Monday, April 9, 2007

Are Latin American Equity Markets Going Downhill?

Has the U.S. recession spread out to Latin America? A single question underlies this week’s global turmoil: has the world’s reliance on America faded or are Asian and European companies and Latin American commodity producers as dependant as ever on the United States?

The fact that the US Federal Reserve announced a surprise cut in interest rates by 75 basis points, led to a positive reaction in Latin stock markets. While this is a good aspect it is hard to argue that Latin countries will decouple from the US. It is true that China is an important engine of growth and in 2008, and will contribute to global GDP growth more than the US and Japan together. Still, the idea that China can be a back up if US falters is a fragile argument. China accounts for less than 10% of total Asian final demand and Chinese consumers are not driven towards consumption as their American counterparties.

One may then asks if Latin countries will observe a significant downturn in the local markets, given the strong financial and commercial linkages with the US. In other words, do Latin countries have better macro policies than before or the 2005-07 growth cycle was basically due to good luck? In our view, some countries display signs of structural improvement in their fundamentals. Brazil, for example, has bought back a significant share of its external debt, decreased the debt-to-GDP ratio, preserved inflation within its target and significantly raised its international reserves. Since the 1994 Tequila crisis, Mexico has better fundamentals with a developed stock exchange, free floating exchange rates, inflation target regime and independent Central Bank. Besides, president Calderon implemented fiscal and pension reform in 2007, two important changes towards a stable economy. In contrast, Argentina needs to solve the holdout problem; reach an agreement with the energy companies; avoid changing the inflation index and remove price controls, among other problems.

In turn, it is possible to conceive that the impact of a US recession to be distinct across Latin America markets, with some countries being more affected than others. In any case, it is hard to argue that today’s rebound in Latin stocks can be sustained. This is so because equity markets in general, ultimately rise or fall on corporate earnings, which depend in turn on consumer spending. However, earnings and consumption in the US are falling and hence chances of a sustained rebound in the US markets are small. We then expect Latin stocks to follow, to a certain degree, the US markets.

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