Mexico continues along the path to reform with President Enrique Pena Nieto recently presenting the government’s fiscal proposals. Labour, education, telecom, financial and energy bills are already at various stages of the legislative process. According to the Mexican finance ministry, the combination of these reforms will put the economy on a path towards potential annual GDP (gross domestic product) growth of above 5%.
The fiscal reforms are not the sweeping overhaul of the tax code that many had hoped for and that are needed to reduce the government’s reliance on oil revenues. However, more bold changes such as the imposition of a value-added tax (VAT) in order to improve collection from the informal side of the economy would prove both unpopular and could run the risk of creating a fiscal headwind at a time when the economy is in a fragile position. Additional reforms will be required in the long term, but in order to ensure that the impressive momentum behind the cross-party “Pacto por Mexico” accord is maintained and that the energy bill is approved, the government is erring on the side of caution with this latest bill.
The impact on Mexican corporations of these changes is onerous in the short term but presents big opportunities in the long term. Productivity improvements will improve the cost structure of labour-intensive industries, more formal employment will drive domestic consumption, and there will be energy savings and investment opportunities from the proposed opening up of the energy sector and other infrastructure plans. The reforms are no free lunch though as they will also spur competition in some sectors, meaning that only the most nimble companies will be able to capitalise.
Opinion column by Nicholas Cowley, Investment Manager, Global Emerging Markets at Henderson Global Investors
Photo: Jean-Christophe BENOIST. Have investors become more sensitive to central bank decisions?
Central bank actions have arguably been the single most important driver of market performance since 2009. The turnaround was catalysed by the US Fed’s pursuit of unconventional monetary policy, spawning ‘sons and daughters’ of QE as other central banks hopped on the bandwagon. Since the advent of QE1 (November 2008) the MSCI World Index has roughly doubled in US dollar total return terms, and 10-year treasury yields have been as high as 3.98% (April 2010) and down to as low as 1.40% (July 2012). No wonder investors are on tenterhooks when central bank decisions fall due, and why they scrutinise statements for evidence of future intentions. In the case of the bond markets, central banks have had an explicit policy of driving yields lower across the yield curve and implicitly pushing prices higher, in order to stimulate higher economic activity. In equities, however, policy has been less clear cut, but nevertheless the Fed in particular has spoken about confidence levels and wealth effects being driven by asset prices. It seems reasonable to deduce that they have been supportive of their move higher.
But, inevitably, as economic activity improves, the taps will have to be turned off. And therein lies the rub. Going cold turkey won’t work in a market that has become very fond of virtually unlimited liquidity. In this respect, US tapering is a more nuanced version of stopping QE: in theory stepping down asset purchases weans markets off central bank support a little at a time. But, the beginning of this withdrawal period is something that the world fears – not simply because of the risk of a policy error, but because a return to fundamentals-based investing has to occur. This could greatly affect areas of the capital market that have seen substantial inflows, an effect recently seen clearly in emerging market debt. The pace of economic recovery will differ across countries/regions, so greater care will have to be taken with asset allocation decisions. Making the correct call on fixed income exposure could be one of the most crucial decisions if the outlook for rates changes dramatically
Article by Bill McQuaker, Head of the Multi-Manager Team at Henderson Global Investors
Recently, I had the opportunity to join one of our Matthews Asia portfolio managers during a research trip to India, and was reminded of both the importance of such on-the-ground visits as well as the rigor required to conduct them.
A typical research trip for our investment team members can involve a hectic schedule of meetings with up to 50 companies during a two-week period. This may often entail travel beyond large cities to sometimes remote inland reaches in search of the best companies to meet a portfolio’s objectives. These face-to-face meetings are critical not only in the evaluation of individual companies and management teams, but in keeping a finger on the pulse of a particular market as a whole. They allow us the ability to take in any changes in a company’s environment and competitive landscape, and better scrutinize their outlook.
We started our trip this time in Mumbai before moving on to Pune and then to Chennai, the capital city of the southern state of Tamil Nadu, and met with firms in a variety of sectors. Perhaps the most striking aspect of life in the world’s largest democracy may be the vibrant tapestry of contradictions. In India, the chasm between the supremely wealthy and abject poor is notoriously wide and yet also in surprisingly close and constant proximity to one another. You only need to walk from your car to the entrance of a board room to witness the disparity. Outside, chaos (although a sort of organized chaos) seems to rule and yet once inside, you may likely find the sort of savvy, forward-thinking entrepreneurs with whom we frequently visit.
