in their stride.
He says: "Latin America is a lot less vulnerable to economic and political shocks than we are accustomed to think. I have believed strongly since early 2003 that the region had turned a corner, and I think I have been proven right. Contagion is a lot less likely than in the past, and we have seen episodes over the past couple of years where there has been volatility but it has been contained.
"For example, in the first quarter of 2003 Venezuela had a coup and [president Hugo] Chavez was first forced out and then returned to office. Before he was temporarily ousted there was a big strike among oil workers, and Venezuela was on its knees, but the market shrugged it off. The same thing happened with Ecuador," Dominguez added, referring to the removal of the country's president by the National Assembly in April after months of unrest.
Economic changes are an important factor in reassuring the markets, he argues."Surpluses are the norm, inflation is low, and interest rates are coming down. Most currencies are completely or partially floating, which goes a long way toward providing a buffer for [economic] shocks. Add to that lower deficits or even surpluses, the role of increased global capital flows, and the chances of huge shocks are a lot less than what we were accustomed to 10 years ago."
Dominguez says that sophisticated investors in North America and Europe are starting to appreciate that the risks of investing in Latin America may be less than at home. "Today you can make a case that the leverage market and the high yield market in the US are immensely more prone to disaster than any of the fixed income or foreign exchange markets of Latin America," he says. "These economies are not nearly as leveraged as they used to be, so they are a lot less risky. Other markets in the developed world are a lot riskier."
Political factors are impinging less on the markets, according to managers and investors, because of increasing confidence that political problems can and will be addressed by constitutional means. "The political outlook is becoming more and more clear," says Mauricio Safdié, a partner withBanque Safdié in Geneva. "There has been a lot of noise over the past few months in Brazil, for example, but this is positive, because it's becoming more transparent."
Brazil is a good example of how economics and business are becoming less vulnerable to changes in government, even ostensibly dramatic shifts. As the likelihood grew of a presidential election victory by Luiz Ignacio Lula da Silva and his Workers Party in 2002, the markets took fright, only to recover following Lula's election as it became clear that he would not return to the anti-capitalist rhetoric of his younger days. "In 2002 with the election looming the market completely collapsed," says Dara Chapman, head of sales and investor relations at Polo Capital Management. Instead, Brazil was to enjoy a surging market boom as the former firebrand risked unpopularity with his supporters by sticking with the fiscal rigor of his conservative predecessors: "Because there were no hiccups in Lula's first 100 days, themarket just exploded."
William Trosman, head of business strategy at Mauá Investimentos, says the Brazilian government's growing fiscal surplus is a sign that "values don't have to change" along with a change in government. "There is more consensus now on what is important," he says. Javier Guerra, managing partner of the Latin American-oriented but Miamiheadquartered brokerage Bulltick, says that even the election of a leftist candidate can reassure the markets, because peaceful changes of government in countries that have been unused to them in the past indicate that politicians can be held to account for their stewardship of the country and economy. "The political change in Mexico has changed things for the better, regardless of how the new president will do things or not," he says. "The fear that a different party will take power makes people more accountable, and I think the same thing is happening in Brazil," where there is also a presidential election next year.That's not to say that the markets will be indifferent to election, especially when, as in Mexico, a leftist front-runner could bring to power a party that has not held government office before. Says Guerra: "In terms of investment, I think the next two years are going to be very volatile, with the political changes in Mexico and in Brazil. The fact that a leftist candidate is leading the polls in Mexico could increase volatility and affect the secure feeling of investors, and likewise in Brazil. But I think it will be business as usual in two years' time."
Whatever wobbles are experienced in Brazil between now and the presidential election, managers agree that the economy and markets of Latin America's biggest and most sophisticated economy is benefiting from lasting improvements that have played an important part in attracting previouslywary foreign investors - as well as a highly welcome boost from soaring commodity prices.
Says Trosman: "This year we have had very good economic news. Brazil is ready to take advantage of global growth, being a huge producer of many commodities. There is a good appetite for risk, and Brazil has been able to finance its growth easily. The government is doing very well in terms of economic management, delivering an excellent fiscal surplus of around USD40bn for this year."
Brazil's economic bugbear is sky-high interest rates, but Trosman sees signs of movement toward more normal levels. "For the first time in a long time, the central bank has started to reduce interest rates, albeit just from 19.75% to 19.5%. It's still huge, especially when you consider that the real interest rate is more than 12% per annum. However, we expect rates to continue to fall over the next 12 months."
Bartunek points to the wave of new companies coming to the stock market not only as an opportunity for hedge funds that use equity-based strategies but as an indication that private capital is elbowing out state control as the driving motor of the economy. He says: "You have global-class companies, such as the third largest mining company in the world.
"Prices are driven much more by the international commodities cycle than by local issues. More and more companies are using the capital markets to finance their growth through equity, and good companies are crowding out the state-owned companies from the past, like Petrobras or Electrobras. Now the bulk of the market is composed of private companies."
Dominguez notes that Brazil already benefits from a much greater degree of financial sophistication than its continental neighbours. He says: "For decades the Brazilian financial market has been the most developed in Latin America. The futures exchange, the BMF, is one of the most efficient and sophisticated exchanges in the world."
By contrast, he says, "until five or six years ago Mexico didn't have a real financial market - it was very illiquid, fragmented and over-regulated. Regulations have been lifted slowly, but today you can see that Mexico is a real market with good liquidity, with intermediation, with fixed-income instruments across the curve, and with a well-developed pensions industry."
Dominguez believes that an important key to both economic development in general and an enhanced role for hedge funds in particular will be the growth and increased sophistication of pensions industries in Latin America. He says: "In the long term a natural growth area for hedge funds is if national pension systems areallowed to use them for part of their investments. However, it still seems some time away, given the reticence of the pension system to invest even in funds of hedge funds.
Chile is one country that does have a well-developed pensions sector, he notes. "The market is smaller than Brazil or Mexico, but the assets of the Chilean pension system amount to more than more than 50 per cent of GDP, by far the largest in the entire region, whereas for Brazil, Peru or Mexico it ranges between 6 and 10 per cent."
There are still economic question marks over Argentina, which still carries the stigma of the 2001 collapse of its currency peg to the dollar and subsequent default on its foreign-currency debt. "This remains a negative factor," says Guerra. Dominguez is cautious: "Argentina is starting again after the default, and the attitude is still very much wait and see. They have a good central bank, but the liquidity of the marketplace leaves a lot to be desired. There are still signs of sclerosis in the Argentine system, and the banking system is still being fixed."
However, Mark Purdy, managing director of Toronto-based Arrow Hedge Partners, is more upbeat in his outlook. "I think Argentina is an interesting economy," he says. "After the most recent write-down of its bonds, it's got an opportunity to come out fairly well."
Perhaps the most important message About the region's economic development, says Trosman, is that Latin American countries are now considered for their own merits rather than being treated as a single homogeneous bloc. "Today the picture is mixed because you have two very populist governments, in Argentina and Venezuela," he says. "It's a pity they continue to talk a different language. But Mexico is doing very well, and so are Chile, Uruguay and Brazil."
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