The events in the Middle East and North Africa coupled with the earthquake and tsunami in Japan unsettled markets everywhere. There was a sudden rush to liquidity, and currencies, commodities and bonds responded irrationally. The Japanese yen strengthened even though the Bank of Japan was expanding the money supply vigorously, which, in effect, was debasing the currency. The Group of Seven intervened in the currency markets, showing a degree of impatience over the weakening of the dollar. Over time the yen should decline. Oil, which had risen over Middle East instability, declined because of concern about slower growth around the world. Other commodities also were weak for the same reason. Japan may require more fossil fuel for electrical power generation if nuclear capacity is reduced, and some Japanese food production may be contaminated, requiring more imported supplies. The 10-year Treasury yield declined even though the Japanese, who hold the second largest amount of U.S. government securities (after China), were likely to use their trade surplus to rebuild their country and not buy at Treasury auctions. The flight of fear capital into U.S. Treasurys and the expected weakening of the U.S. economy were the likely reasons for this. Gold also declined in the liquidity rush even though it usually rises in periods of major uncertainty. This initial behavior (since reversed) mostly is indicative of a world where fear and a desire for current liquidity cause conditions at variance with what might have been expected.
I believe the situation in North Africa and the Middle East will stabilize soon. Colonel Qaddafi’s power will be reduced in Libya; the country may be divided into two parts. To remove Qaddafi from power probably will take U.S. and other forces on the ground and President Obama has clearly stated he will not authorize that. By supporting the “no-fly zone” intervention we are effectively providing aid to the Libyan rebel forces, and their political objectives (other than being anti-Qaddafi) are unclear at this time. Regime change will not move beyond Egypt and Tunisia. In spite of current demonstrations I think Jordan and Syria will remain under their present leaders. We should be aware that dictatorships do not become democracies overnight and the delicate political balance that existed in the area before the turbulence will be changed with implications for American influence and Israel. Kingdoms in Bahrain and Saudi Arabia will remain in place.
In Japan the Fukushima nuclear facility will eventually be brought under control and the country will begin the recovery process. Japan’s economy was improving before this happened. While the country was shaken by this major nuclear incident, Japan is a remarkably resilient nation and the rebuilding could prove stimulative. There have been some plant closings and supply disruptions, but I believe these will prove to be temporary and most manufacturing facilities will be back to normal in several months. The United States economy was also gaining momentum before these events and Gross Domestic Product (GDP) estimates were being raised. While the circumstances in Japan may have a short-term negative effect on world growth, I believe 2011 will turn out to exceed the expectations held by economists at the end of 2010. As for the equity markets, I expect them to move higher by year-end.
Opportunities Broadening South of the Border
While investors have China and India at the top of their emerging market focus lists, investment opportunities in Latin America continue to improve. Brazil is most notable because of its high level of food and oil production, giving the country a favorable natural resource to population ratio, and investors have included that country on their list of favored emerging markets in global portfolios. Much less attention has been paid to other countries in Latin America in the belief that those markets are too small or there are too few attractive companies there. Not many investors have positions in Chile, Peru or Colombia.
For some time I have been wondering whether global portfolio managers are missing something, so I decided to go down there and talk to analysts and institutions to see if a broader approach to investing in Latin America should be taken. I spent time in Brazil, Chile and Colombia, and my overall conclusion is that South America is going to present global investors with abundant opportunities going forward. The countries have young populations yearning to improve their standard of living. Several of them have substantial natural resources, including oil, gold, copper and iron ore. Most of the countries have made considerable progress in improving their infrastructure over the past two decades. I visited São Paulo, Santiago, Bogota and Medellin and was impressed with the number of modern buildings, the quality of the residential neighborhoods, the cleanliness of the streets (although there is a fair amount of graffiti) and the optimism of the people. Latin America has come a long way from my first visit in the 1960s.
Brazil has a population of about two-thirds and a GDP of about one-tenth of those of the United States. Its per capita income is about one-quarter of that of the U.S. and 26% of its population live below the poverty line. The country is growing at better than 5% and the inflation rate is 4%. Brazil has a budget deficit of about $80 billion and its public debt is about 60% of GDP. The country has 12 billion barrels of proven oil reserves. Its principal problem is inflation. Food prices are rising rapidly and food accounts for more than 30% of the Brazilian consumer price index. The central bank there is curbing money supply growth to control the rise in prices and the risk is that the tight monetary policy slows the rate of growth below 5%.
Opening a business in the United Kingdom takes five weeks; it can take seven months in Brazil. Hiring and firing is complicated. Taxes as a percentage of GDP have doubled compared to 15 years ago. Brazil is ranked 20th in the world in terms of ease of doing business. The savings rate is 15% and the government accounts for 20% of the consumption of goods and services. The country requires considerable capital investment to create the jobs necessary to keep growth above 5%. In many ways Brazil is a more attractive place to invest than China or India, according to analysts there. They must continue to develop their natural resources to attract capital and provide job opportunities for the people. There seems to be widespread confidence that Dilma Rousseff, the new president of Brazil elected last year, will continue the policies of Lula da Silva which proved so positive for the development of the Brazilian economy since 2002.
