The Pacific Alliance is in the bargain basement. Buy it now
The recent political turmoil in Latin America doesn’t change the auspicious long-term economic outlook for Chile, Colombia, Mexico and Peru. It spells opportunity for contrarian investors, says James McKeigue.
Have you had an exciting year? The Pacific Alliance certainly has. Since I last wrote about the Latin American trade bloc in September 2018 its members Chile, Colombia, Peru and Mexico have lived through the type of political and economic turmoil that makes Brexit Britain appear uneventful. Chile and Colombia were upended by violent protests. Mexico's socialist president led his economy into recession. In Peru, where corruption allegations caused the imprisonment, exile or suicide of the last five presidents, the current leader has dissolved Congress in a move opponents claim was a coup.
Nevertheless, the upheaval spells opportunity for investors who believe in the long-term potential of the Pacific Alliance. The drama has panicked the market and created a buying opportunity for the brave. The solid macroeconomic fundamentals and long-term growth prospects that first prompted me to recommend the Pacific Alliance to MoneyWeek readers in 2012, one year after the bloc's creation, are still in place today. The only difference is that we can get a better deal now.
Latin America's best trade bloc
Since independence Latin America has seen countless unsuccessful customs unions and trade blocs. So when the Pacific Alliance was launched in 2011, analysts were sceptical. But its quick progress soon made it stand out from other regional groupings. Infrastructure projects, visa agreements and tariff reductions have increased the movement of people and goods, while the creation of a shared stockmarket and standardised financial-sector regulation will increase capital flows between members.
Another key characteristic is that the Pacific Alliance avoids politics and sticks to trade and investment. The tendency of other blocs to get embroiled in political matters invariably leads to problems in a polarised region. The Pacific Alliance is rightly viewed as a pro-market, pro-trade grouping, but it continued to thrive after member countries elected socialist leaders such as Peru's former president Ollanta Humala or Mexico's incumbent one, Andrs Manuel Lpez Obrador (AMLO).
So the Pacific Alliance is here to stay. And that's good news for MoneyWeek readers because it gives investors an interesting way to play Latin America. With a combined population of more than 225 million people and a GDP of more than $2trn (not far behind Britain's $2.7trn), the Pacific Alliance offers real scale. It accounts for almost 40% of Latin America's economy, making it an interesting counterweight to Brazil, which dominates the Latin America-focused funds available to retail investors.
Then there's the economic variety on offer. From the commodity-dependent "Andean Three" of Chile, Colombia and Peru to the manufacturing powerhouse of Mexico, there is plenty of room for diversification. Finally and this is the main reason why I'm so positive about the Alliance there is the economic strength of its members. They are all well-managed, open economies with good demographics.
Upheaval in the Andean Three...
Still, for now violent protests have overshadowed the long-term advantages. They started in Ecuador, when an uprising of indigenous groups and students triggered by a proposal to cut fuel subsidies forced the government temporarily to flee the capital. Soon afterwards in Chile, Latin America's most-developed country, planned metro price hikes were met with a campaign of arson followed by mass protests. By November Colombia had joined the fray with a general strike and mass protest that also turned violent.
Investors didn't wait around for the analysts to come up with an explanation. The Chilean peso slipped to a record low of 857 against the US dollar, while the country's stockmarket dropped by 10%. In Colombia, the peso declined by 4%. As the protests died down in both countries financial markets started to recover, but they are still well below their September levels. Investors are rightly worried about the impact on short-term growth. London-based consultancy Capital Economics downgraded Chile's 2020 GDP growth forecast to 2.5% from 3.5%. But the long-term growth potential of the Pacific Alliance won't be affected by the protests.
...is not a long-term problem
Take Chile, where the protests have been the most violent and widespread. The only threat to long-term investors is if the protests force Chile to change the economic model that has made it Latin America's most developed economy. While metro fares sparked the protests, they were fuelled by legitimate grievances of the working and middle classes in a country that has the highest inequality in the OECD and a rigid social and educational hierarchy that keeps most of the best jobs for a small upper class. To quell the protests the president had to replace the entire cabinet and agree to rewrite the constitution.
