LatAm: A Compelling Emerging Market for Investors

• With inflation peaking throughout Latin America, monetary policies are unlikely to tighten much further and might ease. This should be supportive for LatAm equities, especially when global central banks remain hawkish.
• A weaker USD should alleviate growth and equity headwinds, and be supportive of LatAm.
• US nearshoring trends could bolster LatAm’s growth outlook, especially for countries like Mexico.
• Valuations for LatAm equities remain cheap on both an absolute and a relative basis, even after accounting for an expected moderation in earnings this year.
• We expect a potential upside of +46% by end-FY24, one of the strongest within emerging market regions. Investors who wish to gain exposure to LatAm equities can consider the Schroder ISF Latin American A Acc SGD fund.

Within the Emerging Market (EM) universe, Latin America (LatAm) was one of the strongest-performing equity regions (Chart 1) led by a robust performance by Brazil, which was also the top-performing market under our coverage (SGD terms) last year.

While we have already articulated our positive view on Brazilian equities, we now look at LatAm as a whole. This region includes 5 markets - Brazil, Mexico, Chile, Peru, and Colombia – though investors should note that this will largely be a play on Brazil and Mexico, which take up about 60% and 30% of the regional allocation respectively (Chart 2). In this article, we will highlight the major reasons why LatAm remains compelling for equity investors in 2023.

Related article: Brazil: Look to this 2022 top performer to repeat its stellar performance

Chart 1: LatAm was one of the best-performing EM markets in 2022

Chart 2: LatAm equities comprise 5 markets with large allocations to Brazil and Mexico

Easing policy headwinds to be net positive for equities

First, we expect LatAm central banks to be less hawkish in 2023 than last year, which should help to support regional equities. LatAm was one of the earliest regions to start its rate-hike cycle between Mar 2021 (Brazil) and Oct 2021 (Colombia) (Chart 3). As a result of tight monetary policy and moderating commodity prices, inflation readings in many economies have peaked or are showing signs of peaking. We see this in Brazil (10.7% peak in Nov 2021), Mexico (8.7% peak in Sep 2022), and Chile (14.1% peak in Aug 2022) (Chart 4).

The topping of inflation in the region will be crucial in paving the way for receding hawkishness in 2023. This could take the form of smaller rate hikes this year, or potentially even rate cuts in markets like Brazil, where price pressures have notably subsided. While this will likely be a gradual process rather than a full-on policy normalisation this year, as inflation remains above central bank targets, this wind-down in LatAm’s aggressive monetary policy should be supportive for equities, especially when many global central banks are still hawkish.

Chart 3: LatAm central banks started their rate hike cycle relatively early in 2021

Chart 4: CPI inflation rates in LatAm markets have fallen off their peaks

Weaker USD supportive of LatAm equities

We believe the USD is set to reverse in 2023, and this should be positive for LatAm equities. Currency movements often play a major role in equity returns for foreign investors. This is because LatAm currencies generally tend to be more volatile than developed market currencies. Sharp currency movements are frequent and can potentially boost (or detract from) equity returns significantly. We can observe the large extent of this FX contribution if we decompose total returns into price returns and FX gains/losses (Chart 5).

Furthermore, historical data shows that a weakening greenback is negatively correlated with LatAm equity performance – in other words, LatAm equities often climb when the USD depreciates (Chart 6). One reason is the region’s dependence on commodities exports - because commodities are typically denominated in USD, a weaker greenback makes commodities cheaper in general, thereby supporting demand. Another reason is that a depreciating USD makes it easier for LatAm issuers to service their USD-denominated debt as debt repayments become cheaper in local currency terms. For sovereign issuers, this means an easing of fiscal pressures, which will ultimately be supportive of the regional growth outlook.

Related article: Don’t count on the US Dollar next year – it’s time for a reversal

In addition, higher-for-longer policy rates in LatAm (in the previous section) should also help to support broader currency performance against the USD. With yields expected to remain elevated, and LatAm currency volatility more normalised (Chart 7), we think that the carry trade may still look attractive to traders. This should support LatAm currencies against a weakening USD, which as explained above, will be positive for the region’s equities.

Chart 5: FX contribution plays a major role in determining total returns within the LatAm equity space

Chart 6: Weaker USD has typically coincided with periods of stronger LatAm equity performance

Chart 7: LatAm FX volatility remains manageable

US nearshoring trends could bolster LatAm growth outlook

We are also witnessing ongoing trends of deglobalisation and global supply-chain reconfigurations. US businesses are increasingly looking to relocate manufacturing operations away from China for a few reasons:

1. Simmering US-China tensions (especially with the recent balloon saga) could be detrimental to US-China trade (Chart 8) and will have reignited concerns over situating one’s manufacturing operations in China. US business owners will likely be mindful of the dangers of over-relying on any single country (especially a strategic rival to the US), and the sudden pullout of global companies from Russia following the Russia-Ukraine War will serve as a tangible reminder.
2. China’s unpredictable policy environment has made it riskier for manufacturing operations there – factories had to suffer through two years of COVID-zero disruptions with little warning when these disruptions would be lifted.

