With the return of David Kotok from a week of matching his wits against the wily trout of Patagonia, it is a good time to look at how Argentina is handling the challenges of the global recession.  We will also discuss the three major Latin American economies in which we can invest using country-specific ETFs: Mexico, Brazil, and Chile. It will become clear that selectivity will be very important for investing in the Latin American region this year.

Argentina 

Riding on the global boom in commodities, Argentina experienced a strong economic rebound from the deep recession of 2001-02, with annual GDP growth averaging 8.8% in the 2003-07 period.  Since then, however, Argentina’s increasingly discretionary and interventionist growth-at-any-price policies, including ignoring the IMF, abandoning price stability objectives, breaking contracts with foreign investors, and shafting bondholders, are finally slowing the economy sharply. This comes at a time when the external environment has become decidedly negative, with export volumes tanking. The Kirchner government (Peronist Party) is rapidly declining in popularity. Rising tensions with farmers are threatening a repetition of the costly March 2008 farmers’ strike.

Investors’ confidence has deteriorated sharply. Credit default swaps soared to 4300 in early January and are now at 3120. That means one must pay $3,120,000 per year to protect $10 million of Argentine debt against default.  Investors have not forgotten that in 2001 Argentina was responsible for the largest sovereign debt default in history.  The government’s nationalization of pension funds in November, a transparent grab of assets to fill a growing gap in debt-service finance in 2009, dealt a serious blow to business confidence and eliminated a significant portion of the domestic capital market. 

Argentina’s equity market is moribund except for the Buenos Aires-listed Brazilian company Petrobras and the Luxembourg firm Tenaris.  The situation can be summed up by last week’s action by MSCI Barra, which is downgrading the Argentine market to “frontier-market” status from “emerging-market” status in its indexes.  Others sharing that status are Sri Lanka, Lebanon, and Kazakhstan. This is a sorry situation for a country, blessed with ample natural resources, that once had one of the strongest economies in the world. The blame rests solely on the shoulders of those who have been guiding economic policy.

Mexico

The very close interrelationship with the US economy, which in boom times is a great benefit to the Mexican economy, is bringing the latter sharply to a halt.  Merchandise exports (non-oil) to the US (24% of GDP) have been hit particularly hard. The negative effects on government finances of the global downturn in the oil market have been offset significantly for 2009 by a successful hedging program. The full brunt of lower oil prices will hit in 2010.  Remittance flows from the US are contracting. 

Economic policy responses have been behind the curve and too timid. In particular, monetary policy has not eased sufficiently to keep credit flowing.  The banking system is largely foreign-owned, and US and Spanish parent banks, under great pressure in their home markets, have significantly reduced their lending while increasing credit costs.

Along with these substantial economic headwinds, Mexico is experiencing a sharp increase in violence on three fronts: between the authorities and the drug cartels, among the drug cartels, and between the general public and a wide range of criminal elements. Increasingly, this violence involves the use of military weapons.  Mexico has become a dangerous place for businesses to operate. Heightened security risks together with a likely increase in social tensions due to economic problems will weigh heavily on investor and consumer attitudes.

Brazil

As signaled by recent credit default swap trends, investors have a more favorable view of Brazil than they do of Mexico.  Nevertheless, Brazil’s growth has also collapsed, hit by the global confidence crisis and the plunge in Brazil’s global markets, particularly China. In December Brazil’s industrial production was down 14.5% year-over-year, the worst decline ever recorded. In part, this appears to reflect a sharp inventory correction.  While the slowdown no doubt will continue in the first half of 2009, there are reasons to expect that a recovery will become evident by the summer.

First, the Brazilian economy is not suffering from a crisis in the housing sector, nor is the Brazilian consumer overextended.  Second, the government has moved rapidly to adopt important policy stimulus measures. The central bank, drawing upon the country’s ample foreign reserves, stepped in to provide funds to companies with important foreign liabilities.  It has also encouraged large banks to buy the loan portfolios of relatively weak smaller banks. Third, Brazil’s economy is becoming increasingly linked to China and the rest of Asia, while links to the US economy are weakening. The relatively positive outlook for the Chinese economy and non-Japan Asia is bullish for the Brazilian economy and for its equity market.

Chile

Economic and central bank policies in Chile have for a long time stood head and shoulders above those of other Latin American countries, and the Chilean economy and markets are now realizing the benefits.  Of course, Chile, a small open economy, has not been able to avoid the downdraft from the global recession and financial market problems. The price of its major export, copper, has plummeted. Economic growth for the year may be on the order of 2%, compared with 3.5% in 2008.

Nevertheless, relative to other countries in the region, Chile has outperformed. Indeed, its equity market has been one of the few bright spots in a global sea of red. Over the past three months the Chilean equity market increased by 10.7%. This compares with a 2.6% increase in the Brazilian market and declines of -19.8% in Mexico and -18% in Argentina, according to the MSCI indices for these countries.

Because of past rigorous fiscal policies (a cumulative fiscal surplus of 21.7% of GDP over the 2006-08 period), the government was in a good position last month to announce a $4 billion fiscal stimulus package. The proactive central bank followed up on February 12 with a swinging 250-basis-point reduction in the policy interest rate.  While this cut might have been expected to lead to a weakening of the currency, the Chilean peso strengthened by more than 2% after the announcement, a striking market endorsement of Chile’s economic fundamentals and policies.  Lower interest rates are likely to be more effective in Chile than elsewhere in the region.  Years of sound regulation have resulted in a capital market that is far deeper than those of Brazil and Mexico (measured by credit as a % of GDP).

Investment Implications

All Latin American economies have been hit by the global recession and will continue to be affected by swings in global risk aversion. However, the prospects for the national equity markets of the four countries under discussion differ markedly.  Only one of the four, Argentina, is suffering from the self-inflicted wounds of seriously unsound economic policies.  One other, Mexico, is confronting domestic security concerns on an unprecedented level as well as the (temporary) disadvantage of very close linkages to the declining US manufacturing sector.  The economies of the remaining two countries should outperform during the coming months and the eventual global recovery. At Cumberland, we have positioned our ETF portfolios accordingly, overweighting Chile and Brazil and significantly underweighting Mexico.