But as Quinn Markwith, Latin America economist at Capital Economics notes, investors shouldn't be unduly worried. "Fundamentally, our medium-term view on the economy hasn't changed. It doesn't seem likely that the protests will have a long-lasting impact on investment. A large amount of investment relates to mining and shouldn't be affected by protests in the capital. Chile's strong public finances also mean that future spending to appease protesters is not worrying. So we're still comfortable with our 2021 GDP forecast of 3.5%."
As for Colombia, there is real frustration over the controversial and poorly implemented 2016 peace deal with Farc, the Marxist guerilla movement; austerity and a botched tax reform have also rattled people. And it's true that some protests turned violent and were met with heavy-handed security forces. But this is still a big improvement for a country where political differences have long been settled through armed conflict. That's why the impact of the Colombian protests on the country's financial markets was far more subdued than in Chile. Meanwhile, the medium-term growth prospects are encouraging. A post-protest report from credit ratings agency Standard and Poor's predicted it will be one of the fastest-growing major economies in Latin America between now and 2021, with growth of 3.2% in 2020.
Finally, Peru shows why investors can afford to ignore political drama when the economic fundamentals are solid. Peru's political system is broken and most of its political class, including five former presidents, seem to be corrupt. The latest display of institutional failure came when President Martn Vizcarra used a controversial interpretation of constitutional law to dissolve Congress and call for its re-election. It's a mess. Yet its economy is still set to grow by 4% in 2020.
Shared economic strengths
Ultimately the economic destiny of the Andean Three won't be decided by protests, but by copper, gold, oil and iron-ore prices. Prices are currently solid and the demand story seems steady. Of course, there are plenty of commodity-producing countries that have proved terrible investments. What I like about the Andean Three is that in recent years they have managed to ride out bear markets in their key commodities without succumbing to recession. They've also made shrewd use of their commodity bonanza to build the infrastructure needed to boost productivity. Chile's solar energy is 75% cheaper than the fossil fuels it is replacing and is helping to wean the country off imported oil. Colombia has put together Latin America's most advanced public-private partnership infrastructure programme and is starting to benefit from both the inflow of foreign direct investment (FDI) to build the projects and the productivity boost they produce. In Peru, new pipelines have brought water from across the Andes, turning the country's desert coast into a new agricultural frontier; ambitious road, rail and energy projects that have been held back by corruption scandals now look likely to be built.
Finally, they are all benefiting from a boom in alternative agricultural export crops. This trend of growing high-value niche exports such as avocados, berries and beans was pioneered by Chile 30 years ago. In Peru non-traditional crops are now the country's second-largest export and have helped non-mining exports grow from 2% of GDP in 1994 to 6% today. The boom looks likely to continue with new irrigation projects set to increase the land used for alternative agriculture by 70%. Colombia was the last to follow the trend and is now entering the avocado, berry and pineapple markets.
The push towards alternative agriculture is evident across Latin America. According to a United Nations report, fresh water, low population density and favourable climates give the region more potential to boost agricultural production than anywhere else in the world. Meanwhile, rising living standards and populations in Asia are increasing demand for these types of fresh fruit and vegetables. But the Pacific Alliance is particularly well placed to benefit from the trend because its main focus is Asia. It was set up in the belief that the 21st century will be dominated by China.
Mexico has room to grow
Mexico was untouched by the wave of protests. That's probably because AMLO, elected last year, remains very popular. So Mexico stands out in the Pacific Alliance because it's the only country where most people are content with the political system. It's also the only member with a stagnating economy. This is largely due to AMLO's bellicose attitude towards some sectors of the economy, along with some unhelpful external events such as the General Motors strike in the US.
The incoherent economic policy, combined with the president's socialist rhetoric, has scared investors away. But the long-term fundamentals of Latin America's second-largest economy remain attractive. Take oil. His predecessor's energy-sector deregulation has been written into the constitution, so while AMLO can delay its progress, he can't reverse it. Private-sector production is expected to grow to 280,000 barrels per day by 2024, up from 50,000 this year. Mining, an area that has his support, will continue to thrive, but more because of solid commodity prices than anything the president does. FDI will return to the country's factories once the new US-Canada-Mexico trade deal is ratified.
