Brazil and Mexico: Reversal of Fortune
For much of the past decade, Brazil’s economy grew rapidly, while Mexico suffered from lackluster growth and governance problems. In recent years, however, Brazil’s growth has fizzled while Mexico’s economy has gone from longtime laggard to manufacturing powerhouse.
T. Rowe Price investment professionals explain the reasons for the divergent performance of the countries and describe how they have positioned their portfolios in response to the changing fortunes of Latin America’s largest economies.
- Brazil’s deteriorating economic profile is partly due to fading commodities demand from China, which has weighed heavily on its resource-driven economy. In contrast, Mexico is benefiting from close ties to the U.S., where the economy is improving.
- Mexico’s appeal as a global manufacturing hub has increased as more multinational corporations take advantage of its lower costs and close proximity to richer North American markets. Rising labor and transportation costs have also eroded China’s longstanding cost advantage.
- Politics is another reason for the reversal in sentiment. Brazil’s government has tried to revive growth and gain favor with its people by pursuing policies to boost employment, but at the expense of higher inflation. Mexico is reaping the benefits of free trade pacts implemented over the past two decades and a new president who has pushed through market-friendly reforms.
- “From a top-down perspective, Mexico is in a sweet spot,” observes Paulina Amieva, a T. Rowe Price emerging markets equity analyst. “The combination of cheap labor, reasonable rule of law, proximity to the U.S., and low energy costs leaves Mexico ideally positioned to benefit from a recovering external environment over the next few years.”
- On the other hand, Brazil has the potential to reward portfolio managers who can select securities that have the potential to benefit from an eventual turnaround.
Why T. Rowe Price managers are bullish on Mexico
- After a weak 2013, T. Rowe Price investment professionals believe Mexico has the economic underpinnings in place to deliver considerably stronger growth in the next few years.
- Mexico’s gross domestic product (GDP) grew 1.1% in 2013 but is expected to expand 3.0% in 2014, according to the International Monetary Fund (IMF). In contrast, the IMF expects Brazil’s economy in 2014 to expand no more than 2.3%, its 2013 growth pace. “The slowdown in 2013 has given us a nice shot at increasing our investment in Mexico,” says David Eiswert, portfolio manager of the T. Rowe Price Global Stock Fund.
- Besides benefiting from stronger U.S. growth, Mexico has a globally competitive labor market and a small current account deficit, Eiswert observes. The political situation is stable, in contrast to other developing countries like Thailand and Turkey that are suffering from governance crises. “Violence, drugs, and corruption are significant problems, but compared with many emerging governments, improvements are happening here,” Eiswert notes.
- Mexico stands to gain from the 2015 completion of a massive natural gas pipeline from southern Texas to central Mexico. The pipeline, a project of the state oil and gas monopoly Pemex, offers Mexico’s economy a potential windfall from lower energy costs. “Investors are underestimating the stimulus from cheap natural gas from the U.S.,” Eiswert observes.
The significance of Mexico’s reforms
- Reforms under Mexican President Enrique Peña Nieto are a key reason for T. Rowe Price’s positive outlook. Since taking office in December 2012, the president has engineered education, telecommunications, and tax reforms.
- Energy reform is shaping up to be the most important overhaul , however. Last December, Mexico’s Congress passed a bill ending the 75-year-old state oil monopoly and opening up its oil industry to foreign companies.
- “If passed and implemented correctly, this energy reform would be the crowning achievement in this year’s reform push,” says Richard Hall, a T. Rowe Price sovereign credit analyst . A successful energy reform could raise Mexico’s GDP growth rate from 3%–3.5% to 4%–4.5% in the medium term, Hall believes.
- Stronger economic growth would also boost the value of the Mexican peso. “We’re bullish on the peso as a result of Mexico’s strong linkages with the recovering U.S. economy a nd the ongoing reforms in the country,” remarks Andrew Keirle, portfolio manager of the T. Rowe Price Emerging Markets Local Currency Bond Fund.
- Mexico’s implementation of market-friendly changes at a time when reforms in many other emerging markets are foundering is another reason why T. Rowe Price investment professionals have optimistic outlooks. “In a world of tighter liquidity, high inflation, and lackluster growth, markets without a reform agenda will struggle to sustain the level of growth they became accustomed to when commodity prices were high and money was cheap,” Amieva notes.
