Are rising U.S. interest rates finally putting an end to the three-year
in Latin American stocks?
Until a few weeks ago, Latin American fund holders had been enjoying the investing equivalent of a massive street party. Their funds averaged greater than 20% returns for three straight years, according to Morningstar.
But climbing U.S. interest rates, along with investor concerns over the unwinding of the so-called carry trade, have rained on Latin America's parade over the past month. The region's funds have dropped 3.5% in that span.
Considering those same funds are still up over 3% year to date -- outperforming most domestic stock funds -- most Latin American fund managers say the good times will roll at least through 2005, though they are not expecting the 40% gains that were common last year. Will Landers, portfolio manager for the $200 million
Merrill Lynch Latin America fund, for one, expects Latin American stocks to return 15% to 20% for the year, on the basis of his belief that the region's equities remain undervalued despite the multiyear run-up. Landers' fund is up 5.3% for the year and has returned an average of 23.3% over three years.
In a conversation with
, Landers explains why rising rates -- and the carry trade -- won't sink Latin American stocks, as well as which countries will be partying the heartiest from here on in.
Latin American stocks have been falling sharply since the end of February. What's behind the volatility?
In my opinion, the volatility we have been seeing lately is not just specific to Latin America but to emerging markets overall. There has been a decline in risk appetite for global markets as the expectation that interest rates in the U.S. might start to move up a little faster than previously forecast.
Why do rising yields in the U.S. weigh so heavily on emerging markets?
I think it's a bit overblown right now, but historically emerging markets, both the countries and companies, have been tremendously overleveraged. That means that rising rates will really drive up the costs of their debt payments.
What we have been seeing over the past few years is that with yields so low in the U.S., Japan and Asia, investors have moved to emerging markets like Latin America as a source for high yield with relatively low risk, given the improvements that we have seen on the macro level. Interest rates are still so far apart between the developed world and emerging markets -- especially in places like Brazil -- that I think we are oversold a bit here. But still, it's hard to find momentum right now.
A lot of the recent jumpiness has been attributed to the unwinding of the so-called carry trade by hedge funds and the possibility of another Long-Term Capital situation. How prevalent is the carry trade, and how much of a problem is it?
The carry trade means that people are borrowing at very low rates in the U.S. and buying Latin American bonds with much higher yields. If this was to unwind quickly, you could have some liquidity trouble. But the fact is that rates in Brazil are still going up -- the central bank in Brazil just raised rates -- and they are going to stay up for a while, at least through the third quarter. So there is no rush for investors to unwind that trade right now since they are still making a decent return on it.
Also, the Latin American countries affected by this trade -- Brazil, Mexico and Chile -- have reduced debt levels quite a bit, which limits the possibility of things getting out of hand.
Let's go through the players on a country-by-country basis. Mexico has been having some peso problems lately. What's going on there?
U.S. dollar weakness has been the real problem behind the Mexican peso's volatility. Over 80% of Mexican exports are directed toward the U.S. market, so when the dollar weakens, the Mexican peso is somewhat forced to weaken along with it in order for Mexican exports to continue to be competitive in the U.S. market.
Mexico has also lost a great deal of U.S. market share to countries like China. China has surpassed Mexico as America's No. 2 trading partner behind Canada. Of all the major currencies in Latin America, the Mexican peso is the one that has suffered the most in order to maintain its competitiveness. If you look at the Brazilian real or the Chilean peso, those currencies have strengthened against the dollar in the last year and a half. Even the Argentine peso strengthened against the U.S. dollar when Argentina was going through its debt-restructuring period.
Is a weakening currency the only risk facing Mexican stocks?
Other than U.S. growth, there are few catalysts for the Mexican economy. High oil prices will mostly help government accounts. From a corporate standpoint, we are very stock specific in the stories we like. We like Mexican homebuilders like
. We also like
as not only the No. 1 wireless company in Mexico but the largest in the region.
Not really. Mexican homebuilding is more geared toward low-income housing, which is primarily funded by government accounts. Cemex has just gotten too big after a recent acquisition. It needs to digest that acquisition for a few quarters before we see growth.
Let's move on to Brazil, which to a large extent means Petrobras (PBR) - Get Report since it makes up a large part of the Brazilian stock exchange. How are higher oil prices affecting the Brazilian economy?
People forget that Brazil is a net importer of oil since the crude they produce is heavy and the oil that they use is light. But they are getting close to self-sufficiency, which is a long way from where they were 20 years ago, when they were importing most of their oil.
Commodities are very important, but they only make up about 30% of Brazil's exports. Brazil has become a much more diversified economy over the last several years. Nevertheless, higher commodity prices are absolutely benefiting the country, and oil and metals prices are expected to remain high throughout this year -- which, by the way, will help the currency as well.
So what is the big risk for Brazil?
The main risk for Brazil is that the unwinding of the carry trade will take a lot of money out of Brazil and force the government to move interest rates higher for much longer than expected. As I said, it is not too great a risk, but it is a significant risk.
There is a big focus on domestic growth in Brazil, and we especially saw it late last year. If rates don't start to come down by the third quarter of this year, there will be some serious questions as to whether they can meet their GDP growth forecasts, which are at 3.5% to 4%.
It's a bit of a tug of war. Prices were frozen in place for gasoline and energy in Argentina when they were attempting to pacify the economy. And now that the debt restructuring is more or less over, the energy companies are trying to play catch-up in terms of prices. But the government is fighting the energy companies, saying that they have not unfrozen the prices and they can't be raised yet.
Argentina is in a bind because it has high unemployment and a big portion of its middle class has fallen in stature. The reason why things have not gotten any worse is due to price controls. It's totally a political call now. The news flow has not been positive at all.
Latin America was a huge performer last year and is still outpacing the U.S. indices. What should we expect from here?
At the start of the year, I was looking for a 15% to 20% return for the funds we manage in Latin America. And I stick with that. Valuations are still attractive and -- despite this week when some investors got nervous -- fund flows have been positive. Brazil is especially undervalued here since it is trading at a P/E of 8 and has earnings growth north of 20% for this year. And in Mexico, some stocks look good.
I'd say hang in there, because over the last five years, on an annual basis, Latin America has been one of the best regions to invest in, and there is still good value out there.