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Gemologist

Latin America’s new liberals

A long tradition of playing to the crowd: Eva Perón adds a human touch to her husband’s dictatorial rule

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Hermes Emerging Markets

Newsletter, July 2016

For professional investors only www.hermes-investment.com

Key pointsRevelations of corruption and profligacy have undermined the leftist governments of Latin America, angering electorates which have seen economic growth fall with the commodity cycle

The political right is resurgent, appealing to a renewed desire for fiscal discipline and sustainable growth based on orthodox economic policies and less reliance on the boom-bust resources trade

Stock markets have surged, particularly in Argentina and Brazil, where new centre-right governments aim to implement reforms that should support growth in corporate earnings

Is this rally driven by political promises, or are strong foundations for long-term growth being built? We are optimistic but also cognisant that Latin America’s new liberals have plenty of work to do

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To understand the current political and economic turmoil in Latin America, some historical context is necessary. Its origins can be traced back to the four-year currency crisis of the late 1990s, which started in Thailand and gathered force like a cyclone to make landfall in Indonesia, Russia and Connecticut before rupturing Silicon Valley’s dotcom bubble. Storm surges hit countries with no direct connections to either Bangkok or Pets.com, including the nations of South America.

The rough markets helped to intensify movements against out-of-favour governments whose orthodox policies had brought economic stabilisation. Rising to power, leftist administrations implemented generous social programmes and voiced anti-capitalist views while their countries benefited from an exceptional boom in commodity exports. With strong approval ratings but weak fiscal discipline and scant zeal for productivity-enhancing investment, they failed to harness such economic good fortune while undoing the progress achieved by their predecessors. This exacerbated the shock of the financial crisis, leading to painful recessions and stock-market underperformance – but also political reversal, as electorates now seek leaders that can resurrect their national economies.

Investors have also appreciated this change. The Argentine and Brazilian stock markets have risen 9.2% and 13% respectively in the year to the end of May, benefiting from strengthening commodity prices and political change. However, to gauge the longer term outlook for the markets of Latin America, we need to understand the paths these countries have taken and their current directions of travel.

Swinging to the leftThe turbulence of the late 1990s changed the political course of Latin America. Centre-right reformist leaders, who had slain the dragons of inflation, found themselves on the wrong side of the economic cycle and the electorate. In Argentina, President Domingo Cavallo, whose convertibilidad plan to peg the peso to the dollar had brought inflation down from 1300% to almost zero, was exposed as the cycle changed. His subsequent decision to freeze personal savings accounts in order to prevent a run on the banks sparked riots in December 2001. In Brazil the following year, where President Fernando Henrique Cardoso’s plano real had been reducing hyperinflation since 1994, the currency crisis stalled economic growth and exacerbated unemployment and energy shortages, weakening support for the incumbent leading into the 2002 national elections. In the contest, Workers’ Party (PT) candidate Luiz Inácio Lula da Silva promised to expand welfare and claimed a decisive victory.

In a similar vein, economic orthodoxy proved too painful for the Argentine electorate, which in 2003 opted for the left-wing populist Néstor Kirchner, whose policies included a resumption of state hand-outs. Three years later, Bolivia elected its first indigenous president, Evo Morales, whose focus on nationalising assets – particularly natural gas – and anti-capitalist rhetoric helped him become the three-term incumbent we see today (though in the end his actions were more moderate than those of some of his Latin American peers).

Chile swung left after the fall of Augusto Pinochet by electing Ricardo Lagos, a centre-left social democrat who had bravely opposed the military dictator. Lagos enjoyed a consistently high approval rating despite failing to disown corrupt members of his cabinet and engaging in heated disputes about energy policy with Bolivia, Venezuela and Argentina. In 2006, Ecuador elected Rafael Correa, another leftist with strident policies against the US and multinational corporations, especially regarding their involvement in Latin America. One of his most controversial moves was to declare a portion of the national debt to be “illegal” and then duly defaulting on and restructuring it. By changing the constitution, he has been able to seek re-election, alter the mandate of the armed forces to include maintaining security, and enable the state’s takeover of the media.

