Brazil Outshines Argentina

The Brazil and Argentina stock markets have fallen in step this year, blurring last year’s trend for outperformance from Brazil’s Bovespa and weakness in Argentina’s Merval indexes. In spite of Brazil’s long bull run and Argentina’s bearish performance and the recent weakness of Bovespa, investors continue to be much more overweight in Brazil and are still neutral to pessimistic on Argentina. Last year, they were ploughing into the São Paulo exchange on the back of the country’s sensible economic policies, liquid and well-run markets and improving growth prospects, while whacky economic policy and lack of market liquidity relegated Buenos Aires to the sidelines. Those trends are set to continue.

Equity performance could hardly have been more different between the rivals and neighbours last year. While Brazil yielded the second best results in dollar terms ending up 74.1% Argentina languished as the second worst, down 6.2%. By February 11, the Merval was down a further 5.92% and the Bovespa had succumbed to weaker market conditions, falling 4.8% in local currency terms.

Last year’s performance may appear surprising at first. After all, both countries are commodity driven and have big agro-sectors that should benefit from the current emphasis on metals, mining and foodstuffs. And Argentina has been recording substantially higher GDP growth than Brazil. Argentina grew 7.5% last year and is expected to grow 5.5% this year whereas Brazil grew 4.4% last year and is expected to grow 4% this year, according to the International Monetary Fund.

The differential is first and foremost the country’s policies, both in capital markets and in the wider economy.

Macroeconomic Policies
For Argentina, investors like to cite the toxic mix of a pre-election splurge that damaged earlier sensible fiscal policy and negative real interest rates which have kept the currency artificially low against the dollar. Coupled with the consumer boom, that has led inflation to surge. To make matters worse, the government started cooking the books to try and disguise the inflationary mess.

Indec, Argentina's national statistics agency, reported inflation of 8.5% last year, well below the estimate of economists who say the cost of living is rising at about 20% per annum. Price caps have continued to play an important role in inflation too applying to basic staples such as milk.

Argentina has poor fiscal policy and limited monetary policy and the government is using a controversial benchmark of inflation measurement, believes Scott Piper, executive director and portfolio manager for Morgan Stanley Investment Management’s Latin American equity portfolio. With large increases in government expenditure last year, the country has consequently struggled to attract investment, he says.

Economic policy since the crisis has been extremely disappointing for international investors, agrees Jules Mort, Latin American fund manager at Threadneedle in London. Government blundering can be seen in everything from controls on electricity prices, high inflation and the subsequent meddling with inflation numbers. Everyone knew that the Argentine crisis was coming. It was an accident waiting to happen and was just a question of time, he says.

The election of Cristina Kirchner in October represented a ray of hope. Investors felt that her populist electioneering was just that. For many, the illusion that the new Kirchner would implement change was brief.

As well as disappointing investors by continuing with broad macroeconomic policies and failing to change key ministers, Cristina Kirchner has been inept in dealing with pressing issues. A new US-style core inflation measurement was meant to have been brought in at the start of this year to help Argentina renegotiate its $6.3 billion debt with Paris Club creditors, but the launch has been delayed. The energy crisis has worsened with regular black-outs. That crisis has had a long gestation through subsidised prices and a lack of investment in productive capacity.

Mort believes the feeble response to the energy crisis, consisting of giving out energy saving light bulbs and changing the clock by an hour, is telling. There are some signs that Cristina Kirchner is more orthodox on the fiscal side, he believes, pointing to increased taxes on luxury cars and the abolishing of VAT reimbursement on credit cards together with increased taxes on exports. And Argentina has a cushion from external shocks in the shape of record $47 billion in central bank reserves,

Paulo Leme, director of emerging markets research at Goldman Sachs, says that confidence that Kirchner might implement change has not completely evaporated although decisions and appointments in the first months of her administration suggest a strong degree of continuity.

The contrast with Brazil could hardly be greater. The re-election of President Luiz Inácio Lula da Silva in 2006 meant continued policies of macroeconomic stability. Hawkish monetary policy, with only gradual cuts in interest rates, has controlled inflation and driven up the currency, which proved one of the best performing against the US dollar last year, posting gains of 20%. That same monetary policy has kept GDP growth rates subdued, but growth has recently been accelerating on the back of a consumer boom thanks to more credit as rates and spreads have come steadily down.

The trend in Brazil, unlike Argentina then, is for accelerating GDP growth. Meanwhile, reserves have topped $180 billion offering a strong cushion against market turbulence.

Equity markets
It’s not only macroeconomic policies that deter investors from Argentina, but capital controls that make life more difficult.

For Piper, these have proved one of the most significant deterrents. The firm, which manages about $5 billion in dedicated assets in Latin America has its largest overweight in Brazil and is neutral in Argentina. Not only do its Brazilian holdings dwarf those of Argentina in real terms and in weighting, but its largest holding, Tenaris, is a global pipe producer that happens to be headquartered in Argentina, meaning that the firm is cautious on the exposure to the domestic economy. From an investor perspective, capital controls are a roadblock, Piper says. Argentine stocks are less liquid and capital controls make it more difficult to invest.

