South America: Some Light at the End of the Tunnel?

After years of fast economic growth fuelled by a commodity boom, South America has recently languished in the doldrums. A slump in commodity prices, soft Chinese demand, high inflation largely caused by depreciation in South American currencies against the U.S. dollar, and numerous political problems have even driven a few countries (Brazil first and foremost) into recession.

On the bright side, we note that the Brazilian economy appears to be nearing a turning point. Many indicators such as confidence indexes have begun heading up. The annual changes in retail sales and industrial production are still mostly negative, but the downturns are less severe.

Since the beginning of the year, many commodity prices have been stabilizing or increasing, supporting the improvement in the Brazilian economy. One of the factors helping Brazil see some light at the end of the tunnel is the change in the country’s leadership. Numerous political scandals linked to the Rousseff administration and to the Brazilian ruling class in general were factors in deteriorating confidence and decline in investment of recent years. The government led by Vice-President Michel Temer has been welcomed very favourably by the markets, notably thanks to high-calibre appointments to important economic positions.

Argentina has also experienced serious economic, financial and political problems in recent years. However, the replacement of the populist regimes of Christina Fernandez and, before that, her husband Nestor Kirchner by the reformist government led by Mauricio Macri is generating a good deal of optimism. In the very short term, the reforms could be harmful to economic growth, because the government is trying to regain financial credibility by reforming a system that is largely based on subsidies and state-sponsored waste. However, we already see reductions to import trade barriers and export taxes. If these efforts are not curtailed through legislative action by supporters of the former regime, they should bear fruit and accelerate Argentina’s economic growth in the longer term. We note that the government has managed to return to the international financial markets with its first bond issues after 15 years of “exile”.

Investment Outlook

Stabilization of the commodities market and the moderate continuation of price increases should lift the economy of the entire region. Some indicators are already showing this, and it is reasonable to assume that this new trend will continue. In fact, the IMF’s forecasts are calling for such improvement. The IMF is now predicting a 0.4% contraction of real GDP in the region this year, and a 1.6% gain next year. This economic spurt should promote the renewal of faster growth in the domestic market and in investment in Brazil and Argentina.

Stock Markets

South American stock markets, which have been depressed throughout the slowdown and contraction phase, have started picking up in recent months. Since the beginning of the year, the main indexes have seen very strong growth. Peru comes out on top in this regard: its stock market has boomed by more than 50% so far in 2016. However, these gains come on the heels of some fairly large contractions in 2015. Currently price/earnings ratios do not appear to be exaggerated and they are generally below those in the United States. If the economy keeps improving and confidence recovers, higher profits should materialize as stock indexes keep rising. Indeed, the outlook for profits is relatively good; similar to that of the United States or Canada. For Canadian or U.S. investors, the upswing in the South American markets has been inflated by currency trends. However, the sharp appreciation of the currencies of many emerging countries since the beginning of the year is not likely to continue. Relatively strong inflation rates in some countries in the region, especially Brazil and Argentina, should prevent the currencies of those countries from climbing further. The prospect of another key interest rate hike by the Federal Reserve represents another constraint on the appreciation of emerging currencies, one that could even lead to an outflow of capital. We cannot rule out the possibility of more optimistic confidence supporting both the economy and the currencies but, in the short and medium term, those factors should not inflate stock market values when calculated in Canadian or U.S. dollars to the same degree as in the past.

If global economic growth manages to maintain a satisfactory pace and political reforms keep moving forward, opportunities for investors interested in South America should proliferate and become more attractive, although they will remain relatively risky.