By Raymond Michaels – raymond.michaels@internationalbanker.com
The US Federal Reserve first launched its quantitative-easing program in the late autumn of 2008, as the financial crisis raged across the world. Three months earlier, Lehman Brothers had proven to be beyond saving and had collapsed with a mighty thump. During this first round of asset-buying, the US central bank spent a total of $1.7 trillion on mortgage-backed securities, pouring liquidity into the market and restoring some degree of investor confidence. Interest rates fell from 6.3 percent to 5.2 percent, and it seemed as if the economy would regain its balance quickly. However, bank lending continued to be tight for quite some time, and investment opportunities at home were definitely not in abundance. The Fed continued with the purchase of US treasuries, pouring $85 billion into the economy every month during the second phase of the program.
Meanwhile, investors focused their attention on the outside world and more specifically on emerging markets, which offered ample opportunity for attractive returns. Emerging markets need infrastructure, they need housing and most of them are rich in natural resources that need expertise and equipment to exploit. Furthermore, according to an overview of the investment benefits of these markets by the Australian Emerging Markets Master Fund, emerging economies are growing at a healthier rate than developed ones – something that was particularly true between 2008 and 2012, at least – their populations are generally younger, and the affluent class is steadily expanding, driving increased consumption. And then there are the natural resources, a factor that no investor should underestimate. Latin America has been a target for foreign investors for quite some time, and this interest naturally spiked after the Fed’s program started to ease liquidity concerns. The continent features all the main characteristics of emerging markets, including a predominantly young – and growing – population, increasing affluence driving consumer demand and spending, and an abundance of natural resources. Foreign investors flocked to Latin America as they flocked to Southeast Asia, to make the best of their resources.
Then, in May last year, the Fed’s chairman, Ben Bernanke, who had navigated the QE ship since its inception, said that the bank was considering starting to wind down its securities-buying program. Plummeting national currencies, crashing bond and equity indices, the Fed dealt emerging markets a heavy blow. This blow was expected by many as it could only be a logical consequence of these economies’ significant dependence on foreign capital. Instability continued throughout the summer of 2013, while the Fed was giving mixed signals about whether or not it would or would not start tapering, and, later, when it would start. As usual, economic instability could lead to political instability, but Latin America proved to be largely resilient to political turmoil. Aside from that, the continent was hit by wavering investor interest as the dollar started to rise, and domestic bond yields started to look more attractive to US investors, given the lower risk compared to the higher-yielding emerging-market debt. What’s more, as The Economist pointed out in a 2013 analysis, economies that relied a lot on commodity exports had to deal with falling prices, as the growth of the world’s largest consumer, China, slowed down in the same year. Latin American economies have a definite “commodities bent” that makes for potential vulnerability when prices go down.
The Fed announced its first asset-buying cut, by $10 billion a month, last December, which wreaked havoc on many emerging markets, but Latin America withstood this storm. There were several reasons for this relative stability on the continent, and these have been laid out by the head of IMF’s Western Hemisphere Department, Alejandro Werner. To begin with, Latin America has traditionally had close ties with the US, so any effort to improve the financial stability of the latter will be beneficial for the former. What’s more, given the South American continent’s reliance on raw materials, improving US financial stability becomes even more important as it will boost demand. The market shakeup that followed that first announcement by Bernanke in the summer of 2013, however, highlighted some faults in the Latin American economies, including lax fiscal policies, widening current-account deficits and economic growth that’s been losing steam since 2009. As the Fed progresses with the QE wind-down, the need for structural reforms and robust fiscal buffers is becoming increasingly obvious. Still, according to Werner, Latin American countries can be safe in the knowledge that their economic policies are better than 10 or 20 years ago, the banking system is more solid and flexible exchange rates have been adopted, giving central banks a wider berth when having to respond to market challenges. An additional advantage of Latin American economies is that the bulk of foreign capital inflows are in the form of foreign direct investments and central-bank international reserves, rather than the more uncertain portfolio investments.
The relevance of portfolio investments was recently reinforced when the IMF released its latest Global Financial Stability Report, in which it comes to the surprising conclusion that portfolio investors are much more sensitive to events happening outside their target market, rather than focusing on the individual strengths of this market. According to analyst Ralph Atkins writing for the Financial Times, one possible reason for this potential vulnerability is the fact that the flows of bonds issued in emerging markets have increased at a fast pace, especially bonds targeted by retail investors. Bond mutual funds, a common vehicle for retail investors, are as a rule more sensitive to global events concerning financial markets, the IMF notes in the report. They are twice as sensitive to such events as equity funds and much more sensitive than vehicles preferred by institutional investors, such as pension funds, sovereign- wealth funds and insurance funds. Another issue is the size of most emerging markets relative to global capital markets. When foreign investors withdraw their capital from an emerging market, there are no local investors big enough or numerous enough to take their place. Still, the IMF found that European fund flows are more susceptible to sensitivity than US funds, and Latin America is, after all, closer to the US than to Europe.