Mort, whose Threadneedle has some $3.5 billion in Latin America equities, says that Brazil represents 67% of the portfolio and Argentina just 1%. The small size of the Argentine markets has turned investors off in a global environment that prized liquidity, he notes. He too has no direct exposure to the economy and hasn’t for some eight years.

It’s not only the macro economy and capital restrictions but the composition of the market, with its lack of commodity-oriented companies, and a lack of liquidity, Mort says. Over 50% of the Merval index is related to one company, pipe producer Tenaris. Its acquisition of North American Maverick Tube Corporation last year came at a time of rising costs and lower pricing power and Tenaris provided mediocre performance as a result, he says.

At the same time, low trading volumes on the Merval exchange last year counted against the Buenos Aires exchange as investors sought to reposition portfolios away from riskier assets as the economic downturn kicked in. That led to a significant premium on liquid stocks and markets worldwide.

While Argentina’s exchange remained moribund, in Brazil, meanwhile, equity markets are liquid and growing fast. Indeed, Brazil produced the third largest number of IPOs in the world last year with companies raising $32 billion through 66 IPOs. The continuing love affair with the BRIC markets has also pulled in cash to Brazilian markets.

Commodity stocks, which still dominate the São Paulo market, have fared particularly well. That is seen in oil giant Petrobras, which found significant new oil discoveries and managed to increase production some 10% last year, and mining conglomerate Vale, which is enjoying 30% plus price increase in iron ore in 2008, points out Mort.

Still, performance in the market has been decidedly lumpy, with smaller-cap shares lagging in the global stampede to liquidity. Of the IPO crop last year, 70% have trailed the main Bovespa index and 50% are below their own IPO price. The shake-out is healthy, say fund managers, who are focusing on blue chips.

Mort believes it was not just global liquidity trends that hurt these smaller caps. Many had very optimistic earnings forecasts attached to them and the valuation support was not there, he says. As investors turned more to liquid companies, the over-bullish earnings estimates were exposed, he says. He predicts that firms with strong or unique franchises, such as Bovespa Holding, the exchange, will continue to do well. Those that don’t have a strong competitive position may see their share price suffer, he says. That’s particularly the case as investors are no longer keen on offerings of less than $500 million.

He favours blue chips including Vale and Petrobras and increasingly the banking sector, where Unibanco shares should be driven by valuations and earnings growth as there is a convergence of return on equity between the banks.

Piper says that Brazil still looks cheap on a global basis, although less so with the big move up in prices of last year. He believes that prices of agricultural produce, in which Brazil is well positioned, will continue to strengthen.

Furthermore, the outlook for iron ore prices is positive as markets are tight and that suggests price increases will be strong this year. He also likes homebuilders and construction firms for their play on the improving domestic consumer story.

Debt markets
In fixed-income markets the picture is not so clearly in Brazil’s favour this year, even though last year it strongly outperformed its southern neighbour. Argentina was mauled in the debt markets as bond spreads on the JP Morgan EMBI+ stripped sovereign went from some 200 basis points to 421.

Partly, 2007 was driven by profit taking after an excellent 2006. “At the end of 2006, we were asking: ‘Why has Argentina outperformed Brazil so much in debt?’ That’s just the reverse of today’s question,” says Goldman’s Leme. In 2006, the local peso-denominated bonds (Central Bank regulation bonds) and GDP-linked warrants (which are linked to restructured debt) “outperformed anything on the planet,” he says. Upward revisions to growth in Argentina helped spark that rally.

That strong performance laid the seeds for last year’s weakness. Because Argentina rallied so much in 2006, there was less risk premium in debt markets or embedded in credit default swaps. A lot of the yields on Argentine bonds looked pretty rich compared to countries that had not defaulted. And just as they looked rich, the world started to grow less tolerant of risk moving out of high beta countries such as Argentina.

Furthermore, inflation-linked bonds suffered from the country’s meddling approach to statistics. “If you don’t trust the inflation numbers then you can’t trust the instruments that are tied to them,” he notes. The deterioration in macroeconomic policies and the change of Kirchner governments presented a perfect time to take profits, he concludes.

This year, the outlook is brighter. It doesn’t take very much in policies to reignite interest. The small size of the market means that even a few trades can alter perception. “Just an epsilon or minute amount can move the market massively,” says Leme.

Furthermore, the one area that Argentina may outperform Brazil is its currency which has been held artificially low by a loose monetary policy while Brazil’s has already appreciated greatly. The better use of macroeconomic tools such as a flexible exchange rate would help contain inflation and there is a possibility that the Kirchner government may allow the peso to rise.

This would take pressure off tradable goods. “Inflation will continue to rise if you don’t allow either for a higher currency or interest rates,” he believes. It’s difficult to say what might trigger a reversal in policy, he says, but estimates that social pressures from pensioners who suffer from higher inflation may do the trick. Lastly, Leme point out that Argentina has a strong complementarity to the new world economy with strengths in foodstuffs, metals and energy and that suggest pent-up demand.

The economic track of Brazil and Argentina continues to look divergent as Brazil consolidates its lead particularly in markets and liquidity. Brazilians can’t help feeling a bit of schadenfreude, giving this old refrain added piquancy: “You should buy an Argentine for what he is worth and then sell him from what he thinks he is worth.”

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