Ignore the Protests and Invest in the Pacific Alliance

January 3, 2020

Did you have an exciting 2019? The Pacific Alliance certainly did. Last year its members – Chile, Colombia, Peru and Mexico – lived through the type of political and economic chaos that makes Brexit Britain appear positively boring and benign. Chile and Colombia were upended by violent protests. Mexico’s socialist president led his economy into recession. While in Peru, where corruption allegations caused the imprisonment, exile or suicide of the last five presidents, the current leader has dissolved Congress in a move opponents claim was a coup.

It’s been a traumatic time for some of the citizens of these countries. Yet – without wanting to sound too glib – it’s great news for investors that believe in the long-term potential of the Pacific Alliance. The drama has panicked the market and created a buying opportunity for brave investors. The solid macroeconomic fundamentals and long-term growth prospects that first encouraged investors when the Pacific Alliance was created in 2011, are still in place today. But the turmoil means investors can get a better deal now.

Latin America’s best trade bloc

The history of Latin America is marked by failed integration attempts. Since independence there have been countless customs unions, trade blocks and talking shops, all with limited levels of success. So, when the Pacific Alliance was launched in 2011, you can understand the initial apathy. However, its quick progress soon made it stand out from other regional groupings. A succession of infrastructure projects, visa agreements and tariff reductions have boosted the movement of people and goods within the block. While the creation of a shared stockmarket and standardised financial-sector regulation will increase capital flows between members. Another key characteristic is that Pacific Alliance avoids politics and sticks to trade and investment. The tendency of other blocks to get embroiled in political matters invariably leads to problems in a polarised region. The Pacific Alliance is rightly viewed as a pro-market, pro-trade grouping, but it continued to thrive after member countries elected socialist leaders, such as Peru’s Ollanta Humala, or current Mexican president, Andrés Manuel López Obrador (AMLO).

So, the Pacific Alliance is here to stay. And that’s good news because it gives investors an interesting way to play Latin America. With a combined population of more than 225 million people and a PPP GDP of around $4trillion, the Pacific Alliance would be the world’s 8th-largest economy and offers real scale. It accounts for almost 40% of regional GDP, making it an interesting counterweight to Brazil, which dominates the Latin America-focused funds available to retail investors. Then you have the distinct nature of its economies. From the commodity-dependent ‘Andean 3’ of Chile, Colombia and Peru, to the manufacturing powerhouse of Mexico there is plenty of room for diversification. Finally, and the main positive for the Alliance, is that economic strength of its members. They are all well-managed, open economies with a strong macroeconomic position and good demographics.

Political problems in the Andean 3

Since October Latin America has been gripped by violent protests. It started in Ecuador, when an uprising of indigenous groups and students against a proposal to cut fuel subsidies, forced the government to temporarily flee the capital. Soon after in Chile – Latin America’s most-developed country – planned metro price hikes were met with a campaign of arson followed by mass protests with widespread support. Early explanations pinning the blame on the ‘neoliberal economic model’, where thrown out a few weeks later when protests forced Bolivia’s socialist president, Evo Morales, into Mexican exile. By November, Colombia joined the fray with a general strike and mass protest that also turned violent.

The only threat to long-term investors is if the protests force Chile to change the economic model that has made it Latin America’s most developed economy….

Investors didn’t wait around for the analysts to come up with a new explanation. The Chilean peso devalued to a record 900 against the dollar, while the country’s stockmarket dropped 10%. In Colombia, the peso dropped 4%. As the protests died down in both countries, financial markets started to recover but they are still well below their September levels. Investors are – rightly – worried about the impact to short-term growth. For example, London-based consultancy Capital Economics downgraded Chile’s 2020 GDP growth forecast to 2.5% from 3.5%. But the long-term growth potential of the Pacific Alliance won’t be affected by the protests.

Let’s take Chile, where the protests have been the most violent and widespread. The only threat to long-term investors is if the protests force Chile to change the economic model that has made it Latin America’s most developed economy. Because while metro fares sparked the protests, they were fuelled by legitimate grievances of working and middle classes in a country that has the highest inequality in the OECD and a rigid social and educational hierarchy that keeps most of the best jobs for a small upper class. To quell the protests the president had to replace the entire cabinet and agree to rewrite the constitution. But as Quinn Markwith, Latin America Economist at Capital Economics notes, investors shouldn’t be unduly worried. “Fundamentally, our medium-term view on the economy hasn’t changed. It doesn’t seem likely that the protests will have a long-lasting impact on investment. A large amount of investment relates to mining and shouldn’t be affected by protests in the capital. Chile’s strong public finances also mean that future spending to appease protesters is not worrying. So, we’re still comfortable with our 2021 GDP forecast of 3.5%.”

As for Colombia, Yes, there is real frustration over the controversial and poorly-implemented peace deal, austerity and a botched tax reform. And it’s true that some protests turned violent and were met with heavy-handed security forces. But this is still a big improvement for a country where political differences have long been settled through armed conflict. That’s why the fallout of the Colombian protests to the country’s financial markets was far more subdued than in Chile. Meanwhile the medium-term growth prospects are encouraging. A post-protest report from ratings agency Standard and Poor’s predicted it would be one of the fastest-growing major economy in Latin America between now and 2021, with growth of 3.2% next year.

