A lucrative Latin American alliance

Last year four presidents met on top of an 8,000-foot-high mountain, in the world's most arid desert, to sign a new treaty. The event wasn't short on dramatic photo opportunities, but the substance of the deal the Pacific Alliance pact looked pretty good too.

It effectively created a trading bloc made up of Latin America's four most promising economies: Mexico, Colombia, Chile and Peru. But not everyone expects much to come of the deal. Why? Because Latin America loves this kind of thing it already has more than enough major trade blocs and talking shops, and dramatic signing ceremonies are two a penny.

Depending on how you classify these things, there are nine separate, if overlapping, intra-national Latin American organisations, with the main one, until now, being Mercosur.

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Set up 20 years ago by Argentina, Brazil, Paraguay and Uruguay (if you're looking at a map, they're all on the right' side of South America), the bloc was envisaged as a South American EU that would boost trade between members. It was a nice idea. Sadly, it hasn't worked out: politics has trumped the treaty, and the volume of trade between the members has actually grown more slowly than that with the outside world. Why?

The fundamental problem is a simple one: the largest members, Brazil and Argentina, don't believe in free trade. Both use limits and quotas to protect key industries and take a generally statist' approach that allows heavy government interference in the economy. They are unlikely to change their approach anytime soon.

That's why investors should pay close attention to the new grouping. It combines the dynamic, medium-sized economies of the South American Pacific coast with Mexico, a geographical colossus that straddles the North American continent, stretching from the Pacific to the Atlantic. All four have excellent macroeconomic track-records, healthy public finances, young populations and lots of natural resources. But most important of all, they also all have open economies and are committed to free trade.

The contrast between the Pacific Alliance and Mercosur is "obvious", says a Foreign & Commonwealth Office briefing. The Pacific Alliance "is designed as a purely economic proposition to the genuine mutual benefit of its members", rather than a political group set up to "issue political communiqus". Moreover, "this group of pro-free trade, open economies" stands out in a region where "growing protectionism" is an increasing problem. Its creation makes Mercosur look "stalled and unambitious by comparison".

Politicians aren't the ones making the running here: they're really just following the lead set by the private sector in the region. Chilean retailers have already expanded into Colombia and Peru, while Colombian utilities have successfully entered the market in Peru as well. Mexico exports cars to all three of the other member markets and Integrated Latin American Market (MILA), also launched last year, links the stock exchanges of Chile, Colombia and Peru.

The pact hasn't been set up to redirect or to create trade flows just to make the path of economic integration a slightly easier one. It is also encouraging to note that the aims of the new group are refreshingly and unusually realistic, says Sebastin Prez-Ferreiro in Business Chile magazine.

In the first stage the countries will simply strengthen the trade agreements already in place (Chile, for instance, is already close to achieving a zero-tariff zone with Colombia and Peru). The second stage will link the existing bilateral accords between the four countries and add additional steps, such as making it easier for business travellers to move around the alliance, facilitating student exchanges and integrating electronic markets.

These reforms will lower the costs of doing business and give firms access to a wider pool of talent, local suppliers and a larger market. There's serious potential here too. The group has a population of 215 million, but a GDP of only $2trn. That's about the same GDP as Italy, but with three and a half times the population. I know who I'd bet on to enjoy the best growth over the next few decades.

Who's who in the Pacific Alliance?

The biggest of the four is obviously Mexico, a country that despite its efforts to produce a modern economy appears to be a perennial underachiever. Throughout the 1980s and 1990s, Mexico followed the Washington Consensus', says Nomura analyst Tony Volpon. "Significant reform efforts" included "signing free-trade agreements privatising around 1,000 state-owned firms, attaining fiscal discipline [and] achieving central bank independence."

Yet despite all this painful medicine, Mexicans still found themselves stuck with decades of mediocre growth. Eventually they were overtaken by Brazil as Latin America's largest economy and overlooked by investors seeking more exciting emerging markets.

Now, however, Mexico might just be about to come into its own. Opening up the economy may have been painful, but it has served its purpose forcing Mexican firms to be competitive and keeping costs low at the same time as the North American Free Trade Agreement (NAFTA), with the US and Canada, has opened up new markets.

Throw in a large, young workforce, which keeps wage inflation in check, plus a great location next to the world's biggest economy, and it's easy to see why Mexico has finally become a real export power house: manufacturing has grown from just 2% of GDP in the 1980s to almost 25% today.

But the story still has plenty more mileage in it. Mexico's demographic window' should last until 2026, while cost increases in China will continue to make Mexican products more competitive especially in the Americas (80% of Mexican exports go to America). HSBC expects the value of Mexico's exports, which currently stand at $700bn, to double over the next eight years and that's despite the fact that international trade already accounts for 60% of its GDP (the comparable number for Brazil is a mere 19%).

Add all this up and Nomura's Volpon even believes that Mexico's economy has a good chance of overtaking Brazil and regaining its position as Latin America's number-one economy by the early 2020s. "If our forecast comes true, it will be a LatAm' success story based on liberal economic policies and manufacturing productivity, surpassing the commodity-exporting, more statist approach to the economy represented today by Brazil."

Neil Shearing from Capital Economics is also bullish. He expects Mexico to "be among the better performers in the region over the next couple of years", thanks to the remarkable resilience of its main export market (America), the problems in Europe, and also the fact that "Mexico does not rely too heavily on commodities production". This means that for Mexico the effects of a Chinese slowdown and fall in commodity prices will be positive, not negative.