By 2006, Latin America was firmly in the hands of the left. Chile kept the faith, as Lagos was succeeded by Michelle Bachelet of the Socialist Party. Argentina’s Kirchner, who exhibited some pragmatic centrist tendencies in the early days of his presidency, was succeeded by his wife Cristina, who was largely free of them. Brazil’s Lula, in an uncharacteristic move as head of the PT, seemed to allow businesses to operate autonomously despite his socialist rhetoric and redistributionist initiatives – an illusion dispelled by the current lava jato investigation into alleged money laundering at state-owned oil company Petrobras. Lula was succeeded in 2010 by his deputy, Dilma Rousseff, who took government meddling in the national accounts to new heights, seriously damaging the banking, utilities and energy sectors.

Figure 1. Key political events in Latin America, 1998 – present

1998

Brazil: President Fernando Henrique Cardoso (Brazilian Social Democracy Party) is re-elected

Ecuador: New constitution – Jamil Mahuad (Christian Democratic

Union) elected president

Brazil: Fiscal Responsibility Law constrains public spending Colombia: US’s Plan Colombia targets drug cartels, left-wing insurgents

Ecuador: Gustavo Noboa becomes president after a military coup deposes Mahuad

- IMF provides $304m in credit to support the government’s economic programme

- US dollar becomes legal tender

Colombia: Beginning of peace talks between the government and FARC guerillas Peru: Border agreement with Ecuador ends 177-year territorial dispute Chile: Former military dictator Augusto Pinochet accused of crimes against humanity

Venezuela: Hugo Chavez (United Socialist Party of Venezuela) elected president with mandate for constitutional reform

Venezuela: New constitution Ecuador: Banking crisis: severe currency devaluation, distress among key financial institutions

Chile: Ricardo Lagos assumes presidency Peru: President Alberto Fujimori resigns amid political and financial scandals

1999

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Good times, bad timesThese leaders ascended out of economic crises to oversee a golden period of growth driven by commodity exports. China’s industrial boom was a lucky break for these resource-rich nations, and the powers that happily took credit for this and imprudently spent the windfall.

Instead of channelling the proceeds productively, centrally planned industrial policies and bigger hand-outs prevailed. Brazil created an entire oil-services industry from scratch, duplicating the existing and efficient global sector, while Argentina subsidised electricity, gas, water and public transport services. As China built roads, improved ports and installed 4G mobile networks, most Latin American governments established welfare states on the assumption that demand for their nations’ raw materials would remain at the new and elevated plateau. But it was not only China that recycled excess revenues wisely: Singapore, the Philippines and India also spent billions on telecommunications connectivity and productivity enhancements, such as infrastructure. In Latin America, however, no major investment in these areas was apparent. As a consequence, productivity stagnated while the commodity-driven carnaval sustained growth and kept animal spirits high – but only until the next crash.

The 2008 financial crisis tolled the beginning of the end of the good times. Immense Chinese stimulus from 2009 to 2011 temporarily reignited the fading embers of the nation’s industrialisation, and

Figure 2. Brazil: paying the price for spending hard

Brazil’s budget balance as a percentage of GDP

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Source: Bloomberg as at 31 May 2016.

resources demand recovered briefly. In late 2014, aware of the declining commodity trade but not cognisant of the extent of the deterioration in public finances, Brazilians re-elected Dilma, as she is popularly known, on a populist platform. After oil and iron ore prices collapsed, and the Brazilian economy sank into recession, the PT’s fiscal manipulations came to light and destroyed the president’s credibility, resulting in the current impeachment proceedings.

In Argentina, inflation, recession and a collapse in public services spurred a swing to the centre-right and the 2015 election of the Republican Proposal party’s Mauricio Macri. In Bolivia, the collective mood has also fallen with commodity prices: President Morales recently failed to pass a referendum intended to change the constitution (yet again) to allow him a fourth term in office. The end of the oil bonanza has removed funding for President Rafael Correa’s social programmes in Ecuador, and his declining popularity is exacerbated by crackdowns on dissenters and signs that the country will suffer chronic inflation and shortages of basic goods, similar to the post-Hugo Chavez Venezuela. Even there, just three years after the long-ruling president’s death, the legacy of “Chavismo” is cracking: the socialist party’s hold on the population is weakening, demonstrated by the opposition’s claim of victory in the legislative elections last December.

