South America’s fat tail risk in 2013


In a recent presentation, Pimco’s Mohamed El-Erian said that something unusual in the world economy today is that the distribution of possible outcomes has fat tails, meaning that he believes possible futures that differ greatly from the most probable one are not as unlikely as they normally are.

In his opinion, one of these tails, made of negative futures, reflects concerns related to the budget debate in the US, the Chinese economy slowing down and, most importantly, recession and debt in the eurozone.

He believes the other tail, the positive one, represents opportunity arising from progress in developing countries and portfolios currently being too heavy in cash and bonds, waiting for risks to clear up.

Chances are not negligible for any of these drivers, which leads to a future that is indeterminate within a range that goes from a second dip to a quick recovery, El-Erian believes.

El-Erian’s fat tails extend to South America, metaphorically speaking. Although the region has robust macroeconomic fundamentals and policy space left to use, it would suffer if global concerns deteriorate, because trade and capital flows work as inward transmission channels.

On the other hand, I believe that if things improve and risk aversion recedes, it may be sought as a favored destination by growth seekers in a world where growth is not easy to find.

Given the influence of the international context, I will start by commenting about it before reflecting on what is happening in South America economically speaking.

External Environment

The panorama in the US is not too bright, but the pessimistic views that abound these days frequently disregard important positive elements, in my opinion. Housing is recovering, though slowly.

America has been gaining energy competitiveness thanks to its natural and shale gas. If activity picks up, the fiscal deficit will be ameliorated, while an above-average inflation and the lack of outstanding alternative investments may offer relief to the treasury in regards to debt.

Another positive factor that I believe is worth pointing out is that China is acting upon its need to consume more, which may create demand directly and indirectly for American products in the future.

As the Wall Street Journal reported in mid–2012, South America was the top destination for Chinese investment in the first quarter of 2012, at 43 % of total foreign M&A activity by Chinese companies. Most of this year’s Chinese foreign acquisitions in energy and resources are expected to take place there.

However, politicians in the US need to reach consensus on the hows and whens to create a more efficient state apparatus. These are no simple things and it has been frustrating to see insufficient real progress amid debt ceilings and fiscal cliffs that offer suspense with little substance, in my opinion.

The exit road for the economic troubles in America is not a bright one in my opinion, but I would envy the US if I were Europe.

Yet, while European politicians are working on needed reforms, I believe mid-2012 may prove to be a watershed, because we are finally seeing the monetary authority for the eurozone—this is, the European Central Bank (ECB)—largely invested in the prevention of a second dip by means of bond purchases and rate cuts, akin to the expansionist policy of the US Federal Reserve.

Aggressive monetary expansion is like putting a patient on a life-sustaining device, in my opinion: it is indispensable to keep them alive but there are negative effects that will have to be corrected when the crisis is over.

The eurozone tried to do without (much of) this treatment, but the patient’s pulse got erratic in the second half of 2011, as reflected in sovereign-bond yields of countries in its periphery and in the volatility of the STOXX50 index of European blue chips.

Since June 2012,  when the ECB became more expansionist with the announcement of the Outright Monetary Transactions program, the situation has been stabilizing, to the point of causing a reduction in the volatility index to levels not seen since the subprime crisis, besides calming down peripheral yields.

If developed nations continue the recovery that we are seeing in the last half year, then at some point, though not soon, they will need to undo the current monetary expansion and deleverage their public finances.

I believe this implies a scenario of low growth for years to come. As El-Erian pointed out, there is opportunity for investments from a potential reduction in risk averseness. But for growth the world is looking at developing economies.

The growth potential of the emerging markets is not as impressive as it has been during the last decade, basically because technological gaps are smaller and most of these economies are transitioning into new stages that require changes in their mode of development.

As mentioned before, I believe China needs to step into a stage that is more reliant on its domestic demand. This challenge concerns South America due to the benefits that it obtains from Chinese demand for commodities. The appetite for these commodities has moderated, but the gap is slowly being filled by other countries that are in prior stages of urbanization and modernization, such as India, Indonesia and Vietnam.

Besides, I believe developing Asia has gotten rich enough to maintain its purchases of South American food commodities regardless of financial circumstances. In my opinion, it is thus reasonable to expect no more than a limited moderation in South American exports revenue from the so-called Chinese soft landing, as long as there are no major crises in Asia or its trading partners.

Mercosur is the largest trade alliance in South America, commanding roughly three quarters of the subcontinent’s GDP. Brazil is its most important member state, the others being Argentina, Uruguay, Paraguay and, since 2012, Venezuela and Bolivia, though Paraguay is currently suspended due to the block condemning Fernando Lugo’s removal from the presidency last June.