India’s remarkable Unique Identification (UID) project exemplifies the country’s contrasts. Started in 2010, the program harnesses advanced technological power in the form of biometric iris scans with the aim to create a fundamental system of accountability among its 1.3 billion people. Now, hundreds of millions of people born without any formal registration or birth certificates can be documented—their existences verified—and may claim services and benefits that citizens in wealthier economies take for granted. This vast and “cardless” endeavor has tremendous implications—not the least of which is a system of inclusion. A secure identity system should help government efficiencies in such areas as taxation as well as combat corruption and voter fraud. It can offer individuals more control over things like financial and medical records and better facilitate such benefits as insurance coverage. While India struggles with such widespread poverty on the one hand, it is leapfrogging developed nations in technological terms on the other.
Health care and education are two other areas that highlight India’s stark contrasts and complexities. While India boasts some state-of-the-art medical care facilities, malnutrition afflicts more than half of all rural children. In terms of schools, there has recently been an expansion in basic education. However, according to UNICEF, gender disparity is still prevalent as almost twice as many girls as boys are pulled out of school, or never enrolled.
In addition, India’s overall population is projected to grow rapidly, and even outpace China as the most populous nation, according to a 2013 United Nations Development Programme (UNDP) Human Development Report. The UNDP study predicts that by 2050 India’s education distribution will still be highly unequal, with a sizeable group of uneducated elderly adults. The rapid expansion in the country’s tertiary education, however, may build a better-educated young adult labor force.
To be sure, the vast Indian landscape is quite uneven, and in varying stages of development. Its infrastructure faces great challenges. We continue to focus on finding solid companies that have the potential to survive and thrive in the toughest of environments. Particularly in a diverse economy as India, Matthews’ bottom-up stock selection process is critical to help mitigate risks that may arise from such factors as inadequate governance and policy hurdles.
In the end, I left India with conflicting emotions—concerned about the current human condition for large swaths of its population but excited and encouraged by the vast opportunities presented by this populous and ever-changing country.
William J. Hackett Chief Executive Officer Matthews Asia
The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.
Matthews Asia’s investment team members regularly travel across Asia to conduct research. Between meeting with management teams, touring factories and catching flights from one destination to the next, we do, on occasion, need to eat. Sometimes it’s room service at midnight while typing up meeting notes, other times we may try some local food. For me, as a ramen lover, the growing number of ramen restaurants across Asia has been a real treat. Apparently, I’m not alone in that thought.
Recently, one of my favorite ramen chains from Japan, Fukuoka-based Ichiran, opened its first overseas branch in Hong Kong. Ramen fans from far and wide lined up for as long as four hours for a taste. With its ease of doing business, proximity to Japan and influx of regional tourists, Hong Kong is quickly emerging as a hub for Japanese ramen restaurants seeking growth overseas. Other cities across Asia are seeing a similar trend. I even found “tonkotsu” or pork bone ramen in Jakarta, even though the population is mostly Muslim.
Ramen’s roots obviously stem from China and Chinese noodles. In the late 1800s, as Japan opened its ports to international trade, Chinatowns started to spring up across the country, bringing with them their culinary culture. The word “ramen” itself was immortalized when the late Momofuku Ando, the inventor of instant noodles, named his first product Chicken Ramen in 1958. Since then, ramen, both instant and traditional, has been enjoyed by billions of people worldwide.
As I pondered the reasons for ramen’s popularity, my conclusion was that flexibility is likely the key. Ramen can come in any size, shape or format as long as there are noodles and some kind of broth. Noodles can come in different shades of yellow and white, fresh or fried, thick or thin, wavy or straight. The broth can vary from pork to chicken to fish, with any combination of vegetables, seaweed, herbs and spices. Not to mention all the different toppings; I’ve seen soft-boiled eggs, peas, bamboo shoots or kimchi and even shaved parmesan cheese. The lack of a rigid formula gives a lot of freedom to those seeking something new, bringing a constant wave of menu innovations.
