How the Pacific Alliance defused one of its biggest threats

Can the Pacific Alliance patch things up with its Atlantic rival?

A few weeks ago, the leaders of the Pacific Alliance were doing what they do best – taking part in a flashy summit. The trade bloc may only have been around since 2011, but it’s already had nine of these leadership conferences.

I’ve been to one of these summits before – and I’ve got to say, it was a lot of fun. They’re always in a nice part of the country – the one I attended was in Cali, the tropical home of Salsa – and they’re a great place to network.

You can always rely on a big contingent of diplomats and business leaders – so for a journalist, it’s great.

When I was there last time, I got to interview the president of Colombia’s second-largest oil company and the head of the stock exchange on the sidelines of the conference.

Access to the national presidents is obviously a lot more restricted – especially for the likes of your humble correspondent. It’s normally a few staged photos and a very tightly controlled press conference, where you’re lucky if you get to ask a question – never mind get an answer.

I wasn’t at the latest one, but there were two big developments that could have an enormous effect on our investments. Let’s have a look.

This could be the Alliance’s smartest decision so far

The first piece of big news is that the Pacific Alliance has held out the olive branch to its Atlantic rival Mercosur. Regular readers of The New World will know that I’ve long been a fan of the Pacific Alliance, a trade bloc made up of Chile, Peru, Colombia and Mexico – some of the region’s most dynamic and open economies.

The open stance of these countries, which have a patchwork of trade agreements with most of the world’s major economies, stands in marked contrast to Mercosur.

The latter, which is made up of Brazil, Argentina, Venezuela, Uruguay and Paraguay, has recently turned so much against free trade that some members have even found ingenious ways to block each other’s exports – which goes completely against the whole point of setting up a tariff-free trade group.

But at this latest conference, the Pacific Alliance, which has so far been polite, but frosty with Mercosur, agreed to open talks with its Atlantic counterpart. This is a radical change and one that could have serious implications for investors.

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Making peace with another Latin American trade bloc

When the Pacific Alliance launched in 2011, the members were very keen to emphasise that they were different to the multitude of other Latin American regional blocs, bodies and talking shops that had gone before them.

And while the emphasis was always on trade, the fact that all four countries practised the ‘Washington Consensus’ influenced economic model meant that they formed a big contrast with more statist countries such as Venezuela, Argentina, Ecuador and Brazil.

I recently interviewed former Peruvian prime minister and runner up in the 2011 presidential elections, Pedro Pablo Kuczynski, and he told me that politics played a big part. “It was, without doubt, a political reply to other blocs in the region.”

One country that viewed all this with an element of fear was Brazil, says Carlos Fortin, a research associate at the Institute of Development Studies.

“This was perceived badly in some quarters of Brazil, as an attempt to somehow join forces to oppose Brazil in the region. Chile has always maintained that this was not the case, but the relationship between the two countries has definitely cooled.”

Those words were from November last year, but recent events have shown that Fortin was remarkably prescient. “I think now with [Chilean president Michelle] Bachelet, we will see that the relationship between Brazil and Chile grows stronger as she and Brazilian president, Rouseff, are close friends.”

And that is exactly what happened. In her first meeting at the Pacific Alliance, Bachelet demanded that the bloc improve links with Mercosur. “Beyond legitimate differences, it is perfectly possible to achieve levels of convergence between Alliance countries and Mercosur, between the Atlantic and the Pacific… Not only is it possible, it is also necessary.”

For someone like me – who has been investing in Pacific Alliance plays, this is great news. Don’t get me wrong, I’m not expecting results straight away. Talks are planned for later this year, but it’s way too soon to start hoping for something concrete like a free-trade agreement.

It’s true that Mercosur’s smaller members, Paraguay and Uruguay, seem like they’d happily switch alliances. But I’m sure Argentina and Venezuela would put a halt to any linkup.

But what these talks do is remove some of the biggest threats on the horizon for the Alliance. The tension with Mercosur was the elephant in the room that no one would ever talk about at these summits. Now that the issue is out in the open, the tension has cleared.

Critics had also wondered how the Alliance would handle a switch in government of one of the member countries. The fact that it can handle the move from the former Chilean president, the right-wing Sebastian Piñera to Bachelet, shows that the institution is strong enough to absorb change.

And that’s not all…

The final positive from the summit was that it gave further details on the plan to free up the members’ large and growing pension funds to jointly fund infrastructure projects in the region. The pension funds in these countries are worth around $400bn in total and are growing fast.

Until now, their investment mandates have been strictly regulated, with a heavy emphasis on domestic opportunities. If more of their money could be diverted to regional projects, they could help to finally kick-start the oft talked about, but much delayed, infrastructure programmes that are so badly needed in the member countries.

So, what’s the best way to play it?

When I first mentioned the Alliance back in 2012, I chose a steelmaker to play on the infrastructure boom and it’s now up 44%. I picked a regional bank to give me wider exposure to the general economy and it’s up 31%.

And I also picked a Chilean winemaker to act as a hedge in case commodity prices crashed and it’s pottering along with a 3% gain.

Today, I am going to add to that with Peruvian construction firm Graña y Montero (NYSE: GRAM). It’s Peru’s oldest construction firm and has been around for the best part of a century.

In that time, it has survived dictatorships, guerrilla unrest and quite a few wars. But the last ten years have been unlike anything the company has ever experienced. Its sales have rocketed in the last decade as it has spread out to Chile and Colombia.

Eager to fund regional expansion, it has also listed on the New York Stock Exchange, which makes it cheap and easy for private investors like us to buy from the UK. I interviewed the CEO in Lima a few weeks ago and he explained how he plans to take advantage of the regional infrastructure boom.

What particularly impressed me was the business model. Unlike some of its competitors, the firm doesn’t bid for a project and then scramble to get funding. Instead, it uses its own cash pot to get complex, risky projects off the ground – a good example would be the Lima Metro – then once it is up and the running, the firm creates securities to sell the rights to some of the revenues.

In essence, the firm isn’t just a builder. By assuming some of the early stage risk, it is also something of a private equity backer for some of these projects.

Clearly, you wouldn’t want to put all of your retirement fund in the firm, but given its track record I am prepared to back it to do it again. Moreover, a forward price/earnings (p/e) of 14.6 seems a good price for a firm that’s growing so quickly.

This article is taken from The New World, MoneyWeek's FREE regular email of investment ideas and news from Asia and Latin America. Sign up to The New World here.

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