So, it seems that unlike other less fortunate emerging markets, Latin America as a whole has been in a good position to weather the effects of the Fed’s continuing QE tapering. What’s more, after the winter start of the wind-down, which saw many emerging-market currencies register huge drops with political instability ensuing, by this spring investors had started to return to these markets. According to a May analysis in the Wall Street Journal, investors are flocking back to emerging economies at the fastest rate in more than a year. Net inflows into EM-focused mutual and exchange-traded funds totaled $13.2 billion over April and May, data from EPFR Global showed, after ten months of net outflows. It is evident that investors are becoming confident once again, after seeing how these markets dealt with the chaos that the Fed’s taper plan caused initially. In other words, fear of the unknown has to an extent subsided, combined with increased risk appetites as the US and European economies signal that, although slowly, they are returning to the growth path.
All in all, one could conclude that despite some temporary market disturbances, the Latin American economies are well placed to survive the Fed’s tapering unscathed and even at an advantage. For example, Brazil’s main index alone rose a total of 16 percent over April-May. These economies are now benefiting from a global race after bigger bond yields, after the recovery in the US and Europe proved to be indeed slow and hesitant, with interest rates lower than investors deem profitable enough. Brazil, again, is a case in point, with its benchmark 10-year bonds yielding 12.4 percent, and investors eager to take advantage of the attractive rate. Last year, Latin America’s biggest economy had quite a bit of trouble on the bond market, following the capital outflows in early summer, but now it is staging a strong comeback. What’s more, emerging economies are increasingly issuing debt in their local currencies, rather than in dollars, which makes them less vulnerable to external influences, US QE tapering included. At the same time, it makes them more dependent on central-bank measures aimed at stimulating the economy, which, though not in itself necessarily a disadvantage, could cut both ways.
Despite the overall rosy outlook, there are risks associated with emerging-market investments, and one of these risks has to do with investor sentiment. Risk appetites tend to swing up and down, depending on a wide variety of factors, and often rumors, which introduces a degree of uncertainty when it comes to foreign-capital flows into Latin American markets. A perhaps more significant danger is China’s slowing growth. As already mentioned, Latin American economies, led by Brazil, Chile, Peru, Colombia and Mexico, are very commodity-oriented, and China is one of the biggest consumers of raw materials in the world, the biggest for some of them. China’s authorities have been dead set on stimulating the economy and restoring the growth pace from recent years, but the truth is that the country’s economy is currently expanding at its lowest rate of two decades. This, if it continues, could have a serious effect on Latin American economies, especially in view of the fact that most of the continent’s exports to China are iron and copper, both of which have been experiencing significant price fluctuations recently. The iron-ore market is currently oversaturated, pushing down prices both for the raw material itself and for steel. This oversupply coupled with lagging demand has been cause for pessimism among analysts, with Goldman Sachs recently projecting that prices for iron ore could drop to as little as $80 per tonne. China’s demand for copper is also declining, weighing on international prices. Recent figures from the country’s statistical office revealed that copper imports have fallen to their lowest in about two years, and analysts suspect further declines are on the horizon.
The oil industry is holding strong, with prices on international markets supported by factors such as the continued output slump in Libya, the gas dispute between Russia and Ukraine and stable demand from the US and China. Mexico’s Pemex recently divested a $2.1-billion stake in Spanish Repsol, saying it wants to focus on domestic-production operations. Brazil’s Petrobras, for its part, announced it will start developing a new group of offshore oil fields that may be the biggest oil discovery of this century, ramping up output that has been falling over the last couple of years and reversing a continual loss of market share. Outside the resources industry, Latin America is investing in major infrastructure projects that, according to fresh London School of Economics research, could push the continent’s GDP growth rate by 3 percent above the trend line in case the region doubles its infrastructure investment. The top 10 infrastructure projects in Latin America, as listed by consultancy CG/LA Infrastructure, include the construction of a subway in Bogota, Colombia, a project worth $3.6 billion; a subway extension in Quito, Ecuador, estimated at $1.5 billion; a 50MW power plant in Uruguay, worth $240 million; an expansion of Colombia’s Cartagena port, worth $500 million; and the construction of a deep-water port on the coast of Rocha in Uruguay, a project estimated to cost $500 million. The top-ten list also includes a $2.8-billion project for the construction of natural-gas and liquid-gas pipelines in Peru; a new airport in Mexico City, worth $4 billion; the building of an $11-million port in Chile; a cargo terminal in Brazil worth $1.5 billion; and the construction of three hydropower plants worth $330 million in Honduras.
So, despite challenges inherent in the region’s classification as one containing emerging economies, political and economic developments from the last few years have confirmed that Latin America has a mostly healthy investment climate, and the overall political stability that could ensure the solid inflow of foreign capital, despite the risks discussed above. Economic recovery in the US and Europe is likely to take a long time, based on the slow pace at which it has been moving and the hurdles it has been encountering, so there is a very good chance that Latin America, along with other fast-growing emerging markets, will continue to be a destination of choice for investors, even after the Federal Reserve completes the wind-down of its stimulus program.