Ramen is one example of how cultures across Asia have influenced each other over the course of history. As one food industry executive used to say, “Good ramen can cross borders. No one is unhappy about eating good tasting food.” I couldn’t agree more. And as ramen outlets continue to pop up across the region, this development makes my travels at least more delectable.
Column by Kenichi Amaki, Portfolio Manager, Matthews Asia
The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.
Foto cedidaMike Kerley, PM of Henderson Horizon Asian Dividend Income Fund. Is the Yield Trade Over?
The US Federal Reserve’s plan to gradually reduce its bond-buying programme, combined with a significant move higher in US 10-year treasury yields, has prompted investors to rethink allocations based on low growth, low interest rates and high liquidity. This has led to increased volatility across a number of asset classes, including Asian equities, which have fully participated in the downturn. Is this the first indication that the yield trade has run its course?
The sell-off in US treasuries has been understandable but the case is less clear for equities. Although the valuations of equities are impacted by expectations of long-term interest rates, the attraction for most income seekers is the comparison of dividend yield with the rates available for cash on deposit. Comments made recently by Ben Bernanke suggest that short-term interest rates are likely to remain low for some time, given the still weak (but improving job market) and low inflation and as a result the appeal of dividend yield over cash is still very much in place.
Asia also offers some distinct advantages over other equity income strategies. With the yield from some traditional sources compressed to unattractive levels, we believe that dividend growth will become an increasingly important driver for income strategies. Underlying economic growth is expected to remain robust, especially compared to the anaemic recoveries seen in most western economies. This should provide superior earnings growth and hence higher dividend growth over time. The structural argument is even more compelling. Asian companies have changed in the last 10 years and now share similar characteristics to their western peers. Capital expenditure is more rational and as a result cash generation compares favourably with companies in the US and Europe. This excess cash has been used to pay down debt and now many companies sit with net cash on their balance sheets. In the years to come we expect more and more shareholder enhancing announcements such as special dividends, share buybacks, and capital reductions. Most importantly, we think regular dividend distributions will rise because pay-out ratios (the percentage of net profit paid out as dividend) are at record lows.
The chart below shows how dividends across Asia have failed to track earnings over the last three years as companies have been reluctant to increase dividend distributions in a volatile period. This illustrates how immature the dividend theme is in the region but it is encouraging to see the number of companies that have raised dividends in the last nine months given a more benign global environment. With companies continuing to accumulate cash we believe this more positive trend will continue and the gap between earnings and dividends will close. We would not be surprised to see dividend growth outstrip earnings growth in Asia over the next five years.
Source: Bloomberg, Monthly data rebased to 100 from 29.07.05 to 31.07.13.
In addition to the changes in the corporate sector, we believe government policy and increased maturity will drive structural demand for yield. Asian consumers currently hold significant levels of cash, mainly held in bank accounts on deposit. As the penetration of financial services such as insurance and wealth management increases over time and government initiatives improve the social safety net, the need to hold cash will recede. As this money gradually finds its way to more sophisticated savings vehicles, the need for yielding assets will increase significantly.
In summary, we believe the recent weakness in Asian markets is an opportunity to acquire the region at valuations that look compelling compared to history and relative to other equity markets. The positive story for Asian income remains in place both from a cyclical and structural standpoint. Short-term interest rates are likely to stay low for some time ensuring that the premium of dividend yield over cash rates remains attractive. The yield trade is not over, it’s just cheaper than it was!!!
Mike Kerley is manager of the Henderson Horizon Asian Dividend Income Fund
Foto cedidaBen Wallace & Luke Newman de Henderson. Seeing Things in absolutes
Fear and greed have been powerful motivators over the past few years, with investors gripped in turn by panic about the health of the global economy and optimism that central banks have done enough to promote growth. From concerns about the burden of government debt in the western world, to the US ‘fiscal cliff’ leading up to the start of 2013, whichever way the pendulum has swung, investors have followed.
The past few months, however, have seen the steady emergence of a different trend. We first saw it at the start of 2012, when stocks were pricing almost entirely on market sentiment. At that time, the importance of economic newsflow far outweighed the detail of individual stocks. Since then, share pricing correlations have steadily fallen and the dominant macro-economic themes that have driven investors to buy or sell over the past few years are no longer overshadowing stock-specific drivers to quite the same degree.