Figure 3. You take the high road: Latin America v global stocks, June 2010 – present

MSCI All Countries World IndexMSCI Emerging Markets Latin America Index

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Figure 1. Key political events in Latin America, 1998 – present

Colombia: Peace discussions break down - Álvaro Uribe (Democratic Centre) becomes president

Chile: Association treaty with EU signed, including a free-trade agreement

Brazil: Central bank implements fiscal and debt sustainability rules

Chile: Free-trade agreement with US signed

Peru: Alejandro Toledo (Possible Peru) becomes the nation’s first president of indigenous descent

Venezuela: Chavez implements land and oil reforms Argentina: President Fernando de la Rúa resigns amid riots over an economic crisis causing sovereign debt default

Brazil: Luis Inácio Lula da Silva (Worker’s Party) is elected president

Venezuela: Chavez increases his control over the monopoly state oil company, the country’s cash flows and debt capacity

Ecuador: Former military leader Lucio Gutierrez (Patriotic Society Party) becomes president

Venezuela: Fixed exchange-rate regime introduced Argentina: Néstor Kirchner (Justicialist Party) elected president

2001 2002 2003

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Swinging to the rightWith the commodity gains all but spent and the left’s political capital squandered, Latin America has arrived at a critical junction. Growth has collapsed – analyst forecasts indicate that Brazil faces its deepest recession in a century, Argentina’s economy is likely to contract in 2016 and the Andean countries of Bolivia, Ecuador, Colombia and Peru are experiencing anaemic growth due to low oil and copper prices – and prospects are unlikely to turn positive until at least 2017. Economic management is a key political concern.

Yet there is cause for optimism. If the economies of Latin America stabilise and their markets exhibit a sustained contraction in the cost of capital, a multi-year recovery in asset prices, complemented by increased participation in global indices, could follow.

This path is visible, but obstacles remain. Low commodity prices will force countries to rely on external capital to fund growth, highlighting once again their vulnerability to financial markets and the counter-productive nature of populist arguments against multinational companies and the investment they can provide. However, the depreciations of the real, boliviano and the pesos of Argentina, Chile and Colombia, plus the subsequent narrowing of national current-account deficits, will aid this transition.

This has already happened in Chile, and Brazil’s trade balance is following suit. Echoing the centre-right Argentine administration of the 1990s, President Macri has committed to reducing the rate of inflation from 32.9% to 5% to allow for a longer term credit market to develop (the nation currently exhibits extremely low levels of financial intermediation). As Brazil’s leaders also commit to reining in inflation, an environment with lower interest rates and more stable growth could follow.

Brazil: reviving the samba The impeachment of Dilma may end the chapter on Brazil’s recent decline, but it does not write the story of its revival. The immediate priority for Michel Temer of the Brazil Democratic Movement Party, who assumes power until the senate votes definitively on the proceedings, should be to stabilise the stricken economy.

With the rate of inflation finally slowing, monetary easing could feasibly begin in the second half of the year to support growth. Such policy decisions may be easier to implement than restoring the public’s trust in politicians. Brazilians are disgusted with the economic ineptitude and institutionalised corruption within the political class, and the new administration would be rightly tested in rebuilding confidence in the system. Temer’s role as Dilma’s deputy has split the electorate, and it will be imperative for him to establish credibility with voters (and investors too).

Appointing former bankers Henrique Meirelles and Ilan Goldfajn as finance minister and head of the central bank respectively should provide the orthodox economic leadership required and help rebuild investor confidence, but new scandals continue to distract from the reform process. In the long term, fiscal and social security reforms aiming to reduce heavy public spending are vital. Pension reform and the de-indexation of the budget are also critical in achieving this and in establishing the fiscal balance that is currently lacking. With gross public-debt-to-GDP now up at 67% and rising, failing to implement these reforms would result in chronic and rising indebtedness, a further loss of confidence, an inflationary spiral and severe currency depreciation. However the appetite of congress, not to mention the population at large, for the bitter medicine of austerity is uncertain.

