War in Ukraine has driven many investors to move their money into safe havens but it has also boosted interest in one of the riskiest regions in the world, Latin America.
Countries such as Brazil and Mexico are far from Russia and Ukraine, but in our interconnected world, no country is an island.
As stretched supply chains and Russia sanctions turbocharge oil, gas and food prices, Latin American commodity exporters are booming. They could offer investors a valuable inflation hedge, right now. So is now the time to venture back?
Many investors have let Latin America slip off their radar altogether. The region is famously cyclical, enjoying periods of blistering outperformance, then slumping back into protracted economic, social and political crises.
The region suffered a lost decade following the 1982 Latin American debt crisis, but came roaring back after the millennium, during the Brics frenzy, when Brazil was named a future global powerhouse, alongside Russia, India and China and South Africa.
The Brics fad eventually collapsed and Latin America has been out of the spotlight for years, while Covid-19 hit it hard. Reuters figures suggest the virus has killed almost 1.7 million across Latin America and the Caribbean.
The MSCI Emerging Markets Latin America index fell 13.53 per cent in 2020 and another 7.73 per cent last year. This was in marked contrast with the West, where the fiscal and monetary stimulus blitz delivered double-digit gains, despite the pandemic.
This year, it’s a different story. Latin American markets have rocketed, rising a stunning 27.33 per cent in the year to March 31. That’s in marked contrast with the US, which is down 5.21 per cent, and Europe, down 7.23 per cent.
The region has been overlooked for years, but it’s this year’s best-performing investment sector, David Morrison, senior market analyst at Trade Nation, says.
Commodity prices are rocketing, with the Bloomberg Commodity Index up 32.27 per cent year to date, at the time of writing, and Brazil, Mexico, Chile, Peru and Colombia following suit.
Brazil’s biggest export is iron ore, followed by crude oil, soybeans, raw sugar, poultry, coffee and corn, while Chile is a major copper exporter.
Mexico has a stronger manufacturing base, exporting more cars, vehicle parts, computers, and telephones than commodities. Its market hasn’t done as well.
Commodity prices usually rise when inflation is accelerating, making them a good hedge against inflation, but there’s a catch, Mr Morrison says.
“Latin American countries are also vulnerable to price rises in the commodities that they don’t produce,” he says.
History shows Latin America is highly susceptible to inflation, which has now hit 50 per cent in beleaguered Argentina, and is expected to top 60 per cent by the end of the year.
Brazil’s inflation rate has climbed above 10 per cent, which is well above the central bank’s 3.5 per cent target. In the US, it’s already 8.5 per cent and expected to climb higher.
Yet rising food and fuel prices have hit the poor hard, triggering civil unrest in Peru, while Ecuador saw violent protests against rising fuel prices, where millions already rely heavily on fuel subsidies. Resentment is also growing in Brazil and Argentina.
Despite the risks, Latin American stock markets look good value after a decade of underperformance, Mr Morrison says.
“The region is also more politically stable than it has been for years, plus its biggest trading partners are in the Americas, which means it has little exposure to European troubles,” he says.
The positives of the commodity rally must be offset against the negatives of a slowing global economy, Leonardo Pellandini, equity strategy researcher at Julius Baer, says.
“The impact of higher energy and agricultural prices on real disposable incomes, tighter financial conditions, and falling consumer sentiment are weighing on growth,” he says.
Central banks face a tricky balancing act as they try to suppress inflation by hiking interest rates, without crushing economic growth.
The Central Bank of Brazil is among the most hawkish global central banks, increasing lending rates to 11.75 per cent in March to combat inflation, while Mexico is hiking, too, Laith Khalaf, head of investment analysis at AJ Bell, says.
“Latin American funds have benefited from strong performance from financials in the first quarter as a result, on top of rising energy and commodity share prices,” he says.
This has triggered a rally in the Brazilian real, Vijay Valecha, chief investment officer at Century Financial, says.
“The interest rate differential with the US is near all-time highs, and the Brazilian real could rally even further from here.”
The Latin American stock market rally could have further to run, Mr Valecha says, and most investors will want a small amount of exposure to the region, although typically no more than 5 per cent of their overall portfolio.
Individual Latin American stocks are too risky for most investors, and Mr Valecha says the best approach for most people is to diversify through a low-cost exchange-traded fund (ETF) tracking one of the region’s stock markets.
These offer capital growth from rising share prices, while some offer attractive levels of dividend income, too, he says.
“The iShares MSCI Brazil ETF, which is the leading Brazilian ETF, yields 5.66 per cent, which is attractive for income investors,” Mr Valecha suggests.
The fund is up 35.32 per cent so far this year, although in a sign of the country’s recent stock market troubles, it trades 18.79 per cent lower than 10 years ago.
Mr Valecha is optimistic about the outlook for Brazil. “The country’s macroeconomic fundamentals are far superior than before, and political risks far lower, which should be positive for Brazil’s equities.”
The smaller countries are still primarily commodity plays, he says, and Peru will tempt those who want inflation protection.
“Its top exports are copper ore, gold, refined copper, petroleum gas, animal meal and pellets, which have all rallied lately,” Mr Valecha says.
The copper price is expected to stay strong for many years due to accelerating demand for electric vehicles, he says.
“The iShares MSCI Peru ETF is an ideal way to play the trend.”
The ETF is up 24.3 per cent this year, but trades just 1.07 per cent higher measured over the past decade.
Mr Valecha also suggests Franklin FTSE Mexico ETF, which is up 10.29 per cent year to date, but says most investors will prefer to dilute their risk with a broad-based fund.
The iShares MSCI EM Latin America UCITS ETF follows a familiar trajectory to the other funds. It is up an impressive 26.83 per cent this year, but down 18.01 per cent over 10 years.
Its top holdings include Brazilian mining company Vale and oil giant Petrobras, Mexican telecommunications corporation América Móvil and Walmart Mexico.
As with any regional or sectoral stock market rally, the danger is that investors come to the party a little too late. Yet this year’s Latin America rebound has only been running for a few months, and could have further to go. Just be prepared to hold on during those lengthy periods of underperformance, too.