The performance of the Mercosur nations was weak this year compared to the rest of the region, owing partly to problems in Europe arriving via capital and trade volatility, particularly from mid–year 2011 to mid–year 2012.

Capital expenditure diminished as a result, not only from the temporary reduction of credit and demand coming from abroad, but also from domestic risk aversion stemming from those renewed worries in the developed world. Particularly in Brazil, where trade and credit from Europe and the US weigh the most.

Paradoxically, this situation had some positive effects in the BRIC country, because reduced demand and capital inflows helped taming inflation and the overvaluation of the local currency, the real. This allowed for a reduction in domestic interest rates from their prior, high levels.

Yet, fiscal consolidation played an important part in obtaining these positive results. It is yet to be seen how much was caused by fiscal prudence and how much by the external factors, which is not a minor issue because it will indicate how much benefit will remain to be enjoyed by industry in the long run, once and if the external situation improves.

As a matter of fact, the external situation partially recovered during the last semester and much of the macroeconomic improvement remains. But in my opinion the dynamics of production have failed to impress. Could it be that more time is needed for the macroeconomic progress to translate into business action?

Or is it insufficient given Brazil’s need to increase its productivity, which has been rather stagnant in the last years? Most of the production increase in the country during the last decade was obtained from employing more workers, as opposed to obtaining more production from each one of them.

This was not bad, because it meant incorporating most of the population into a production system that had been modernized during the nineties, when unemployment had raised as a result of leaving behind old productive practices. But now that this second stage of the two-decade modernization process has run its course, Brazil faces the challenge of resuming an increase in productivity.

Compared to the early nineties, there is a smaller gap between Brazilian technology and the world’s best. It will therefore be a more-complex development stage, requiring education, modern infrastructure, an efficient state apparatus, competition and a reduction of business informality. However, the country now enjoys hefty commodities exports, as well as global liquidity and a larger domestic market.

President Rousseff’s administration is working on several required improvements while she enjoys high popularity, but we shall see how fast the pace is.

The latest news is the announcement of a new price scheme for electricity that is expected to lower tariffs by around 20 %. The state is affording most of this reduction via tax cuts for the sector, compensation to electricity companies and, presumably, subsidies on electricity bills.

But there is controversy about the share that electricity companies are being asked to contribute, and some are not accepting the new terms at the risk of losing concessions when these expire. Nevertheless, the scheme was generally well received and I believe it will add to the better environment that industry will enjoy in 2013 compared to 2012.

These tariff cuts are basically destined for industry because, even though consumers will get sizable but smaller discounts, it is presumed that their benefit will be offset by gasoline-price rises later this year, aimed at recovering profits in that other sector.

Fuel prices were contained to control inflation these past years, which was one of the causes behind the underperformance of state-led oil giant Petrobrás (PBR).

Growth in Mercosur during 2012 was also affected by bad weather conditions for crops, as it was most noticeable in Paraguay, although it affected Brazil and Argentina too.

Argentina grew weakly in 2012 owing to less traction from Brazil and poor harvests. But some domestic developments played a part and will go on doing so, in my opinion. The Kirchners, who govern since 2003, applied policies that spurred growth in the short term at the expense of a mid–to–long term that is starting to show.

One of them was fixing the prices of locally-produced hydrocarbons at low levels, at the expense of a reduction in oil and gas exploration and the consequential contraction of production. Another one was printing money in excess in order to finance a fiscal deficit, leading to high inflation.

Local costs raised and the balance of trade deteriorated due to the country changing from being a net exporter of hydrocarbons to a net importer. US dollars from exports thus became insufficient to cover requirements for imports, foreign-debt paybacks and demand by individuals who wanted to save in currencies that were not debased as the Argentine peso.

The problem aggravated when the Brazilian real devalued in September 2011 and then again between April and May 2012, pressing on Argentina via its trade flow with its largest partner.

The roots of the problem preceded 2011. But, since that year, government measures that were meant to counteract it have made matters worse. Normal remedies, besides fiscal prudence, would have been to finance the deficit with foreign debt instead of excessive monetary emission, and to have the central bank sell its dollars more expensively.

But Argentina is not able to place new debt in foreign markets because its 2001 default is not fully solved yet. And trading dollars more expensively was also discarded, arguing that it could fuel an inflation that was already high. Instead, the government implemented tough import rules and disallowed the purchase of foreign currency for private savings.