Alongside reforms, investors would welcome a business-friendly, liberal agenda that promotes partnerships and open markets. Attracting foreign investment, particularly into infrastructure, and increasing Brazil’s share of global trade should be priorities for the next administration. These structural changes may not be fully achievable in the two-and-a-half years remaining before the 2018 elections, however a new government with cross-party support in Congress could set the foundations in a relatively short space of time. Such a pivotal move could direct Brazil to a path of more sustainable growth.

Figure 1. Key political events in Latin America, 1998 – present (continued)

2004 2005 2006

Chile: Free-trade agreement with South Korea signed

Peru: - Trade deal with US signed - Fujimori arrested

Peru: - Alan Garcia Pérez (American Popular Revolutionary Alliance) becomes president

Peru: - Leader of Shining Path guerilla group sentenced to life in prison

Colombia: Uribe wins second term as president

Peru: President Fujimori’s head of intelligence, Vladimiro Montesinos, imprisoned for corruption

Chile: - Pinochet detained for tax evasion - Constitution reformed to shorten presidential term from 6–4 years

Ecuador: - Gutierrez removed amid corruption allegations and public protests, - Alfredo Palacio (independent) becomes president

Venezuela: - Land reforms introduced to eliminate large estates - Chavez consolidates power in parliament

Argentina: Public debt restructured with 75% of creditors accepting the new terms

Chile: - Michele Bachelet (Socialist Party of Chile) becomes president

- Death of Pinochet Brazil: - President Lula is re-elected

- Economic policy starts to loosen

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Promise or profits?For Latin American stocks, which have lagged the global equity index by more than 110% since 2010, stable growth and market-friendly political change would be hugely positive. These markets are not cheap on the basis of near-term earnings multiples, given the broad collapse in corporate earnings, with Brazil trading on a 14x forward price/earnings multiple and Latin America overall on 16x. However one should look beyond low short-term earnings to a more normalised level of profitability, in the event that the economies of these nations stabilise and grow. Even a moderate recovery in profit margins would considerably boost valuations: estimates that Brazil and Chile are both forecast to deliver only a 10% return on equity (ROE) this year, and Colombia and Argentina 8% to 9%, are reflected in price/book (P/B) valuations that are well below historical averages (see figures 4 and 5).

Figure 4. Valuations in the Brazil, Chile and Colombia stock markets

Estim

ated

P/B

Brazil: estimated P/B Chile: estimated P/B Colombia: estimated P/B

May2009

May2010

May2011

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Figure 5. Return on equity in the Brazil, Chile and Colombia stock marketsEs

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Given the sensitivity of these markets to commodity exports and the continuing slowdown in Chinese fixed-asset investment, is it reasonable to expect strong recoveries in corporate earnings – even in the medium to long term? We think it is. The MSCI Emerging Markets Materials Sector Index posted an ROE of more than 20% at its peak in 2005, but now shows a mere 2.3%. It’s not unreasonable to expect ROE to reach 10%, as the current global supply of materials moderates to match expected demand. Also, the sector has previously traded at 1.5x P/B value – 25% higher than its current valuation – while generating an ROE of 10%.

Similarly, the MSCI Emerging Markets Energy Sector Index peaked in 2007 at 3x P/B value (when the ROE was 18% and oil was rising to $130 per barrel) but now trades at 0.8x with a 6% ROE. Although there are doubts about the long-term viability of fossil fuels (which we share), it is possible that a stabilisation or further recovery of oil prices, combined with cost cutting by producers, will drive the ROE of the sector towards 10% and justify a P/B value that is 25% to 30% higher. Therefore, with P/B values in the energy and materials sectors capable of rising in the next several years, combined with lower capital costs from more orthodox economic policies and a broader increase in activity, it is possible that Latin American stock markets will climb substantially higher.


