×

3 reasons Latin American stocks will continue to soar

The BM&F Bovespa Stock Exchange in São Paulo, Brazil
Cris Faga | NurPhoto | Getty Images
The BM&F Bovespa Stock Exchange in São Paulo, Brazil

If you just pay attention to the headlines, it looks as if Latin America has taken a turn for the worse. Data revealed last week showed that Brazil GDP contracted by 3.6 percent in 2016, prolonging its worst-ever recession, Mexico's peso has been sunk by talks of U.S.-built walls and renegotiated trade deals, and Venezuela is nearing a total collapse.

However, stock markets tell a different story. In 2016 several Latin American markets began soaring, reversing years of negative returns. The MSCI Emerging Markets Latin America was up 21 percent, the MSCI Brazil climbed by 61 percent — it was the best-performing emerging market country last year — MSCI Peru rose by 53 percent, and others experienced gains as well.

Despite continued economic challenges in some locales, the strong returns have continued into this year. The main Latin American index is up 12 percent, Brazil is up 12 percent, MSCI Argentina has soared by 29 percent, and others have seen solid gains.

While markets that perform well in one year often fall behind the next, that's not what's happening in Latin America. If anything, the region should continue to see even stronger gains ahead. "It's still very attractive," says Gerardo Zamorano, a director and analyst Brandes Investment Partners. "Especially on a relative basis, compared to the U.S."

Why might Latin America continue to outperform? For these three reasons.

1. Pro-business push

Poorly run populist governments is one of the main reasons countries like Brazil and Argentina have suffered economically over the last several years.

When external factors, such as the 2008 recession and, more recently, falling oil prices, started putting pressure on emerging market growth, its leaders failed to implement economy-saving measures, says Robert Neithart, a fixed-income portfolio manager at Capital Group.

"They needed to tighten their budgets, get inflation to come down, deregulate the economy and introduce reforms so their countries could function better," he said. "For whatever reason — politics, a lack of urgency — none of them were able to do that."

That's starting to change. Last year Brazil — the biggest contributor to Latin America gains, accounting for about 60 percent of the overall market — impeached Dilma Rousseff, its corruption-riddled president. Her replacement, Michel Temer, is considered more pro-business and could potentially usher in economy-saving reforms.

More from ETF Strategist:
Investing like Buffett without paying for it
One of the most critical moves you can make before a market correction
The best income moves for retirees in a market signaling a downturn

In particular, it needs to overhaul its pension system and encourage people to work past 55, the typical retirement age. "If you don't make changes to pensions, then there's no money left for anything else," says Will Landers, head of BlackRock's global emerging markets team.

Argentina president Mauricio Macri is also a pro-business economic reformer. He's helped turn the country around, with GDP growth expected to rise by 3.5 percent in 2017, according to the Argentinian government.

2. Rising currencies

When U.S. investors buy emerging market investments, they're usually purchasing them in American dollars. These stocks then get a return boost when their currencies strengthen.

For instance, over the last 12 months the Brazilian real has climbed by about 12 percent, and that's pushed the MSCI Brazil higher than the local Ibovespa index. The former has returned 45 percent over the last year, while the latter has risen by 35 percent.

"When you look at that dollar performance, you're getting some added returns just from a real strengthening of where the currency was at the beginning of the year to where it is today," says Zamorano.

Currency gains have also helped Mexico's stock market over the last month. Over the last 30 days, its risen by about 3.6 percent. That's helped move the MSCI Mexico into positive territory — it's up 1.8 percent since mid-February, while the Mexican Bolsa IPC Index has fallen by about 1 percent.

If economic reforms continue in Brazil and if its interest rate continues to fall — it's dropped from 14.25 percent to 12.25 percent since Oct. 1 — then its currency should continue to strengthen, says Zamorano. While Mexico's currency is more volatile, if the United States doesn't take as hard a line with trade as some think it may, then the peso should rebound, too.

3. Still attractive valuations

The other reason Latin America should continue to do well is because it's still attractively valued compared to the United States. Currently, the S&P 500 is trading at 25 times earnings, while Latin America is trading at 14.3 times earnings, according to data from Credit Suisse. While that's higher than it has been in the past, there are still plenty of good deals in the region, says Zamorano.

On a country-by-country basis, Peru and Colombia look cheap, trading at 12.3 and 11.9 times 2017 earnings, respectively. Brazil is slightly more expensive, trading at around 13.2 times earnings, but with an expectation of a turnaround — the country's central bank is predicting 2.8 percent growth in 2018 — multiples will likely expand from here, says BlackRock's Landers.

"If you look at normalized earnings, then valuations are in line or below historical levels," he says. "In an environment where risk is coming down, and if Brazil has a more efficient economy, then this multiple will go higher to where it has been historically."

As for specific sectors, Zamorano likes Mexican REITs, which are now cheap, having been hit hard by a weakening peso. Brazilian banks, which have been impacted by the recession, are also attractively valued today and should do well when the economy finally turns a corner. Brandes' Emerging Markets Value fund has holdings in two banks, according to Morningstar — Banco do Brasil and Banco Bradesco, which are trading at 11.7 times and 12 times, respectively.

Investors who didn't buy in last year will have missed out on some returns, but there are still reasons to think that more gains will come, says Capital Group's Neithart. Peru continues to be a well-managed economy, and Colombia's peace deal with rebel group FARC should go a long way in helping its economy stabilize, while reforms in Brazil, if done properly, will be a boon to the country and the region overall.

"Things have definitely changed for the better," says Neithart. "They're in a position where they're going to be more prosperous."

— By Bryan Borzykowski, special to CNBC.com

Latest Special Reports

  • Top States 2016

    CNBC's annual study measures all 50 states on more than 60 different metrics.

  • People walk amongst aircraft exhibited on the tarmac during the opening of the International Paris Airshow at Le Bourget on June 15, 2015.

    The International Paris Air Show is celebrating its 52nd anniversary this year with the big movers and shakers in the aerospace and defense industry all attending the event.

  • International business and political leaders gather in Dalian, China for the 2017 instalment of the World Economic Forum’s Annual Meeting of the New Champions.

Investing

Exchange Traded Funds