To The Moon

Elevated inflation prints not seen in years have led to Central Banks laying out a road map for a series rate hikes. Shortly after, a military conflict between Russia and Ukraine broke out which saw prices of commodities trend higher. Since then, market participants have sounded a cautious tone as they come to grips with the prevailing market environment, sparking a rout in both equity and bond markets.

Amidst all the selling pressure witnessed in global markets, the Latin America (“LatAm”) equity market stood out as one of the best performing market as we draw an end to the first quarter of this year – MSCI LatAm Index registered returns 27% as of 25 March 2022, in USD terms, outperforming global peers by a huge margin.

Chart 1: LatAm Index is the standout performer till date. Source: Bloomberg

To put things into context, LatAm was wildly favored in 2021 by many investment professionals as a confluence of catalyst such as 1) the global growth recovery gaining traction, 2) commodity upcycle as well as 3) the weakness of the greenback, sets the stage for LatAm equities to perform. Nonetheless, the region’s equity market ended yesteryear as one of the worst performing markets despite several tailwinds.

That said, after its poor performance last year, we saw a quick turnaround for the region’s equities three months into the new trading year. In today’s write up, we will be elaborating more on what drove the LatAm region’s market performance and evaluate the outlook for the region’s market ahead.

What is the Latin America region?

The Latin America region comprises of both North (includes central America and the Caribbean) and South America. The regional bloc is particularly sensitive to global economic growth conditions, with most economies in the region classified under the emerging market (“EM”) umbrella – commodity exporters like Brazil and Mexico equities accounts for the bulk of the Index.

Chart 2: MSCI LatAm Index geographical allocation. Source: Bloomberg

Delving deeper under the hood, we notice that cyclical sectors such as financials, materials and energy makes up for more than half of the total weightage of the index, which explains why the bloc is sensitive to economic changes.

Chart 3: MSCI LatAm Index sector breakdown Source: Bloomberg

What drove the region’s equity performance?

As gleaned from Chart 2, Brazil has more than 60% weighting in the Index. With its strong performance year-to-date, the country’s equities has uplifted the performance of the index. This leads us to the point on what drove Brazilian equities stellar performance. In our view, supporting the performance of Brazilian equities was

1. the fact that the country is a huge beneficiary of the surge in commodity prices;
2. high interest rates and;
3. cheap valuations after being shunned by market participants.

Surge in Commodity prices is a tailwind for Brazilian equities

Before the invasion of Ukraine by Russia, commodity prices have already risen markedly as demand appears to outstrip supply. However, with the military conflict that has come to fruition in late February, market participants have priced in a supply shock due to the two country’s role as an exporter of commodities.

For a better understanding, Russia is amongst the largest global oil producers with a market share of 12% and the second largest producer of natural gas. Additionally, it also has a decent market share for copper, steel and nickel. On the other hand, Ukraine is a huge exporter of food sources with wheat being the commodity widely exported.

While the US and its allies have thus far stopped short of imposing direct sanctions on Russian oil and gas, it has become increasingly clear that Russian exports are being ostracised – US has signalled that it will ban imports of Russian oil and economies in the Euro-area have pledged to reduce dependence on Russian energy exports.

Hence, with so much uncertainty surrounding the supply side of the equation and demand has been growing as global economies continue to ease restrictions, prices of commodity have rallied ferociously. This spell positive for Brazilian equities given the weighting of energy and metal companies in the index.

Chart 4: Bovespa Index breakdown. Source: Bloomberg

Rate hikes initiated by the Brazilian government is yet another catalyst for equities

Alongside a rise in commodity prices, the Brazilian Central Bank has also been on a tightening cycle for a yearlong – the Central Bank has delivered one of the most aggressive tightening cycles in the world, raising rates by 975bps over the past year to curb with the sizzling hot inflation.

Given the financial sector having a sizeable allocation in the Bovespa Index, the rise in rates is a major catalyst for companies in the sector, bolstering the performance of the index – financial institutions tend to benefit in a rising rate environment as profit margins expands when rates climb.

Valuation of Brazilian equities appear cheap

After two years of poor performance, Brazilian equities have become relatively cheap – equities trade at a P/E of 7.5x compared to a 10-year average of 14.2x. Yes, a low P/E does not translate to potential price appreciation. In our view, what triggered investors to pile into Brazilian equities in droves is the fact that the index comprises of a rather heavy weightage towards mining and energy companies where earnings growth has historically been in sync with changes in commodity prices.