As manufacturing operations of many global companies move away from China, a nearshoring trend has accelerated. LatAm stands out from other markets (e.g. ASEAN and India) as a prime beneficiary of this trend, for US-based or global companies seeking to gain a foothold in the US. LatAm has the strategic geographical position right next to the US, with Mexico even sharing a land border – this allows for potentially cheaper logistics/transportation costs, and an avoidance of the shipping/port disruptions that were the hallmark of supply chain distributions in 2021.

This nearshoring trend is bolstered by other factors, including relatively cheap labour costs (Chart 9), the presence of trade agreements like the 2020 United States-Mexico-Canada Agreement (USMCA), and policies like the 2022 CHIPS Act which could bring about cooperation with Mexico on regional semiconductors production.

Overall, the economic benefits of near-shoring are clear and will increasingly be a tailwind for LatAm’s growth. A 2021 Kearney study showed that 70% of CEOs are at least considering nearshoring part of their manufacturing operations to Mexico – 17% of them have already nearshored to Mexico, with another 16% to Central America. The Inter-American Development Bank (IADB) also estimates that nearshoring could add $78 billion in additional goods and services exports in the near-to-medium term to the region, with prime beneficiaries including Mexico and Brazil (Chart 10).

Chart 8: Ongoing US-China tensions could result in lowered imports from China – LatAm could be a beneficiary

Chart 9: Labour costs in China have shot up compared to those in LatAm

Chart 10: IADB estimates nearshoring could result in $64bn in benefits for goods exports. Mexico accounts for a bulk of this benefit

Expect to see a moderation of earnings in FY23

Despite the positivity expressed above, we expect earnings to contract in FY23 by -26% YoY, in line with our forecasts for Brazilian equities (Chart 11). Similarly, we remind investors to keep this number in perspective - it does not necessarily represent a bearish view on LatAm earnings for a few reasons:

1. LatAm equities contain a high concentration of cyclical sectors, such as Materials, Financials, and Energy, accounting for over half the MSCI EM LatAm Index. With an incoming global recession, organic earnings declines are therefore neither uncommon nor unexpected.
2. Our estimates are on the conservative end, given our expectation of a recession.
3. Forward earnings are coming off an extremely high base, following strong growth numbers in 2021 (+228%) and (to a smaller extent) FY22 (+23%).
4. LatAm equity earnings are typically volatile, and double-digit earnings movements (in either direction) are the norm.

In particular, Materials and Energy names are expected to lead broader index EPS declines in FY23, due to the aforementioned high-base effect. But as a whole, we do not expect a massive earnings collapse, as their outlooks remain supported by constructive supply-demand dynamics within the commodities space. In addition, LatAm equities in these sectors also include non-Brazilian names like SQM (lithium) and Grupo Mexico (copper), which could benefit from the ongoing green transition and its consequent impact on demand for related metals.

The Financials sector is expected to see lower but positive earnings growth in 2023. While the prospect of a growth slowdown could weigh on earnings, we believe that policy rates should generally remain elevated in the region in 2023 given the above-target inflation readings. Therefore, we do not expect a meaningful deterioration in LatAm banks’ net interest margins and net interest incomes.

Chart 11: We expect earnings to decline in FY23, before rebounding in FY24

Valuations remain cheap despite our slightly fair P/E downgrade

Given our recent fair P/E downgrade for Brazilian equities based on higher political and fiscal risks, we are also lowering our fair P/E for LatAm equities from 14.0X to 13.5X due to Brazil’s large weight (Chart 2). Aside from Brazil, we see little risk of further political uncertainties across the region as the political calendar for 2023 is fairly sparse, with presidential elections only in non-index constituent countries like Argentina.

Even with a double-digit earnings decline forecast for FY23 (previous section), LatAm equities are trading at a FY23 P/E of about 9.6X, much lower than our revised fair P/E of 13.5X, and at a 28% discount to its historical average of 13.2X (Chart 12). On a relative basis, valuations also look cheap compared to EM regional peers such as Asia-ex-Japan and EMEA (Chart 13).

Chart 12: Even after accounting for projected earnings declines, LatAm P/E valuations remain well below historical averages

Chart 13: LatAm P/E valuations also look attractive relative to other EMs

LatAm equities remain attractive for Emerging Market investors

To summarise, we believe that LatAm equities remain attractive for EM investors. Easing monetary policy coupled with a weaker USD are supportive of LatAm’s equities, while nearshoring could also be an additional impetus for the region’s growth. Moreover, equity valuations also look very compelling even after accounting for a likely earnings decline in FY23 on the back of a high-base effect and slowing global growth.

With our revised fair P/E ratio of 13.5X, we project a target price of around 3,300 for the MSCI EM LatAm Index by FY24, giving an attractive potential upside of +46% (Chart 14, Table 1). Investors who wish to gain exposure to LatAm equities can consider our Recommended Fund for three consecutive years – Schroder ISF Latin American A Acc SGD – which has displayed its ability to generate alpha and outperformance over the past few years (Chart 15).

Chart 14: MSCI EM LatAm Index Price Performance and EPS

Table 1: LatAm Equity Market Projections 2023 – 2024

Chart 15: Our recommended fund has generally outperformed benchmark and fund peers over the past 5 years

Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.