2007 2008 2009

Colombia: Government forces kill senior FARC official In Ecuador, creating a diplomatic impasse

Colombia: Venezuelan military prepares for conflict with Colombia after years of geopolitical tension

Chile: Government draws on sovereign wealth fund to distribute an $8bn stimulus package

Chile: New public-transport network Transantiago debuts, incurring political costs and resulting in an overhaul of Bachelet’s cabinet

Peru: Chile extradites Fujimori to Peru to face charges of corruption and human-rights crimes

Ecuador: Finance Minister Rafael Correa becomes president and targets the economic establishment

Venezuela: Nationalisation of companies begins with key telecommunications and energy businesses

Argentina: Cristina Fernández de Kirchner (Justicialist Party) elected president

Ecuador: New constitution, overseen by President Correa, is approved by referendum

Argentina: Government conflict with farmers about higher taxes on soybeans and sunflower exports

Ecuador: President Correa re-elected under new constitution, which does not require a runoff contest

Peru: Fujimori imprisoned on kidnapping and murder charges

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Post-populism, pre-reformEvidence of this change is already manifesting. Argentina’s stock market rallied 380% from mid-2013, when Cristina Kirchner’s disastrous mid-term election result spelled the demise of her leadership, to late 2015, when Macri came to power (see figure 6). Now the president must embed economic reforms to establish foundations for growth. Argentina has already returned to international debt markets and its equity bourse is likely to feature more listings and deepening trading volumes.

Figure 6. The market is not crying for Kirchner’s Argentina

MERVAL Index of the Buenos Aires Stock Exchange

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In Brazil, a powerful combination of falling risk premia and forward rates since February – well ahead of any recovery in earnings – shows how much the market is anticipating change (see figure 7). This has driven a re-rating that echoes the early days of the recent surge in Argentine stocks. And, as in Argentina, structural economic reform is essential. This currently remains only a hope, but a new and united centrist coalition government with a strong mandate for change could engender vital fiscal and social-security reforms. This, combined with firmer global demand for commodities, would justify higher equity market valuations in advance of growth.

Figure 7. Brazil forward interest rates, June 2006 – present

Brazil forward interest rates

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Now that the prosperity of the last decade seems illusory, Argentines have rejected populism in favour of fiscal rigour, and Brazilians demand substantially greater competence, discipline and responsibility from their leaders. Stock markets in Buenos Aires and São Paulo have rallied in response, more on the possibility of growth than tangible profits. Despite these upward re-ratings, further stabilisation of the underlying economies and strengthening global trade in commodities would likely generate a level of ROE beyond what is currently priced in.

This is welcome, but it is a short-term prospect. What would truly be transformational would be for Macri to achieve the economic reforms he seeks, and for the future administration in Brazil to part with the profligacy and corruption of the recent past in favour of efforts to boost investment and productivity. Latin America would then become a destination for long-term investment rather than a series of short-term trades.

2010 2011 2012 2013

Colombia: Juan Manuel Santos (Social Party of National Unity) becomes president

Argentina: President Kirchner suffers poor mid-term election results

Argentina: Néstor Kirchner dies

Brazil: - Dilma Rouseff, Lula’s deputy, is elected president

- Economic policy loosens further; public spending increases

Peru: Olanta Humala (Peru Wins) becomes president

Venezuela: Government sets price controls on goods In an effort to control inflation

Argentina: President Kirchner is re-elected

Brazil: Government confirms ‘new matrix’ of economic policies Intended to spur growth: low interest rates, weaker currency and lower business taxes

Argentina: Oil company YPF is nationalised

Ecuador: President Correa re-elected until 2017

Venezuela: Nicolás Maduro (United Socialist Party of Venezuela) elected as president with Chavez’s backing


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Argentine politics: the cycle lives onArgentine economic policy oscillates between liberalism and populism – often within the same party and sometimes within the same family. Since the military dictatorship fell in the early 1980s, the leftist Radical Civic Union has had two tenures in power: from 1983-1989, during which President Raúl Alfonsín stepped down early due to a resurgence of hyperinflation; and from 1999-2001, which saw Fernando de la Rúa forced out of the casa rosada amid riots sparked by three years of recession and the government’s economic policies. Otherwise, the country has been run by the Peronists of the Justicialist Party.

In the 1990s, they adopted more liberal policies that were effective until the turbulence of the Asian currency crisis resulted in widespread unemployment, sovereign debt default and the fall of the government. In 2002, GDP shrank by 10.9%, the peso depreciated 65% and the unemployment rate soared beyond 20%. Towards the end of the year, the country began to recover but the Argentine electorate, still in shock, veered left by electing Néstor Kirchner in May 2003.