Source: Bloomberg, CBOE S&P500 Implied Correlation Index (indicating the expected average correlation of price returns of the stocks that comprise the S&P500 Index), as at 7 August 2013
A market where prices move in tandem, such as we saw in the period prior to 2012, limits the opportunities for stock-pickers like us to generate active returns. The lower the correlation in share price movements, the greater the opportunity to find stocks capable of generating higher or lower returns than the market average. This gives room for independent stock characteristics to play a bigger role, providing more opportunities to generate profits from long and short stock-picking ideas.
It can be something of a challenge to overcome some investors’ ingrained preference for bond funds, particularly for those who lost money in the post-Lehman Brothers crash (15 September, incidentally, marks the five-year anniversary of when the company filed for bankruptcy). Bond markets have come under abnormal and sustained pressure in recent months, however, as markets consider the implications of the US Federal Reserve’s plan to start pulling back on its $85 billion per month bond-buying programme.
This has left investors looking for other options for their money in a low growth, low interest rate world. Absolute return funds, which are generally considered to sit somewhere between a bond fund and an equities fund in terms of potential risk are, in our opinion, an attractive halfway house.
For our Absolute Return strategies, the long and short books are equally important and, as always, the key is getting the right mix of holdings. It is an intrinsic part of our management style to be very proactive in scaling positions on the fund. The portfolio is divided into our core long book and a tactical short book, which allows us to move quickly when responding to market events, or when looking to exploit what is a diverse investment universe. Our willingness to utilise this flexibility to adjust the net and gross position has enabled us to generate consistent positive returns, while helping to preserve capital and minimise volatility.
January 2013 marked the first time in some years that we moved the gross exposure above 100%, a statement of confidence that it was a sensible time to put investors’ capital to work. At the time we took some material long positions to more defensive areas of the market that displayed very safe and secure dividend-paying characteristics, such as HSBC and Vodafone. HSBC in particular seemed very well positioned, with a recent dividend increase suggesting that future earnings might be quite good.
Financials has been quite a busy area for us in 2013, across both long and short books, given the sector’s sensitivity to economic data and monetary policy. Central banks have taken extraordinary measures in the past couple of years, directing the risk-free rate to help restore confidence in the economy and to make other asset classes more attractive. While we would not ordinarily choose to go long in miners, a number of resources stocks also seem unduly out of favour, given management changes and improvements in capital expenditure.
The fall in share pricing correlations hopefully marks an end to what has been a lingering hangover from the financial crisis, at least for the time being. In a perfectly efficient market, all investment decisions would be based on rational and measurable factors, with share price volatility driven primarily by the fundamentals of individual companies. Markets certainly aren’t perfect, but in this environment, we believe that an actively managed long/short strategy with an absolute return focus can play an important role for cautious investors.
The past few weeks have been difficult for India as it struggles to stabilize its currency, the rupee, which has depreciated somewhat sharply against the U.S. dollar. The rupee has generally trended down over the past three years due to underlying fundamentals, but a widely anticipated tapering of stimulus by the U.S. Federal Reserve seems to have accelerated its fall. The currency movement has greatly impacted investor nerves and led them to increasingly question India’s balance-of-payments (BOP). However, fears of a potential BOP crisis may be overblown.
One of the key measures that determines the vulnerability of an economy to such a crisis is the external debt-to-GDP ratio. For India, that metric is nowhere close to the level of the early 1990s when the country needed to be rescued by the International Monetary Fund after finding itself on the verge of defaulting on its sovereign debt. Another reassuring factor is the country has foreign exchange reserves of nearly US$300 billion—although only enough to support up to seven months of imports.
Nonetheless, the falling rupee is a challenge to the economy, and policymakers can use this as a clarion call to bring in much-needed reforms. The Indian economy’s challenge has long been to attract sufficient foreign capital to fund domestic growth. On a sustainable basis, the flow of capital can occur either through a robust export industry or through foreign direct investment (FDI) in long-term projects. Reforms are critical to achieving either of these improvements.
However, we are concerned that policymakers are drawing the wrong conclusions about the current state of the rupee. Recent measures announced by the Indian government and the Reserve Bank of India (RBI) suggest that policymakers are viewing the rupee movements as a short-term issue while paying less attention to some of the structural problems confronting the economy. Hence the measures seem to focus on reducing the country’s need for U.S. dollars by restricting or raising the cost of “non-essential” imports such as LCD televisions or gold. Furthermore, in recent days, the RBI has placed some restrictions on the ability of its residents to move capital overseas. The efficacy of such measures is questionable.