Finally, Peru shows why investors can afford to ignore political drama when the economic fundamentals are solid. Peru’s political system is broken and most of its political class, including five former presidents, seem to be corrupt. While the three branches of state, executive, legislative and judiciary, interact with a dismal mix of incompetence and hostility. The latest display of institutional failure came when the president Martín Vizcarra used a controversial interpretation of constitutional law to dissolve Congress and call for its re-election. Some Peruvians cry coup, others cheer good riddance to a house full of venal politicians – either way it’s a mess. Yet its economy is set to grow 4% in 2020.

Shared economic strengths

Ultimately the economic destiny of the Andean 3 won’t be decided by protests but by copper, gold, oil and iron ore prices. Right now, prices are solid and the demand story seems steady. Of course, there are plenty of commodity-producing countries that have proved terrible investments. What I like about the Andean 3 is that in recent years all three managed to ride out bear markets in their key commodities without succumbing to recession. They’ve also made shrewd use of their commodity bonanza to build the infrastructure needed to boost productivity. Chile’s solar energy boom has brought down peak power prices by 75% and is weaning it off imported oil. Colombia has put together Latin America’s most advanced public-private-partnership infrastructure programme and is starting to benefit from both the inflow of FDI to build the projects and the productivity boost once they’re built. In Peru, new pipelines have brought water from across the Andes, turning the country’s desert coast into a new agricultural frontier. While ambitious road, rail and energy projects that have been held back by corruption scandals now look likely to be built in coming years.

the idea behind the Alliance is that economic integration will create the efficiency and scale to better trade with Asia….

Finally, they are all benefiting from a boom in alternative agricultural export crops. This trend of growing high-value niche exports such as avocados, berries and beans was pioneered by Chile 30 years ago. In Peru non-traditional crops are now the country’s second-largest export and have helped non-mining exports grow from 2% of GDP in 1994 to 6% today. The boom looks set to continue with new irrigation projects set to increase the country’s agricultural land by 70%. Colombia was the last to follow the trend and is now entering the avocado, berry and pineapple market. The push to alternative agriculture is evident across Latin America. According to a UN report, fresh water, low population density and favourable climates give the region more potential to boost agricultural production than anywhere else in the world. Meanwhile rising living standards and populations in Asia are increasing demand for these types of fresh fruit and vegetables. But the Pacific Alliance is particularly well-placed to benefit from the trend because its main focus is Asia. It was set up in the belief that the 21st century will be dominated by China, and the idea behind the Alliance is that economic integration between the members will give them the efficiency and scale to be able to trade with Asia.

No growth Mexico

Mexico was untouched by the wave of protests. That’s probably because only last year Mexicans went to the polls and voted in the, still very popular, AMLO. So Mexico stands out in the Pacific Alliance because it’s the only country where most people are content with the political system. It’s also the only member with a stagnating economy. Much blame can be placed on AMLO, with the economy flatlining since he came to power. His bellicose attitude to some business sectors plus some unhelpful external events, such as the GM strike in the US, led to 0% economic growth in his first 12 months.

The incoherent economic policy, combined with the president’s socialist rhetoric has scared investors away. But the long-term fundamentals of Latin America’s second-largest economy remain attractive. Take oil for example. His predecessor’s energy reform is established by the constitution, so while AMLO can delay its further roll out, he won’t reverse the contracts already awarded. As a result, nascent private-sector production is expected to grow to 280,000 barrels per day by 2024 up from 50,000 this year. Mining, an area that has his support, will continue to thrive but more because of solid commodity prices than anything the president does. FDI will return to the country’s factories once the new US-Canada-Mexico trade deal is ratified. And it will be further boosted by the trend for nearshoring and the fallout from the US-China trade war. The key drivers of the Mexican economy – mining resources, untapped hydrocarbon reserves, the potential of renewable energy to give it low-cost power generation, positive demographics and integration with US supply chains – will push growth in the coming decade. AMLO might hinder some of these sectors but he can’t, nor wants to, erase them. Meanwhile Mexico’s institutional strength, especially its independent central bank, help to ensure the macroeconomic strength of the country, where inflation is well under control. Indeed, one positive surprise with AMLO has been his commitment to fiscal discipline, with the deficit remaining steady in his first year.

A common criticism of the Pacific Alliance is that little links Mexico to the Andean 3. That’s not true. Mexico’s positive demographics, which will boost growth over the coming decade, is far more similar to the population profile in Colombia and Peru than Chile. All four have strong commodity sectors, while the Andean 3 are working to achieve Mexico’s level of economic diversification. Mexico is, and will always be, US-focused, but the Pacific Alliance allows it to take advantage of the coming century of Asian growth.

The main reason to invest in the Pacific Alliance countries is that they are going cheap. At MoneyWeek one of our favourite ways to check the value of a stockmarket is to look at its cyclically adjusted price earnings – or CAPE. This compares the current price of a market with the average earnings over the last decade, thereby smoothing out any one-off effects from abnormal years. At the end of November, German asset manager, StarCapital worked out the CAPE for global stockmarkets. Chile looks great value with its stockmarket at 14.3 compared to almost 20 when we looked at it last year. Indeed, they have all fallen, with Colombia on 16.3, Peru on 16.9, while Mexico’s score of 17.9 is the first time we’ve seen it below 20.

Lots of investors like to say that they’re contrarian but few really are. Investing in Latin American countries in the midst of political turmoil or stagnant economic growth is a genuinely contrarian play that will bring rewards over the long term.

A version of this article first appeared in MoneyWeek on the 13th of December 2019