Latin American Markets: Opportunities & Weaknesses

Latin America is widely regarded as a growth play in the equity markets. The explanation for this view is that the region is a commodity producer — agricultural goods in Brazil and Argentina, metals in Brazil, Chile and Peru, oil in Venezuela and Ecuador, natural gas in Bolivia, etc.

In general, that’s a fair vision. However it must be better understood. Not all commodities are the same, and not all countries have the same economic policy or the same stage of development

It is well known that there is a high correlation between economic growth and commodities prices. In the past few years, this correlation has increased since the main source of growth was the emerging economies, in which economic growth is more intensive in commodities. For the future, we expect this correlation to increase even more, as emerging economies will keep on leading the growth and developed economies, particularly the U.S., will rely a lot on government investments in infrastructure.

It seems that the scenario is not bad for basic material producers — it is undeniable that economic growth in the near future will be very commodity-intensive. However, the basic question remains: Will there be any economic growth?

The first days of 2009 showed how the market is aware of this high correlation. The expectation for a new economic package in the U.S. as soon as President-elect Obama takes office has created a more positive environment for basic material producers. Mining companies like Vale do Rio Doce (RIO) and Companhia Siderurgica Nacional (SID) went up 24.8% and 29.3% in just 3 days! The Brazilian currency, which is also a good measure of the international demand for basic materials, went up 7.2% against the U.S. dollar.

The emergence of the war in the Middle East also influenced oil prices and led all commodities to move ahead. Nevertheless, we understand that the major force behind this huge movement in the beginning of 2009 was the expectation for President Obama’s economic plan and the depressed prices of most commodity stocks.

After a crazy three days, we would advise some caution. Even if Mr. Obama’s plan is strong enough, it will take some time for it to deliver results, and in the short-term there will be the negotiation between iron ore producers and Chinese steel companies.

Until recently, there was an expectation that iron ore prices would be cut as much as 30%. However, in the last weeks the Indian spot iron ore prices recovered to US$80.50 per ton, a very good price if we consider that the average sale price of RIO’s iron ore in the third quarter 2008 was US$80.19.

According to our model, the current price of RIO, between US$13.00 and US$14.00, incorporates a price cut for iron ore for 2009 of 25% and a reduction on the the company’s production of 20%. RIO already announced a decrease in its production of 10% and we expect further cuts. It is too soon to have a more positive outlook on the stock, but it is something to keep in mind: if iron ore prices were to be cut by no more than 15% in 2009, the current price of RIO would be attractive again.

The better mood towards commodities has some advantages for Brazil. Brazil still has the highest real interest rate in the world. Domestic rates are 13.75% and 2008 inflation reached 6.1%. The lower volatility of the Brazilian real will enable the Brazilian Central Bank to reduce interest rates in the very short-term.

OPPORTUNITIES

In such a business environment we would recommend some Brazilian domestic focused companies like the telecom companies Vivo (VIV) and Oi Participacoes (TNE), consumption products producer like Ambev (ABV), fuel retailers like Grupo Ultra (UGP), high dividends utilities like Telesp (TSP) and clear bargains like Telemig (TMB).

WEAKNESSES

On the other side, we would avoid some companies that are still facing seemingly endless problems with currency derivatives like Aracruz Celulose SA (ARA) and Votorantim Celulose e Papel SA (VCP), and highly leveraged Latin American companies exposed to the U.S. market like Cemex SAB de CV (CX).

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