Chile is a much smaller country, but somewhat better off than Brazil. It has 17 million people and the per capita income is one-third of that of the United States. The poverty rate is only in the teens, much lower than other Latin American countries. The budget deficit is $7 billion and public debt is 6% of GDP. Everyone is aware of Chile’s copper exports, but the country ships a wide variety of agricultural products and fish (sea bass) abroad. China, the U.S. and Japan are important customers. About 20% of their imports come from America.
Colombia is a country of sharp contrasts. Its 44 million people have a per capita income of $9,200, which is comparable to Chile, but 47% of its population live below the poverty line. The country’s budget is roughly in balance today, but its public debt is 46% of GDP. Like Brazil, it has considerable oil reserves but it also exports a variety of agricultural products including cut flowers.
While we only stopped over in Peru, I think it is useful to review some of its data. The country has 23 million people and a per capita income of $8,600, but 44.6% of the population live below the poverty line. Debt is only 25% of GDP. The country has a trade surplus as a result of exporting a wide range of agricultural products and fish. It has gone a step further in exploiting its natural resources by refining some of the minerals it mines. The United States is its largest partner in both exports and imports, with China in second place.
Chile, Peru and Colombia combined have a GDP of less than half that of Brazil, so right now they seem too small to deserve much investor attention. But each of these countries is growing at a rate approximately twice as fast as the United States, so by the end of this decade they will be more important and now is not too early to start to learn about them. While many American and European investors think of the smaller emerging market countries as rapidly growing but volatile places to put money, few appreciate how developed their regulatory framework has become. The Latin American countries I visited are all democracies; they all have sophisticated, if not Byzantine, tax and business approval structures.
Latin American investors are very aware that events throughout the world can have an important impact on their economies and their financial markets. I was repeatedly asked how the United States market could do well in the face of rising interest rates. I pointed out that interest rates were aberrationally low today compared to where they were at this stage in the recovery in earlier cycles. The reason for this is that events around the world such as the European credit crisis had driven considerable amounts of fear capital into the United States. Even if the 10-year Treasury went to 5% (where I think it is going), the Standard & Poor’s 500 could still sell at 15–16 times earnings based on historical experience. Investors I spoke with also worried that interest rates would rise sharply once the Federal Reserve stopped its quantitative easing program. However, I do not believe the present low yield on the U.S. government securities is solely a result of Fed buying. Another concern is China, because it is such an important customer of Latin America. Investors are worried that a collapse in real estate there will slow growth and reduce demand for Latin American imports. I responded by saying the real estate problem at the high end is serious, but I still expect the Chinese economy to grow close to 10%.
Investors are also concerned about inflation in Asia causing growth to slow there because the central banks are tightening. They wonder if the unemployment problem in the U.S. will result in more stimulus and bigger deficits, so eventually taxes will be raised and growth will slow, reducing demand for Latin American imports. Investors fear that regime changes in the Arab world will destabilize the area, resulting in higher oil prices and slower growth in the developed world. In sum, the Latin American investors have most of the same worries we have in the United States. Several of the institutional investors I spoke with are curious about the investment prospects for Russia. With the price of oil over $100, the economy there should do well. I explained that Russia becoming more business friendly was one of the “also rans” of this year’s Ten Surprises. Russia believes emerging market investors are avoiding its equities because of a lack of confidence in the country’s legal system, and that had held me back as well, but there was clearly great potential there.
There is considerable interest in how President Obama is doing and whether he will be reelected in 2012. I told them that if the economy is continuing to expand and the situation in Afghanistan and Iraq has improved, his chances of a second term are good. Another concern investors have throughout Latin America is education. There is a feeling that much more needs to be done to raise the standards of schools to keep pace with the increasingly complex technical needs of growing economies in the current competitive world. During the last decade there has been considerable effort to put a higher percentage of the population in school, but recent studies of performance in reading, math and science raise questions about the quality of the education provided. Improving education is critical in dealing with the poverty problem.
Of all the Latin American stock markets only Brazil seems large enough to attract serious investor interest at this time, with a total market value of $1.5 trillion. Chile, Peru and Colombia together have a market value of only one-third of that amount. Average daily trading volume in Brazil is $3.8 billion; the other three countries combined have an average daily trading volume of one-tenth of that. The markets in Latin America are dominated by banks and utilities, with natural resource companies important in certain countries, like Petrobras in Brazil and copper companies in Peru. Widespread international institutional ownership of stocks in countries in Latin America beyond Brazil may not occur for a while, but these countries are filled with promise and they will become more attractive for their investment prospects in the future.
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New York, NY 10154