Is the Latin American party coming to an end?

The continent's markets are in a strong position, but the high might not last, warns Jenne Mannion

The Latin America Index has returned 58.1 per cent in sterling terms over the year to 27 June. Meanwhile, the funds that specialise in the Latin American market have posted similarly impressive returns, of around 50 per cent or more over the year (see table), making them the best performing of some 2,000 funds in the market place.

A key reason behind this outstanding performance is that the Latin American market is dominated by oil and commodity stocks, and rising prices have fed through to company profits. The Latin American index has almost a quarter of its weighting dedicated to natural resource companies. It also helps that these countries have had virtually no exposure to technology and healthcare companies, which were among the world's weakest sectors over the past year.

From a British investor's perspective, the recent strength of the US dollar – which influences the direction of many of the Latin American currencies – has boosted returns when converted back to sterling.

But it's not expected to be smooth sailing from here. In fact, Rupert Brandt, manager of the F&C Latin American Investment Trust and Latin American Equity fund has taken the unusual step of suggesting that potential investors do not buy his funds right now. "There are too many storm clouds gathering over the region's markets and there is likely to be a near-term setback," he says.

The catalyst for this correction, Brandt says, will be slower US growth, rising inflation and weakening commodity prices. Additionally, presidential elections in key Latin American markets in the year starting from December 2005 have added further uncertainty.

Countries to hold presidential elections include Chile, Brazil, Mexico, Venezuela and Columbia.

Brandt also suggests that two key currencies in Latin America, the Brazilian real and the Mexican peso, are now overvalued and are likely to weaken in the next 12 months. However, he says any setback would offer a good buying opportunity, as the outlook for this market is exciting over the longer term. "We believe the region is set for a secular bull market, potentially equivalent to that experienced by the US in the 1980s," he adds.

Brandt says the three key markets of Mexico, Brazil and Chile, which account for 90 per cent of the index, have substantial long-term attractions. Mexico is a major convergence story with the US, Brazil has undergone deep-routed reforms and has tamed inflation. Meanwhile, Chile has a very pro-business government. There are also plenty of attractions at a company level. The companies in these countries are generating plenty of free cash flow, says Brandt.

Jules Mort, fund manager of the Threadneedle Latin America Growth Fund, says one of the chief concerns with the Latin American market is rising US interest rates. Indeed, seasoned Latin American investors remember how the Fed's monetary tightening in 1994 helped precipitate the Tequila crisis, where the value of the peso plummeted.

However, Mort points out that Latin American markets are now in a far stronger position than they were 11 years ago. For instance, in 1994 Mexico was running a current account deficit equal to around 7 per cent of GDP, while trying to protect a fixed exchange rate. Compare this to Brazil more recently. Last year, Brazil had a current account surplus of 1.9 per cent of GDP.

"It should also be noted that in 1994 most Latin currencies were fixed, but now all major economies have floating currencies," Mort adds. "And back in 1994, valuations were at a premium to developed markets but now they are at a discount."

Finally, he says, in 1994 the speed and magnitude of US tightening surprised markets. Today the Fed has made it clear in both its actions and statements that monetary policy is too accommodative and will continue to be tightened.

Nevertheless, Mort warns that the Latin American market will be volatile. A short-term risk, he says, is that while rises in interest rates have been well flagged, it is not clear that investors have priced these into their expectations.

Justin Modray, an independent financial adviser at BestInvest, believes the outlook for Latin America is mixed. Indeed, slowing growth from China will hurt commodity prices and there is a big question mark over whether oil prices can rise any higher than their existing levels, he says.

However, on a more positive note, he says the local economies are stimulating domestic demand.

Modray is keen to warn that Latin America is a high risk market and investing in a Latin American fund means concentrating your bets into just a few countries and sectors.

For instance, the Latin American economy is led by Brazil and Mexico. In turn, Brazil is dominated by commodities and oil while telecom is a dominant sector in Mexico, which is also strongly influenced by the US economy.

The Threadneedle Latin American Growth Fund, for instance, has 24 per cent of its portfolio exposed to commodities, 20 per cent in telecoms, 17 per cent in financials and 10 per cent in energy. "This shows that more than 70 per cent of the fund is exposed to four potentially turbulent sectors," Modray says.

There are only four Latin American unit trusts, or Oeics, and one Latin American investment trust that British investors can choose from.

There are also a handful of offshore funds. There used to be more Latin American funds, but these have either closed or merged into mainstream emerging markets funds.

Modray suggest clients gain exposure to Latin America via mainstream emerging markets funds rather than one of these specialist offerings. This is partially due to lack of choice among specialist Latin American funds and due to concern that the markets are too dominated by a handful of sectors.

Darius McDermott, an adviser at Chelsea Financial Services, says even high-risk investors should hold no more than 5 per cent of a diversified portfolio in Latin American funds because of the high- risk nature.

Comments