The key drivers of the Mexican economy mining resources, untapped hydrocarbon reserves, the potential of renewable energy to give it low-cost power generation, positive demographics and integration with US supply chains will underpin growth in the coming decade. Mexico's institutional strength, especially its independent central bank, bodes well too; it has ensured that inflation is well under control. Indeed, one positive surprise with AMLO has been his commitment to fiscal discipline. Mexico does not have a budget deficit.
A common criticism of the Pacific Alliance is that little links Mexico to the Andean Three. Not so. Mexico's demographics, which will boost growth over the coming decade, are far more similar to the population profile in Colombia and Peru than in Chile. All four have strong commodity sectors, while the Andean Three are working to achieve Mexico's level of economic diversification. Mexico will always be US-focused, but the Pacific Alliance allows it to take advantage of the coming century of Asian growth.
The region is on sale
The main reason to invest in the Pacific Alliance countries is that they are going cheap. Take the markets' cyclically adjusted price/earnings ratios (Cape). This compares the current price of a market with the average earnings over the last decade, thereby smoothing out any one-off effects from abnormal years. Chile looks great value with its stockmarket at 14.3, compared with almost 20 in late 2018. Indeed, they have all fallen, with Colombia on 16.3, Peru on 16.9, while Mexico's score of 17.9 is the first time I've seen it below 20. Lots of investors like to say that they're contrarian, but few really are. Investing in Latin American countries in the midst of political turmoil or stagnant economic growth is a genuinely contrarian play that will bring rewards over the long term.
What to buy now
An unfortunate side-effect of EU investment regulations introduced last year has been to put US-listed exchange-traded funds (ETFs) beyond the reach of UK retail investors.
US providers concentrate on their own market and have decided not to shell out for the paperwork now required to sell to Europeans. So British investors cannot access a US-listed Pacific Alliance ETF. The next logical step would be to buy one of the Latin American investment trusts listed in London. But they are heavily skewed towards Brazil, so they won't reflect the Pacific Alliance's fortunes.
That means considering the individual ETFs of each member country. The only UK-listed one is Mexico. The HSBC Mexico Capped ETF (LSE: HMEX) tracks the MSCI Mexico Capped index, which includes all listed Mexican companies in the top 85% of the country's investable universe. The capping stops one or two large firms having an outsized position in the fund, which can be a problem with emerging market indices.
Fortunately, there is a simple way for us to get around the ETF issue. Many years agoWill Landers, the head ofLatin American Equities for Brazil's BTG Pactual Asset Management, gave me a clever way to get exposure to smaller countries. "If you have a country with a clean banking system... 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."
That advice has served me well. In 2012 I tipped Peruvian bank CrediCorp (NYSE: BAP), which had risen 81% (even more for British investors in pounds) by the time I revisited the story in 2018. But last year I decided BAP looked too pricey, so I tipped Colombia's largest bank, Bancolombia (NYSE: CIB), instead. That's up 20%,
so I hope that some of you bought in. If not, I think it's still a good way to invest in Colombia. It's been one of the major backers of the country's infrastructure programme and should benefit both directly, as projects are realised, and indirectly as they help stimulate wider growth.
Now that CrediCorp has fallen back a bit it is on a forward price/earnings ratio (p/e) of 10.6 it's a good time to buy in. In Chile I like the Banco de Chile (NYSE: BCH), the country's fourth-largest bank. The Chilean financial sector is extremely well regulated, while the size of the bank means it's involved in every sector of Chile's economy. On a forward p/e of 12.9 it offers a fairly priced way to gain exposure to Chile's long-term prospects.
Commodities are a key part of the growth story for all four Pacific Alliance countries. Antofagasta (LSE: ANTO), Chile's largest privately owned copper producer, is listed on the London stockmarket and comes with a healthy 4.2% dividend. Fresnillo (LSE: FRES), the world's largest silver producer and Mexico's second-largest gold miner, is also listed in London and offers a 2.7% dividend yield. In Peru, Buenaventura (NYSE: BVN) is the big local player with a mix of copper, gold and silver mines that give it a cross section of
the country's all-important mining sector. Colombia's most valuable commodity is oil and the safest way to play it is via national producer EcoPetrol (NYSE: EC). The new government is keen to kick-start the sector, holding new oil and gas auctions this year, while peace with guerrillas should reduce attacks on pipelines.