How to profit from the crisis in emerging markets

As you know, emerging markets are not too popular right now. If you believe what you read in the mainstream financial press, they're on the cusp of a crisis that could bring the rest of us down with them.

Investors are panicked, and we've seen record capital outflows as they've rushed to get their money into safer' investments. A lot of the countries being talked about Indonesia, India, South Africa aren't places I know much about. For all I know everyone is right and they really are screwed. But when it comes to Latin America I do have a strong opinion. In fact I think all this talk of a crisis has created a great buying opportunity.

Just to be clear, I recognise that Latin American economies along with other emerging markets face some challenges at the moment. It's just that I think these challenges will actually end up benefiting the countries and companies that I've been talking about for the last year.

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Investors fear a stampede from South America

There are two main reasons for investors suddenly turning cold on emerging markets. One is the US Federal Reserve, which in mid-May, made it clear its money printing programme, known as quantitative easing (QE),won't carry on forever. All of a sudden the market started imagining a world without QE, and prices started changing accordingly.

Until now, QE has forced down bond yieldsand forced investors to look further afield for a decent return. With US Treasuries offering less than nothing once you factor in inflation, investors scoured emerging markets for exotic sovereign and corporate debt.

But I knew things were getting silly when Bolivia started issuing bonds late last year. I've been lucky enough to spend a fair bit of time in Bolivia, and it's a lovely place. This is pretty subjective, but I think it's the most different' country in Latin America. But while I'd recommend it to a tourist, I wouldn't be in a rush to lend the government money. Yet last October that's just what a load of sophisticated, institutional investors did. Bolivia, which is South America's poorest country and has good recent form in expropriating Western firms, was able to borrow $500m at just 4.9%, even though it had been almost a century since it had issued a bond.

That was just one of many deals that started to look a bit less clever when Ben Bernanke talked about tapering QE. As US ten-year Treasury yields have started to rise, investors feel less need to buy exotic paper. And while markets are incredibly short-term, many investors have long memories. There is a long history of a tighter US monetary policy forcing crises in Latin American markets. So what worries some investors is not just the idea of tapering, but the fear that it could cause a full blown stampede from Latin America that would cripple these countries' financial systems.

The other worry weighing on sentiment is China. For most major Latin American economies the boom of the last ten years or so has been fuelled by selling more commodities for higher prices. And, for the large part, the end customer has been China. Even when China isn't the main consumer for example, Colombia sells most of its oil to the USA China has still played an important role in maintaining prices. So the negative economic news coming out of China and the slow realisation that it won't grow at 8% a year forever has caused investors to worry about commodity producers.

These countries are well-prepared for this crisis

Firstly I think it's important to make some distinctions. Emerging markets may be a handy catch-all term, but there's a lot of difference between South Africa, say, and Mexico. Even within Latin America the individual countries are a pretty mixed bunch. And it so happens that the economies I like most Chile, Peru, Colombia and Mexico look well-placed to survive, and even benefit from the current emerging market storm.

For starters all four but particularly Chile and Peru are in great macroeconomic nick. I'm not going to labour the point here, because it's one I've made a lot over the past year. But, put simply, their low debt levels, high reserves and controlled inflation means that they have plenty of room to employ countercyclical monetary or fiscal policies to help the economy out if it hits a sticky patch. And that's no accident.

Policymakers in these countries have clear memories of the Latin American debt crises of the 80s, of Mexico's Tequila Crisis' in 1994, and of the Asian crisis and Russian default in the late 90s. As a result, they've built their defences accordingly. Unfortunately, that's less true in other countries in the region, such as Brazil, where debt levels are higher and inflation more challenging.

I also think that crises are part of capitalism and can be good things. Obviously that's easy for me to say I would think a lot differently if I was unemployed or my family was going hungry. But a crisis is capitalism's way of saying that something is wrong. In this case it serves as a wake-up call that these countries can't just rely on commodity price rises but need to develop other areas and improve productivity. Again, this is something that policymakers in these countries have been trying to do which is one reason I like them and this current crisis should give their reform drive a bit more impetus.

Leading the way is Mexico. Far less dependent on commodities than the others more than half of its exports come from manufactured goods new president Enrique Pena Nieto has delivered a series of key reforms since his election last year. After a brief pause he's now embarking on another round of structural adjustments. In total, analysts at Spanish bank BBVA believe the reform package could add as much as 1.2% percent to real annual GDP growth.

Meanwhile, Peru, Chile and Colombia, which have gone through spells of impressive reform during the last 20 years, are looking to boost productivity again. They have been desperately trying to encourage other industries, such as the tech sector and manufacturing.

Now these efforts have been given a boost by the crisis. The sell-off in emerging markets has hit Latin American currencies hard. Taken as a whole, they've devalued by around 10 to 15% against the US dollar since Bernanke's speech in May. That's been great news for local manufacturers who have been less competitive in recent years as huge commodity investment inflows pushed up the value of the local currency.

According to Capital Economics, it is already making a difference: "Latin American exporters have enjoyed something of a renaissance in recent months What's more, there appears to have been a shift in the composition of the region's exports. Whereas previous increases in nominal exports have tended to be due to the effect of higher commodity prices, our calculations suggest that around half of the increase since the start of the year has been due to stronger sales of manufactured goods." In short, the crisis is helping the politicians do what they've been trying to do for years rebalance the economy towards manufacturing.

Currency devaluation isn't the only thing helping domestic businesses. For local factories, improved transport and power infrastructure and the creation of a new common market and export union, the Pacific Alliance, should all boost manufacturers. I wrote about a good way to invest in this trend back in April.

Finally, it's important to bear something in mind. If QE is pulled, it will be because the US economy, still the world's largest, is improving. And that's a good thing for Latin America, especially for Mexico and Colombia, who send most of their exports up that way.

This chemicals giant is a good bet

There are lots of ways to play this theme but one of my favourites is Mexican chemical conglomerate, Mexichem (OTC: MXCHF). The group mines salt and fluorite and then turns these raw materials into various plastics and chemicals to sell to industry. The firm's chlorine, vinyl and calcium fluorite are used to make anything from shampoo to cement and glass.

It also has a line in tubes made from PVC the third most commonly used plastic in the world. The wide customer base means that Mexichem has exposure to almost every type of industrial activity, making it a sort of industrial exchange-traded fund (ETF). Around 40% of its sales come from Mexico and another 40% from the rest of Latin America so as the region's factories start taking advantage of the weak currency, Mexichem's products will be in high demand.

The shares currently trade on a forward price/earnings ratio of 15.9, well below its five-year trailing average of 32. So it offers a good chance to take advantage of the crisis and buy into a Latin American growth stock with great potential.