Latin financial markets: The rot spreads

Latin equity and debt markets have been especially hard hit in the last few weeks by the generalized flight-to-quality and a growing sense that emerging markets are proving the last shoe to drop, compounded by dramatic currency volatility throughout the region. The rapid drops in commodity prices and fears of a global recession have seen Latin market falls accelerate and overall declines have now surpassed those of the developed world. More is likely to be on the way, before any rebound.

Just six months ago, optimism reigned supreme in Latin America. Stock markets had taken off, investment banks were pouring into the region and scrapping for talent and forecasts were for continued sunny skies.

The latest figures add to the sense of an unfolding apocalypse.

Latin American funds lost 11.79% in the week that ended October 23 and are down 56% year-to-date while BRIC funds posted the 12th consecutive week of negative performance in the same week. Redemptions from Latin funds have reached close to $7 billion since early June. Surprisingly, this is slightly better than the results for all emerging markets which are down 12.51% over one week and 58.93% over the year, although this is small consolation for investors. Meanwhile, debt funds were down 9.73% in the same week.

As if that were not bad enough, many expect things to get worse before they get better. “The downturn in Latin America is just beginning...the region is facing its most serious threat in decades,” according to Morgan Stanley.

Not only are results worse than any expectations, but doom-mongers have replaced optimists throughout the region as analysts have torn up previous forecasts and many have simply given up trying to make predictions until clear trends on what are driving the market emerge.

The brunt of the burden has been borne by the very stocks that were the top performers a few months ago, particularly those in commodities. Investors have been focusing on the region’s heavy reliance on commodity exports and reinterpreting macroeconomics, seeing what was just months ago a robust macroeconomic picture as weak public finances.

The gloom may now be overdone, but it is clear that Latin America will not reach the jubilant highs of the last 12 months for a long time. Latin markets had been in fashion for the last couple of years as heavy exposure to Asia was slowly reduced in the Amercias’ favour, explains Brad Durham, managing director at EPFR Global in Boston. He adds that some Latin markets were overbought last year, with Brazil representing the single biggest overweight in the region. As managers have unwound positions, those markets that have enjoyed the fastest expansion in the last couple of years have fallen furthest.

Two other factors have helped to destabilise Latin markets. In most countries of the region, precipitate and unclear public policy announcements have contributed to massive uncertainty.

And, as if all this were not enough, foreign investors have seen losses compounded by steep declines in currencies versus the dollar. The Mexican peso, for example, plunged 18% against the US dollar in October. In recent history, that is comparable only to its monthly performance in December 1994, when the government devalued to staunch foreign reserves.

Market toxicity

The rapidity and scale of the crisis have back-footed investors. A complication is that those economies which are likely to be most affected by the crisis have not had the worst equity market performance.

It is likely that countries such as Chile, Brazil and Uruguay, which have pursued relatively prudent economic policies and have strong reserves, will be the least affected by the crisis. At the other end of the scale Argentina, Ecuador, Bolivia, Venezuela and parts of central America will suffer badly, thanks in large part to dotty policies and over-spending that leaves them particularly vulnerable to investor retraction.

But the transmission between economies and markets is patchy and often contradictory. Venezuela has, to date, proven one of the less awful performers, particularly for foreign investors. The index is down a relatively light 11.5% since highs as recently as late August. And because the Venezuelan currency is fixed to the US dollar, downside for foreign investors is limited. But they are mostly absent: the tiny market is highly illiquid and a complete lack of transparency on corporate and government policy makes the market a crap-shoot.

The main risk going forward for Venezuelan investors is the likelihood of a Venezuelan devaluation post elections. The parallel market has been showing the stresses of liberal spending and the bolivar had reached 5.45 against an official exchange rate of 2.15.

If the Venezuelan market has been relatively immune, those stock markets that are more and more tied into the global economy, and were the strong performers of 2006-07, have been slammed. Brazil and Mexico are the prime examples.

The Mexican market, as measured by the Bolsa index, was trading down 48% from last year’s highs on October 27 while the Brazilian market was down 58% from highs registered as recently as May on the same date. Recent currency movements have made market exposure to the two markets even more disastrous.

In part, the dire performance of the Brazilian and Mexican exchanges reflects both their openness to investment and the number of ADRs listed in the US. ADRs have tended to track broader indices faithfully and this has seen some of the largest, most liquid companies on both exchanges suffer.

Currency weakness has made life more difficult. Mexico has been hard hit both by the likelihood of a US recession and its heavy reliance on petroleum as a foreign currency earner. Weakness forced the hand of the Banco de Mexico, which stepped in aggressively to contain the fall-out. The bank bought $13.1 billion worth of pesos between October 8 and October 27.

Commodity exporters including Chile and Peru have been hurt too. The Chilean market is down just over 33% since hitting highs in October last year. The Chilean peso has been trounced by fears of a global recession and falls in the price of copper, the country’s main export. The currency touched a five-year low in late October, dropping 19% to October 27.

Peru’s Lima General Index losses have been catastrophic. The index is down 73% from highs last year with mining companies particularly hard hit. Peru's securities exchange halted trading in October when the main index registered the greatest falls in at least 18 years. That day alone, the General Index plunged 11% before trading was suspended. It was the steepest drop since at least January 1990.