The government may be aiming to plug the gap in funding India’s current account deficit by increasing reliance on shorter-term sources of funding, including external debt. While these measures may work in the interim, there must be a concerted effort to attract more sustainable sources of capital that can be achieved by easing the cost of doing business, and by improving domestic business competitiveness. Unfortunately, the country’s attempts to improve competiveness in recent years have been half-hearted. Last year’s much-heralded decision to open FDI in retail, for example, amounted to very little due to certain constraints placed on foreign companies seeking to invest in India.
The silver lining to all this is if recent events can become the impetus for Indian policymakers to pay attention to longer-term objectives of improving competition and productivity within the country. In the past, economic stresses have enabled progressive elements within the country to move forward with reforms. We continue to believe that the underlying attraction to investing in India remains intact, and may get a boost with a more thoughtful framework for economic reform.
Sharat Shroff, CFA Portfolio Manager Matthews Asia
The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.
Wikimedia CommonsFoto: Hex. Panamá: algo más que sombreros de paja
The small isthmus of Panama has a fascinating history, with the forging of the Panama canal being one of the world’s greatest engineering feats. The canal has resulted in Panama becoming a vital cog in the global supply chain, with approximately 5% of world trade passing through its locks. Growth in revenues from the canal have provided support for Panama’s economy, enabling it to be the fastest growing in the whole of the Americas last year. This should continue as a $5.25bn canal expansion project is underway that will allow larger modern container ships to fit through the canal.
But there is more to Panama than a stretch of water that links the Pacific and Atlantic oceans. The economy is becoming more diversified with growth from projects related to mining and construction, as well as services industries such as tourism and banking. Panama claims to have the fourth largest undeveloped copper reserve in the world. Panama City already houses numerous regional banking headquarters and has ambitions to become the financial hub of the Central American region. The government is spending on various infrastructure projects, the need for which are obvious from a visit to the city – tall skyscrapers are interspersed with areas of extreme poverty, as well as terrible traffic and broken pavements.
The local stock market lacks liquidity so there are few ways for investors to get direct exposure to the country other than buying an apartment in Donald Trump’s new 70-storey tower. Copa Airlines and Banco Latinoamericano are based in Panama and are listed in New York. As regional players they demonstrate Panama’s ability to extend its influence beyond its borders. Panama is a fine example of how small countries can often punch above their weight.
Nicholas Cowley, Investment Manager, Global Emerging Market Equities, Henderson Global Investors
Wikimedia CommonsFoto: Totya. El rally bursátil de julio y qué hacer a partir de ahora
After a torrid June, stock markets rallied strongly in July, with the FTSE World index up well over 4% in local currency terms. Pleasingly, the UK, which is a large overweight in most of our multi-asset portfolios, also had a stellar month, with the FTSE All-Share producing a sterling total return of 6.8%. Year-to-date total returns for the FTSE All-Share now stand at 15.9%, and within this the Mid 250 has been very strong, with sterling total returns in excess of 20%.
Looking further afield, US and European equity markets also performed strongly, while Japan struggled to make headway. However, Japan’s muted performance needs to be seen in the context of very strong performance year to date, and recent news flow from the likes of corporate bellwethers such as Toyota suggests that Japanese companies really are reaping significant benefits from the softer yen. Asian and emerging markets also rallied in July, although the latter in particular continue to disappoint in terms of their year-to-date performance.
Two key things helped to underpin the July equity rally. First, the US Federal Reserve has been at great pains to point out that the withdrawal of policy support will be gradual and data dependent. This helped to stabilize bond markets during the month, with benchmark 10-year US Treasury yields rising to only 2.6% from 2.5% at the beginning of July. From here, we anticipate a gradual rise in bond yields, not the rout that some market participants have feared. Nonetheless, despite further modest increases in yields in July, we still see better value in high yield and investment grade credit within fixed income, and are not inclined to close our large underweight in core sovereigns at current valuation levels. For investment grade credit markets, yield spreads continue to provide support but valuations will not be immune to the gradual rise in sovereign yields that we expect. It is for this reason that we have been reducing our large overweight in recent weeks. We remain constructive on high yield, and while market liquidity is thin, valuations are supported by the shorter duration of the asset class relative to investment grade.