How Brazil’s monetary and fiscal policies differ from Mexico’s
- In contrast with Mexico, Brazil’s monetary and fiscal policies in the last few years under President Dilma Rousseff have been too stimulative. The country’s highly accommodative monetary policy and heightened government spending have led to high inflation but failed to boost economic growth. Michael Oh, T. Rowe Price’s sovereign credit analyst for South American countries, characterizes Brazil’s current situation as “mild stagflation.”
- Oh says that Brazil’s monetary policy has deviated from economic orthodoxy. The Central Bank of Brazil began cutting its overnight lending benchmark, the Selic rate, in mid-2011. “The Selic rate was 7.25% as late as April 2013, which was far too low,” notes Oh. Loose monetary policy contributed to annual inflation of 5.91% as of December 2013, a level that triggered concern among both Brazilians and foreign investors wary of the country’s history of inflation problems.
- Building inflationary pressures led the Central Bank of Brazil to quickly raise the Selic rate to 10.75% as of February 2014, often moving in aggressive increments of 0.5 percentage points. However, the rate hikes have also restrained economic growth: Brazil’s third-quarter 2013 GDP contracted 0.5% from the previous quarter.
Why investors are worried about Brazil
- Like the other “fragile five” emerging markets countries—Turkey, India, Indonesia, and South Africa—Brazil runs large current account and budget deficits. Standard & Poor’s rates Brazil’s government debt BBB, which is two notches above the highest noninvestment-grade rating. S&P has Brazil on negative credit watch for a downgrade, largely due to the country’s twin deficits and weak growth.
- Brazil’s current account deficit, at 3.66% of GDP as of the end of 2013, is less severe than those of other fragile five nations, but Brazil relies on foreign capital to finance its deficit. The Brazilian real lost more than 13% against the U.S. dollar in 2013, which has helped Brazil’s export markets, but Oh says that the currency needs to fall further to improve the country’s competitiveness.
- Brazil’s budget deficit was 3.28% of GDP at the end of 2013. Despite rising interest rates in 2013, Brazil’s deficit has not worsened over time because rates on its debt are still significantly lower than they were five to 10 years ago. However, Brazil’s total public debt remains high at 57% of GDP. Public spending has also outpaced revenue growth, a worrying trend that will not likely end before presidential elections in October 2014. Rising debt levels in the absence of disciplined fiscal management remain a concern.
- Brazil suffers from very low investment rates, which detract from economic growth. In response, the country has been auctioning concessions (such as airports) to the private sector to boost investment and relieve infrastructure bottlenecks. However, the auctions generally have not been well received due to onerous conditions for investors. As a result, the government has had to improve terms to boost investor interest, causing significant delays in the auction calendar.
- As part of its effort to restrain inflation, the Brazilian government subsidizes electricity and public transportation, but the subsidies also increase the size of the budget deficit. In addition, the government caps the prices that oil giant Petrobras can charge for petroleum products, which helps hold consumer prices down but also limits the revenue of the nationally owned firm.
T. Rowe Price’s outlook for Brazil
- Despite Brazil’s economic obstacles, the unemployment rate is at a record low. Recent polls indicate President Rousseff will win reelection in October. Oh anticipates that Rousseff will gradually tighten Brazil’s fiscal and monetary policies as part of an effort to improve the country’s credit quality, bring down inflation, and earn credibility with financial markets.
- T. Rowe Price investment analysts believe that select Brazilian bonds and stocks have sold off to levels where they represent strong value, particularly if Rousseff can rein in Brazil’s monetary and fiscal policy without undermining economic growth.
- Careful security selection is essential when trying to find securities that offer significant relative value. “We’ve positioned our Brazil exposure to benefit from the country making a transition from bad to OK,” says Michael Conelius, manager of the T. Rowe Price Emerging Markets Bond and Emerging Markets Corporate Bond Funds. “With sentiment so negative, we prefer to be contrarian now.”
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. Past performance is not indicative of future results. The views contained herein are as of March 14, 2014, and may have changed since that time. Investing in rapidly developing economies involves a high degree of risk. Share prices are subject to market risk, as well as risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad.
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