Policy responses and individual markets

Policy responses to the crisis have varied widely throughout the region. After an initial bout of passivity, and in some cases the idea that this was a north American issue exclusively, most governments have rushed out responses. The problem is that the reactions have been mainly defensive and in some cases counter-productive.

Argentina’s reaction has confirmed the country as the pariah of financial markets and investors. The decision to essentially nationalize the country’s pension funds under the guise of protecting pensioners, caused a rout in financial market. Details on the package were being discussed in Congress at the end of October with clarity on how funds would be administered still unclear. Meanwhile, investors ran for cover. The yield on Argentina's benchmark 8.28% dollar bonds of ‘33 rose 838 basis points to 28.8% and the Merval index fell 27% to 890.27 in one week.

The market rout in Argentina has already put a bond deal by petrol giant YPF, one of the few strong names in the market, out of reach. The firm scrapped a planned $150 million bond due 2018 because of weak market demand.

In Brazil, President Luiz Inácio Lula da Silva was initially dismissive of the situation, referring to it as “Bush’s crisis”, but has since woken up to the gravity of the situation. A measure was rushed out with no public consultation to allow public sector banking giants, Banco do Brasil and Caixa Econômica Federal, to take over private sector banks.

That has had the effect of triggering a sharp deterioration in the share prices of smaller Brazilian banks as investors assumed the government knew that there were banks that needed bailing out. More constructively, the Central Bank offered up to $50 billion in FX swaps to the corporate market to help corporate hedge exposure to the US dollar. One of the exacerbating factors behind Brazil’s currency depreciation has been the rush to unwind derivative positions by companies, who have been trying to net out exposure through the futures market.

Individual companies

Companies that have been particularly affected come from a wide slew of industries. Not surprisingly, the banking sector was severely hit and the first to suffer. Commodity firms have seen prices plummet too. And the crisis calls into question what is going to happen to the aggressive investment plans of a range of commodities firms. PDVSA, Pemex and Petrobras are all urgently in need of funds to develop new fields. Petrobras alone is slated to invest just north of $160 billion over the next five years and, according to Credit Suisse, the company may need to fund $30 billion of that amount, even with gas prices at $80 per barrel.

Still, there have been deals in commodities, although the largest have taken the form of private deals. Brazil’s CSN pulled off a deal to sell its Namisa subsidiary, under which it sold a 40% stake in the integrated iron ore mining complex to a Japanese-led consortium, rather than through the public markets. The $3.12 billion deal was concluded in the teeth of the storm. The deal even came at a premium of iron ore asset sales in Brazil.

Firms with high levels of debt or large fund raising needs and those that are capital intensive, such as home builders, have been slammed while those that have been the most immune tend to include safe-pair-of-hands including utilities and counter-cyclicals.

The end of the road for M&A?

For investment banks, the question is just how far will the rot spread, which firms will be most affected and which industries might have a less rough time of it.

One hope had been M&A markets, which had been relatively immune from the crisis. But that seems increasingly vain. Recently, deals have been pulled as buyers postpone expansion plans. The deal by Votorantim to merge with Aracruz were scrapped because of turmoil in the markets and the discovery that Aracruz had made ill-judged bets in the dollar-real derivatives markets, which breached internal limits. And in the extremely hard hit homebuilder sector, giant Cyrela was forced to put off a deal to buy its competitor Agra Empreendimentos Imobiliarios. “Corporate executives just don’t have the confidence to go through with an acquisition with all this uncertainty,” said one M&A banker.

In all likelihood, there will be a complete re-drawing of the financial industry. According to Walter Molano, president of BCP Securities, one possible outcome of the crisis is a fundamental shift in the format of the sell- and buy-sides. He suggests that regulation and deleveraging remove the need for the economies of scale that justified the existence of the large investment banks. “Managers and shareholders will reduce the size and scope of their institutions. This could produce a proliferation of financial services providers, similar to the atomization of the drug industry when the large cartels fell,” he believes.

Already there are questions circulating over the commitment of the remaining Wall Street firms to the region. Perhaps the biggest source of speculation in Latin American financial circles is what will be the future of Merrill Lynch in Latin America since its incorporation into Bank of America. That bank had slowly been exiting the region, particularly with the key sale of BankBoston to Banco Itaú. It has signaled a commitment to Latin America by placing Sonia Dula in charge of developing the bank’s Latin American investment banking business, but the scope and size of the business has yet to be defined.

The demise of Lehman Brothers has also given some pointers to how the new landscape might look. The firm’s burgeoning Brazilian business was bought by BTG, a start-up company run by Andre Esteves, the ex-head of fixed-income for UBS, who recently left to set up his own shop.

At the same time that the buy-side is splitting into specialist boutiques, the highly fragmented buy side could go the other way and consolidate rapidly, Molano reckons. The boutique model was predicated on funds’ ability to use leverage, hedging and derivative instruments that the traditional asset managers, such as mutual funds and insurance companies, were not able to use. The removal of the liquidity from the system makes that business model unfeasible, he believes.

The talk in trading room is no longer about which yacht to buy but who will still have a job this time next year.

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