That is a view that is very much in line with ours. But it also begs the question of how the other members of the Pacific Alliance will cope with falling commodity prices? Peru, Colombia and Chile are all far more dependent on commodities than Mexico. Chile has the world's largest copper reserves, while Peru and Colombia have a mixture of minerals, oil and gas. In all three countries commodities account for more than half of all exports. Clearly, they will be affected in a bad way by falling commodity prices. But it might not be as bad as it seems.

For starters, in yet another unusual turn of events, all three countries have used the commodity cash bonanza of the last decade fairly wisely. Take Colombia. External debt (the sum of public and private sector obligations to foreign creditors) has fallen steadily from 40% of GDP in 2003 to 22% today. The government has also built up about $35bn of reserves. This all gives Colombia "an important buffer", says Will Landers, manager of BlackRock's Latin America investment trust. "It makes Colombia less dependent on foreign creditors. If the Colombian peso falls, the country doesn't have to try to raise taxes or seek more international debt."

Chile has been even more prudent. Its public debt is less than 10% of GDP while it's also built up sovereign wealth of $15bn that it can use to stimulate the economy if copper prices fall. Peru looks good too. Its economy has grown at an average annual rate of 6.6% since 2003 and the national debt has fallen from almost 50% of GDP to 22% over the same period. These low levels of debt have now allowed governments in all four Pacific Alliance countries to unveil ambitious infrastructure building programmes.

Peru recently unveiled a $20bn five-year infrastructure plan, while Colombia has committed to spending $20bn on upgrading transport links and building social housing. Chile is halfway through implementing a $14bn infrastructure plan that will run until 2014, while Mexico's new president, Enrique Pea Nieto, has made upgrading the country's transport infrastructure a key election pledge. Unlike some of the projects being suggested for the grossly indebted UK, these projects mostly make sense: the continent has under-invested in infrastructure for years.

Irene Mia, head of the Latin American department of the Economist Intelligence Unit, feels Latin American infrastructure will be a big theme in the coming decades and one investors should be watching pretty closely. "Public investment in infrastructure fell from above 3% of GDP in 1988 to 1.6% in 1998 Against such a background, it is estimated that Latin America needs to invest between 2.5% and 6% of GDP to upgrade and extend the regional infrastructure," she says. American bank BNY Mellon has counted $450bn of planned infrastructure projects between 2011 and 2015.

A final positive for the Pacific Alliance region comes in the form of monetary policy. When economies start to slow down, central bankers like to cut interest rates to make credit cheaper and hence encourage people to invest and consume. That's why the Bank of England has kept the benchmark interest rate at the all-time low level of 0.5% since the start of our seemingly endless financial crisis.

However, central bankers in Chile, Colombia and Peru haven't done this. Yes, they cut rates back in 2008, but since then they've been able to push them back up again. The base rate in Columbia and Chile is 5% and in Peru 4.25%. So they have space to cut, should they need to if the world moves into a global recession.

Below,we look at the companies most likely to benefit from the growth, as well as the fiscal and monetary stimulus in the region.

How to invest in Pacific Alliance countries

For the average British retail investor, investing directly in the Pacific Alliance countries isn't easy. Accessing the local stockmarkets from abroad can be expensive, but if you buy via an exchange-traded fund you'll find that in the smaller economies the country-specific ETFs are dominated by one or two large, local firms.

One way to get around this is to invest in good regional banks listed in America, says BlackRock's Will Landers. "If you have a country with a clean banking system and growing economy, buying a bank is often a good way to play the wider growth. It's involved in business sectors across the economy so it's almost like buying an ETF."

A lot of Latin American banks are expensive right now, as investors snap them up for that reason. Fortunately, shares in one of our favourites, Peruvian bank CrediCorp (NYSE:BAP), have dropped 10% in the last month. The fall was sparked by recent numbers that showed the past due loan ratio rose to 5.5% in the second quarter, up from 4.6% in the first quarter. That has made investors worried that the bank's ongoing push to sell credit cards to lower-income parts of Peruvian society is starting to backfire, with bad debts rising.

It makes sense for investors to be nervous, of course look at the problems bad sub-prime lending can cause. But in this case, there probably isn't much to worry about. "Peru remains an underpenetrated financial system," says J P Morgan analyst Saul Martinez. "Bank credit to GDP stands at 28%, lower than the 44% in Brazil and 71% in Chile." Moreover, the credit-card division accounts for less than 5% of the bank's total loan book, meaning late payments are manageable. On a forward p/e of 10.4 CrediCorp is also one of the cheapest banks in the region.

In neighbouring Chile, one of our top stocks is wine producer Via Concha y Toro (NYSE:VCO). It's the world's second-largest wine producer, in terms of vineyards planted, and has had a great few years, with sales growing at an average annual rate of 18% since 2001. But more is still to come for Via Concha y Toro.

When commodity prices fall, the value of the Chilean peso should fall too. That would be great for Concha most of its costs are in Chilean pesos, while its revenues are in dollars, pounds and euros. Europe is an obvious danger but most of the firm's European business is in the richer northern countries and over 70% of its bottles sell for £6 or less, so it is safer than the share price suggests: it is down 27% since last June and now trades on a price-to-earnings (p/e) ratio of 14 times low, given the firm's earnings growth.

The biggest market for Latin American steelmaker Ternium (NYSE:TX) is Mexico, but it also has a presence in Colombia. In total the two Pacific Alliance countries account for more than 65% of sales, with Brazil, Argentina and Central America making up the rest. Now is not the easiest time for steel makers, given the way in which overcapacity in China has hit margins across the industry.

But on a forward p/e of seven times, Ternium is cheaper than any of its Latin American rivals. It exports to the Mexican manufacturing industry and is invested in the value-added specialised steel that's especially in demand in the US. J P Morgan analyst Rodolfo De Angele rates it as his top pick in the sector.