The second thing supporting equity markets in July was the general improvement in global macroeconomic data – even in the most stressed areas, such as the peripheral Eurozone. While the better data is clearly positive in terms of sentiment, we are not inclined to reduce our European ex UK equity underweight, given the current political uncertainties and risks. However, this is likely to be something that we discuss in more detail in the months ahead, particularly if the better data starts to translate into meaningful earnings upgrades – although it remains to be seen how well European manufacturers will cope with the global competitive threat that is posed by a weaker yen.
In equity markets, we retain a large overweight in the UK, and are also overweight the Pacific ex Japan, emerging markets and Japan. Our overweight in emerging markets has worked against us this year, but the strength of our asset allocation decisions elsewhere has meant this has not mattered in terms of overall portfolio performance. Moreover, given where valuations are now, we do not think it makes sense to start unwinding this position. In the UK, we continue to regard equity valuations as attractive and further support comes from the UK’s high proportion of overseas earnings, which gives the UK leverage to the global recovery.
Turning to alternative assets, we remain overweight UK commercial property as the high real yield on property remains very attractive and anecdotal evidence suggests that forced sellers have now diminished significantly. Commodities also rallied in July, although perhaps counter intuitively they have been quite volatile when economic data releases have been strong, as market participants have viewed stronger data as hastening the likely demise of quantitative easing. For the year to date, however, returns from commodities remain poor.
Investment Strategy by Mark Burgess, Chief Investment Officer at Threadneedle Investments
Wikimedia CommonsBy Hans Hillewaert. How Will Latin America Weather a “Sudden Stop” in Investment?
Since May, over one-quarter of the past five months’ foreign portfolio investment into emerging markets has been withdrawn, according to the latest available data from Emerging Portfolio Fund Research. For the Latin American economies, this is likely to result in slower growth, but the impact may be milder this time around.
The type of “sudden stop” that we’ve seen in investment flows this year is typically associated with currency depreciations, wider current account deficits and slower GDP growth. Generally speaking, those symptoms are now present across Latin America. The recent selloff followed the announcement that the US Federal Reserve was considering tapering asset purchases later this year. But the deceleration in growth and the increase in external deficits in the region had begun before that, mainly because of weak external demand for the region’s exports and softer commodity prices amid still subpar global growth—and particularly concerns about demand from China.
Previous episodes of capital flow reversals, for instance in 1994, generated significant dislocations across Latin America; they gave rise to sharp contractions in domestic economic activity and prompted emergency adjustment policy packages and multilateral and bilateral loans to help some countries remain current in their external obligations. This happened because countries in the region were overindebted in foreign currency, which after a significant correction in exchange rates required a tightening of fiscal policy to service the debt. That is, the external shock was amplified at the local level.
We believe that although the sudden stop is still likely to result in slower growth in the region, the impact of the flow reversal on Latin American economies should be milder this time around. This is because macroeconomic conditions in the region are now sounder. We see five important differences relative to the situation in the 1990s.
First, current account deficits are generally smaller. Second, fiscal performance is stronger, with some countries even generating an overall surplus. Third, the stock of international reserves is higher, both in absolute terms and as a proportion of GDP, imports or debt payments. The two last and more important differences are that exchange rates are now flexible (see chart), and that the public sector is a net creditor of the rest of the world in hard currency in most countries.
This means that movements in exchange rates will act as partial buffers of the external shock, thus preventing a more severe domestic contraction in those countries with currency flexibility. In our view, this also means that the dynamics of the adjustment will be different, as the depreciation will not give rise to undesirable pro-cyclical fiscal policies. Therefore, we think that although the outflows will prompt diminished macroeconomic performance, most countries in the region are on a sufficiently solid footing to withstand the external shock.
The backup in bond yields is likely to result in increased credit quality differentiation. Thus, there is a good chance that countries with better fundamentals will outperform in the coming quarters. We favor those countries with smaller current account deficits and fiscal imbalances; low external debt amortization schedules; and low foreign holdings of domestic securities. We continue to believe that Mexico is a candidate to perform well in the coming months, while we maintain our view that Venezuela presents significant vulnerabilities.
Fernando J. Losada is Senior Economist—Latin America, at AllianceBernstein
