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JPM report: four things to remember when investing in Latin America

The economic case for emerging markets, including Latin America, has improved, according to JP Morgan Asset Management.

JP Morgan's LatAm report

After a couple years away, investors had started returning to Latin America as the region recovered from political scandals and economic prospects improved.

Then, news broke Wednesday last week that Brazilian president Michel Temer had allegedly endorsed bribes, rattling investors and threatening to curtail the region’s comeback.

It’s unclear whether the scandal might discourage interest in Latin America, where equities look set for a strong year as analysts have upgraded earnings expectations and as valuations remain attractive, according to a report by JP Morgan’s Asset Management.

‘There’s a natural focus on political risk in Latin America, with high expectations for delivery on reforms in certain countries and upcoming elections in others,’ said Gabriela Santos, global market strategist at JP Morgan Asset Management.

‘But the reality is that the economic case for emerging markets, including Latin America, has strengthened over the past year with stabilization in key external variables that impact the region such as currencies, commodity prices, Chinese growth and global trade.’

Here are a few key themes to keep an eye on as investors examine Latin America's prospects.

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Growth

After Latin America’s two year recession, analysts expect growth to turn positive this year as the region’s largest economies, Argentina and Brazil, emerge from their economic slowdowns.

Emerging markets are expected grow at least 4%, while they expect developed markets to grow less than 3%. Latin America grew 0.5% in the third quarter of 2016 after more than a year of contraction, according to the report.

The document also suggests that Latin America stands to gain from China’s growth. It should also benefit from improvement in commodity prices and currencies, which in general look cheaper than those of developed markets.

‘Historically, the Latin America growth alpha over developed markets has tracked commodity prices very closely,’ Santos said.

The corruption allegations might not affect Brazil’s economic recovery, said Jorge Cariola, a senior economist at Chilean financial firm Grupo Security.

‘A large part was already underway thanks to the strengthening of the real in the last year and a half, and to the Brazilian central bank’s more expansive monetary policy,’ he said.

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Inflation

This year inflation in Latin America could start to match the lower levels found in emerging Asia, allowing central banks to implement interest rate cuts, according to the JP Morgan report.

Some countries in the region have already started. Brazil’s central bank cut its rate to 12.25% to 11.25% in April, and it had cut rates four times in a row before that.

Inflation in several countries is expected to return to the mid-point target of each central bank but Mexico might not hit expected levels, the report cautions.

Changes in gas prices and the nominal exchange rate have thrown the country’s central bank inflation target plans. In February 2017, inflation hit 4.9%, according to the report.

In general, global investors have grown interested in local fixed income in emerging markets as they become more comfortable with taking local currency risk following the stabilization of the region’s currencies.

‘Latin American local bonds in particular stand out given the outlook for lower inflation, deep interest rate cuts in certain countries like Brazil, and attractive yields compared to DM,’ Santos said.

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Reform

In recent years, Latin American countries implemented fiscal reforms that have piqued investors’ interest in the region. Argentina, for instance, did away with currency trading controls and recently closed a tax amnesty program that led to the declaration of roughly $117 billion in assets.

Latin American countries have to continue with these fiscal reforms or currency weakness could return and affect inflation, interest rates and growth, according to the report. Besides fiscal discipline, investors expect to see continued reforms to improve the region’s long-term competitiveness.

‘As focus starts to turn to growth prospects for 2018, it will be crucial to see investment spending pick up in the region,' Santos said. ‘In particular, attention will remain focused on whether countries like Argentina and Brazil can implement micro-reforms aimed at improving these economies’ competitiveness rankings.’

Latin America ranks 107 out 189 in the ease of doing business ranking, while high-income OECD countries came in at 26. Argentina ranks 116 and Brazil 123, while Colombia has a rating of 53.

The scandal might have compromised Brazil’s fiscal reforms process, said Cariola.

‘The coalition that the government had to approve them broke, so the reform is in danger,’ he said.

In his view, labor reforms in Brazil that could have increased competitiveness could be dead in the water following the scandal.

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Home bias

Investors around the world feel more comfortable investing in their home market, but Latin Americans stand out in their exposure to local bonds and equities.

On average, Latin American investors invest 97.5% of their allocation in local assets, a figure skewed by Brazil’s large domestic bias. US investors, for their part, have 74% of their allocation at home.

While some Latin American institutional investors have upped their foreign allocation in recent years, the region’s high interest rates have historically reduced the need to look for opportunities abroad.

As of March 31, emerging Latin America’s local currency sovereign debt yield was 8.2%, while that of Europe’s emerging countries was 5.4%, according to the report.

In Chile, the six pension funds had roughly half of their $188 billion assets under management invested in local fixed income as of the end of April, according to a report by Chilean firm Bice Inversiones.

‘Investors in Latin America should remember that by investing heavily in domestic markets there is a high amount of risk concentration taking place,’ said JP Morgan's Santos.

‘In addition, investors are leaving a large opportunity set in the global economy, bond market, and equity market on the table.

Lastly, by investing globally, investors can access sectors that are otherwise underrepresented in Latin America, such as consumer discretionary, technology and healthcare.

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