Forget Brazil. This emerging market is on the rise

Brazil, an emerging-market darling just a couple years ago, is crumbling amid economic stagnation and political turmoil. But there's a far brighter story—one most investors are missing—elsewhere in Latin America.

Lima, Peru
Axel Fassio | Photographer's Choice RF | Getty Images
Lima, Peru

Four countries—Mexico, Peru, Colombia and Chile—three years ago formed a free-trade bloc called the Pacific Alliance. Tiny Costa Rica joined the club in 2013. Together, they're a bigger economy than Brazil, and they're expected to grow three or four times faster than their huge neighbor over the next few years.

Brazil's $1.7 trillion economy contracted by 0.1 percent in 2014, according to Brazilian central bank data released Thursday, and it's seen shrinking by 0.5 percent 2015. A corruption scandal at state-controlled Petrobras, the state-controlled petroleum giant, is expected to further hobble the country's economy.

Pacific LatAm rising

Country Population GDP past 5 years Predicted 2014/2015
Mexico 115 Million 1.90% 2.4%/3.5%
Colombia 47 Million 4.20% 4.8%/4.5%
Peru 30 Million 5.50% 3.6%/5.1%
Chile 17 Million 4% 2.0%/3.3%
Costa Rica 5 Million 3.10% 3.6%/3.6%

In contrast, the five Pacific Alliance members, with a collective GDP of $2.2 trillion, are expected to grow 3.3 percent in 2014, and 4 percent in 2015. Economic reforms within individual member states can take some of the credit.

"The countries that have continued the gradual process of reform are the ones that continue to capture foreign investment," said John Price, managing director of Miami-based consultancy Americas Market Intelligence.

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But the Pacific Alliance itself is expected to spur its members' growth further. All of the countries have free trade agreements with the United States, but the Alliance takes down barriers between the countries themselves. For instance, the agreement eliminates visa requirements among the five states' citizens, said Barbara Kotschwar, a research fellow at the Washington, D.C.-based Peterson Institute for International Economics.

One of the knocks that economists make against Brazil is that it didn't seize the opportunity to push through economic reforms while commodities prices were at record highs over the past decade. Latin America has long benefited from its natural resources—40 percent of the world's arable land and 35 percent of the planet's mining investment are on the continent, according to Price—but Latin American countries have diverged in the way they handled the boom, said Price. Brazil and some others taxed commodities and resisted economic reforms.

Countries in Pacific Alliance are seen as having a history of relative stability—though currency volatility remains a problem—and a stronger commitment to free trade and rule of law.

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"The Chileans and Peruvians had already gone through a strong reform process in the '90s, and they have done well by it," Price said. The IMF cited domestic consumption, record-low unemployment and wage growth in Colombia, Peru and Chile when it made recent GDP predictions.

Mexico, meanwhile, is the largest economy in the group and is positioning itself as a competitor to China for manufacturing. Labor costs in Mexico were lower than in China or the United States in 2012, according to data from AlixPartners, a business advisory firm.

Pacific Alliance countries have grabbed an increasing share of the U.S. foreign direct investment that flows to Latin America, garnering 62 percent of the $27.4 billion total in 2013, up from 55 percent of the $31 billion total from 2010, according to Kotschwar at the Peterson Institute.

Pacific Alliance for individual investors

General Electric, for instance, has 17 plants in Mexico, employing 10,500 people. "Mexico is the gateway to the world's most important market," said a spokesman for the company, whose Center for Advanced Engineering employs 1,800 Mexican engineers.

Stock investors have yet to really pick up on the growth story in the countries. Year-to-date outflows from four country-specific Blackrock ETFs for the four big countries in the Alliance have totaled $932.6 million. Assets in the four funds total $8.3 billion. That comes against a backdrop of outflows from all emerging markets funds, including both broad and country-specific ETFs, of $9.3 billion. Falling prices for precious metals are affecting investors' views, said Todd Shriber, web editor for Irvine, California-based ETF Trends. And the fall of Brent crude since last year hasn't helped either.

"The problem with ... LatAm single-country ETFs largely boils down to commodities," Shriber said by email. "It's hard to get excited about GXG and EPU while gold and silver prices are falling because those countries are big miners of those metals. Colombia is also a growing oil producer, not something to brag about these days."

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Morningstar lists nine broad Latin American funds, but many of their weightings reflect the market's long affinity for Brazil. For instance, the JPMorgan Latin America Fund, JLTSX, has holdings that are 57.5 percent weighted toward Brazil. The fund has five stars from Morningstar.

While public equities investors have been yanking money out, private equity investors have been steadily marching in. Arif Naqvi, CEO of the Abraaj Group, a $7.5 billion PE firm that invests almost exclusively in emerging markets, pointed to the Pacific Alliance countries as a prime investing opportunity in an interview late last year.

Abraaj isn't the only one looking at the Pacific Alliance.

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"There's been a shift in focus, first and foremost, to Colombia over the past year," said Jeff Bunder, global private equity leader at Ernst & Young. For instance, Advent International, a private equity firm with $33 billion of assets, has done two buyout deals in the region in the past 15 months, one of a Costa Rican firm called GTM that is a distributor of chemical raw materials to Latin America, and one of a Colombian asset manager called Alianza Fiduciara.

"Funds are also looking at Chile and Peru, and the most significant movement in terms of private equity is toward Mexico," Bunder said.

"Private equity investors have bought into the concept (of the Pacific Alliance)," he said. "It's an ambitious plan, but if they can move it forward, it's definitely interesting."