Flows dance to salsa beat

For those who are not aficionados of Mexican history, José de la Cruz Porfirio Diaz Mori, president of his country for 31 years, is probably best remembered for a single quote: “Poor Mexico, so far from God and so close to the United States!” For Mexico the Porfiriato was a period of sporadic progress but much upheaval. It ultimately ended in a crippling revolution, the first of the 20th century. In many ways the period is emblematic of the history of Mexico and Latin America in general.

Short bursts of economic growth and optimism are interspersed with crackpot policy, fiscal irresponsibility and currency crises. The LDC debt debacle of the 1980s was barely over before Mexico’s Tequila crisis unfolded in 1994. Brazil emerged unscathed from that and the creation of the real was initially a runaway success. But in 1998 it fell prey to a wave of selling of current account deficit currencies in emerging markets and in spite of a $44bn loan from the IMF devalued in early 1999.

In most economic crises Latin America has either been a catalyst or one of the first to feel the aftershocks. This time it is different. Though growth forecasts across the region have been slashed, institutional investors appear to have awarded Latin America unlikely safe-haven status. In January this year cross-border equity flows were dismal. Aggregate monthly flows into developed markets were close to a record low. Flows into emerging markets languished in the 17th percentile. There was only one region receiving significant inflow, Latin America.

This love affair with equity markets south of the Rio Grande has continued. Though there has been a more general recovery in cross-border equity flows, Latin America remains the region of choice. Flows over the past month are in the 97th percentile of their prior history (flows only higher on 3% of previous monthly periods over the past 12 years). Monthly flows into Mexico hit an all-time high this week.

At first, this seems odd. After all, Mexico remains close to the United States, both geographically and economically. Some 80% of Mexican exports are shipped to its northern neighbour and the historical correlation between US and Mexican GDP growth is 0.86. Indeed, the consensus among economists is that Mexico will suffer a relatively severe recession in 2009 in line with the US, with growth declining approximately 3.5%.

However, investors seem to believe the bad news is in the price. Economic decoupling for emerging markets, the talk of 2008, was always unrealistic. But the market, for a time, disagreed. The MSCI Latin America Index peaked on May 19. It was 18.1% up on the year compared with a 2.9% return for the S&P500 index. However, from that peak the index dropped 61%, faring far worse than the S&P500 which fell 41%.

Having fallen so far, so fast, it is perhaps not surprising that investors began buying again around the turn of the year. Prices reflect this. Year-to-date the MSCI World Index is down 6.94% but Latin America is up 14.75%. The continued outperformance of Latin America cannot be taken for granted, especially among its emerging markets peers. Flows into emerging Asia are showing signs of recovery. However, there are sound reasons why investors continue to put their faith in the region.

First, the main markets, Brazil, Chile and Mexico, are in varying degrees well run economies that have not indulged in reckless credit expansion and whose banking systems appear sound. When UBS needed to sell Banco Pactual to shore up its balance sheet, it was a Brazilian investment group that stepped in. That is just one indication of how economic power is shifting.

Second, a replay of the region’s recurrent nightmare, a full-blown currency crisis, seems highly unlikely in the big three. Mexico is most vulnerable. But it has drawn on a $47bn flexible credit line from the IMF to avert such a disaster. Rather than earning it a black mark, FX and equity flows suggest investors have welcomed this proactive step. Brazil does not look an obvious candidate for currency problems. It is far less reliant on external funding now than at any time in its recent history. Its borrowing requirement this year amounts to only 46% of its FX reserves.

The notion of a currency crisis in Chile is frankly absurd. It has enjoyed successive governments that are genuinely in love with Gordon Brown’s old flame prudence. Chile enjoys the buffer of a $27bn sovereign wealth fund, a pension fund system that should make most of continental Europe blush and a fiscal position strong enough to allow for a $4bn stimulus. The Chilean peso is best performing currency in the world this year, outperforming the dollar by 9.5%.

Finally, though Brazil and Chile are less reliant on exports to the US than Mexico, Uncle Sam remains their largest trading partner. Cross-border equity flows into the US have staged a marked turnaround since the G20 meeting and onset of quantitative easing. It may be that investors believe that unconventional policy will drag the economy out of recession in the second half of the year. If that is the case Porfirio’s famous maxim should be turned on its head. Proximity to the United States will be a blessing, not a curse, for its Latin neighbours.

Chart 1: Investors confident about LatAm …

Source: State Street Global Markets

Chart 2: … as the region outperforms

Source: State Street Global Markets