During his 2003-2007 tenure, Kirchner departed from a pro-market orientation to extend state control over the economy. As the nation profited from the commodity boom, so did the government, by combining sensible policies with prudent fiscal management. With strong approval ratings at the time he stepped down, Kirchner and his wife Cristina planned to keep the business of running the country in the family (and it turned out to be a lucrative business indeed). She ran for the presidency in 2007 and won, capitalising on the couple’s popularity and the optimism generated by the global bull market in stocks, agricultural commodities and interest rates. Their plan was for Néstor to return and run in the 2011 presidential campaign.

But sometimes populists’ best-laid plans go awry. The economy started to deteriorate rapidly soon after Cristina came to power, and while her anti-capitalist and anti-Western rhetoric fit neatly with the policies of Hugo Chavez, Evo Morales and Rafael Correa in Venezuela, Bolivia and Ecuador, it cut the country off from investment and economic progress. Growth, which had been supported by a massive terms-of-trade shock in which the price of wheat more than tripled from 2006 to early 2008, collapsed during the financial crisis, unveiling the shortcomings of a fiscally irresponsible and deeply corrupt government. Cristina found herself presiding over a broken economy, and in 2011 Néstor

passed away. In the ensuing years, Argentina’s terms of trade deteriorated further, inflation rose, and misery spread among the populace. The Kirchners had run out of the political capital built during the previous decade. In late 2015, the people sought change.

Macri: time to deliverThe new centre-right government led by Mauricio Macri is mandated to fight corruption, re-ignite the economy after four years of stagnation and to tame the rate of inflation, which is currently at 35%. Some important milestones have already been passed: the currency has been liberalised, export restrictions have been reduced while taxes on several export products have been cut or eliminated, renegotiations with sovereign-bond investors have taken place and $16bn in debt has been issued to repay claims. The administration has received strong international support with Barack Obama, Françoise Hollande, Matteo Renzi and other national leaders visiting since Macri’s inauguration. Even though the prices of agricultural commodities and oil are weak, economic conditions remain generally favourable given the country’s light debt burden.

The boom-bust cyclicality of the economic model implemented by previous governments – which relies on consumption fuelled by high export prices – is very well understood by the current administration. Macri intends to shift Argentina away from this path and towards an economy driven by investment rather than commodity exports. After more than a decade of self-imposed exile, the prospect of re-integration with the global economy holds much promise. If fulfilled, the energy and agricultural sectors are likely to lead the recovery with investment in roads, ports and other transport infrastructure providing long-term opportunities.

However, as many new leaders discover, ruling requires political deal-making. The current administration lacks control of the lower and upper houses, depending instead on an alliance with dissident Peronists. The key goal of this coalition is to prove that it can govern and implement the required reforms while keeping the Justicialists at bay. This will not be easy. If history is any guide, economic orthodoxy will be eroded by populism in the long term – but the current outlook for Argentina is better than it has been for more than a decade.

20162014 2015

Argentina: Federal prosecutor Alberto Nisman shot dead at home

Venezuela: Opposition gains majority in National Assembly

Argentina: Mauricio Macri (Republican Proposal) elected president

Brazil: Impeachment of President Rousseff empowers centre-right Brazilian Democratic Movement Party

Peru: Pedro Pablo Kuczynski (Peruvians for Change) elected president with slim majority

Colombia: Santos re-elected as president Chile: Politicians of all parties implicated in accusations of tax evasion and irregular campaign funding Colombia: Constitutional reform outlaws re-election of incumbent presidents

Chile: President Bachelet re-elected. Changes in tax laws aiming to fund educational reform are passed

Brazil: President Dilma is re-elected and boosts public spending

Argentina: Sovereign-debt default amid failed negotiations with creditor hedge funds

Ecuador: Constitutional change allows leaders to be re-elected indefinitely but exempts current incumbents

Colombia: Government and FARC announce aim to agree a peace deal by March 2016

Venezuela: Economic crisis results in a three-digit surge in inflation, energy shortages, food rationing and increasing crime

Colombia: Government and FARC miss deadline to commit to a peace deal


This document is for Professional Investors only. The views and opinions contained herein are those of Hermes Emerging Markets, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes Fund Managers does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Hermes. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.

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