Chart 5: Valuations Brazilian equities present an opportunity. Source: Bloomberg

Chart 6: Positive earnings revisions comes on the back of rising commodity prices. Source: Bloomberg

Recognising the fact that commodity prices have been rising across the first quarter of 2022, earnings of Brazilian equities have been revised higher. Nevertheless, there is still greater scope for positive revision ahead, especially with so much uncertainty surrounding the commodity market that could result in higher commodity prices. Therefore, we believe that global investors have been enticed to allocate some of their monies to the country’s equities.

How will LatAm perform going ahead?

Broadly, we believe that LatAm equities still have room to experience price appreciation as 1) a medium-term USD weakness and 2) the commodity upcycle which we opine will continue to remain robust, will act as catalyst to the region’s equity.

The commodity upcycle is here to stay

China is a dominant buyer of metals and the demand from the Chinese will directly benefit exporters in the regional bloc. Now that China has signalled a willingness to deploy extra policy support to ensure stable economic performance ahead of an important party leadership congress later this year, demand from the Chinese will likely be here to stay, providing an encouraging backdrop for commodity prices this year – fiscal policy will loosen to accommodate this year’s growth objective, which includes infrastructure spending that requires large amount of metals such as steel, iron and copper ores.

Chart 7: China credit growth leads to higher commodity prices. Source: Bloomberg

Having mentioned that, there is more to gain from China’s burgeoning demand as China’s relationship with Australia (the country is a key competitor of Brazil in the commodities trade) continues deteriorates. Given that more than half of China’s iron ore supply comes from Australia, the worsening Sino-Aussie relation will turn in favour for Brazil and Latin American countries as China will likely turn to the region to diversify its supply lines.

Noting that China and Russia have strong geopolitical ties, we believe that the likelihood of China turning to Russia for supplies of metals at the current juncture is relatively low as such a move may risk sanctions being imposed by westerns peers, in essence putting the growth objective of China at a disadvantage as well as Xi’s new term as the country’s leader, but do not rule out the possibility.

Lastly, demand outside of China is expected to rise as well. The European Union have committed to a huge fiscal spending over the next few years – a sizeable portion of the EU Nextgen fund is tilted towards climate specific spending.

Moving to the supply front, commodity supply was already tight and was going to lag demand due to structural under-investment, weather and labour, but with the war in Ukraine and sanctions against Russia, supply has tightened further. Being a regional bloc bestowed with rich natural resources, we believe that LatAm will reap the benefits of the commodity upcycle which we think still has legs.

Chart 8: LatAm equities has a positive correlation with global commodities prices. Source: Bloomberg

LatAm equities stand to gain from a weaker greenback

The USD index has risen quite a fair bit but is likely to see continued weakness especially against LatAm currencies such as Brazilian Real and Mexican peso. Dollar weakness is a positive for LatAm assets as it 1) alleviates EM’s USD debt repayment stress, 2) lowers default rate risks 3) supports commodity prices and 4) translate to additional returns for market participants – currency has always been a huge factor affecting returns when investing in EM as the value of assets depends very much on the strength or weakness of the local currency. So, what leads to the conclusion that USD will face downward pressure in the months to come?

What will drive USD to trend lower is 1) the flow towards safe haven if tensions between Russia and Ukraine are long lasting, 2) constant volatility in US asset markets, 3) the wide interest rate differentials and quantitative easing measures between the Feds and Central Banks of countries in the LatAm region and 4) expectations for EM to outperform. The mentioned factors sets up the prospect for a medium-term dollar weakness vis a vis EM currencies.

Key risks

While the outlook for the LatAm region appears rosy, investors should note that an investment into the region does not come without risk. The most imminent risk we see at this point is the upcoming political election.

Brazilian presidential election is occurring in October 2022. Ongoing polls have suggested that the election will be competed between the current president, Jair Bolsonaro and the top contender Lula Da Silva. Regardless of who wins the election, history has proven that due to the uncertainty that comes on the back of the election results, volatility will be expected in the period during the elections

Chart 9: Volatile markets expected before the election. Source: Bloomberg

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