Moreover, reacting to decreasing oil production, it seized back control of YPF (YPF) from Spanish conglomerate Repsol, which had acquired the traditional Argentine oil company in 1999. These measures affected business and investor confidence and, as a result, investment decreased in quantity and quality.

My outlook for 2013 is one of moderate improvement for Mercosur, as long as there is no remarkable deterioration of the external context. I believe growth will be driven by an improved macroeconomic environment, particularly in Brazil, plus better crops and some bounce-back effect.

Even though new regulations in Argentina scare investment away, they also disallow the outflow of revenue from agricultural exports. But it must be noted that currency controls generally have limited effectiveness because there are always ways to leak money out given today’s financial technology.

However, I do not expect remarkable growth until Brazil’s challenge for improved competitiveness shows some success and Argentina returns to a more normal management of its economy.

Unless there are sudden changes in the international environment, I expect 2013 growth rates in Brazil and Argentina to be about 4 % and 3 % respectively. Side note: For any analysis of Argentine GDP growth, let us bear in mind that official statistics since 2007 are questioned.

For stock-market investors, such a recovery, albeit small, could prove valuable if combined with the retraction of risk aversion that we are seeing in the last months and the appreciation of the real that could happen as a consequence.

Worth noting are certain Brazilian stocks that were hit since mid-year 2011 because their SG&A expenses and leverage had increased due to them being caught in the middle of large expansions when the markets deteriorated. But caution must be exercised given El-Erian’s fat-tails argument, political noise in Argentina and the possibility that inflation worsens there.

The Pacific Alliance

Mercosur is an Atlantic-coast alliance. In 2012, another trade bloc was formally launched on the other coast of the subcontinent, more precisely between Chile, Peru and Colombia, including Mexico. This news did not generate much excitement due to these countries already having free-trade agreements between them.

Additionally, the abundance of trade alliances in the Americas, including several failed ones, makes it something of a cliché to speak of a new one before it hits the mark. But, regardless of it becoming weighty in the future or not, the Pacific Alliance is signaling important facts about the current state of political economy in Latin America.

To begin with, it reaffirms these countries’ free-trade strategy in a time of increasing protectionism elsewhere in the globe. Noteworthy examples are Chile, which has signed free trade agreements with much of the globe during the last two decades, and Mexico, which is highly integrated with the US and competing inch by inch with China for the title of America’s second trade partner after Canada.

One of the aims of this new treaty is to negotiate as a bloc with Mercosur and at talks for the formation of the Trans-Pacific Alliance, an initiative that also includes the US, Canada and several Asian economies, which has the potential to become the largest free-trade bloc in the world.

The association of Colombia and Peru in the alliance confirms their tendency towards economic freedom. I find this to be particularly interesting in the case of Peru, due to the question that was open on the accession to power of President Humala in 2011. Will is government be just populist or promote free markets and develop the country’s mineral wealth?

A widespread view is that Humala will be inclined towards the second choice just as Lula did in Brazil a decade ago. However, I believe if we dig below the surface of their leftist discourses prior to their rise to power, we can see differences in substance as well as in the personalities of these leaders, suggesting that we should not discard those doubts so easily. I believe the inclusion of Peru in the Pacific Alliance is therefore a good sign.

The Chilean economy did very well last year in my opinion, with the local markets rising accordingly. Yet, it faces a number of challenges that are rather similar to the Brazilian ones, despite their freer approach. Firstly, Chile needs to greatly expand its electricity infrastructure if it is to keep up with current rates of growth. Though the government is prioritizing that need, environmental concerns are somewhat holding back the pace of expansion.

Secondly, Chile needs to diversify its economy. Copper makes roughly half of its exports, while much of the rest are low-complexity sea products. Besides the obvious critique to make from such a dependence on a single commodity, the lack of complexity in the overall basket of exports is often criticized from a development perspective.

This is acknowledged by Chilean strategists, who rightly prescribe more education and  better infrastructure to solve the problem. But some analysts—notably Ricardo Hausmann, who is head of the Center for International Development at Harvard’s Kennedy School—think that they should be more assertive, particularly in regards to sector policies and financial support to higher education.

There are some positive results though, like a healthy increase in exports of services during the last decade, and of manufactured goods to the rest of the region. It is also encouraging to observe that the Chilean state is a net creditor—a rarely-seen quality in public finances these days—as a result of its virtuous counter-cyclical management of fiscal accounts.

But it remains to be seen if their approach works or if Chilean productivity will stagnate until its government takes a more active role in development. For 2013, I believe they still have room for resource-driven development partly thanks to their regional partnerships, even though their growth rate may diminish a little.

But productivity and diversification will probably become increasingly-important issues to watch, and may affect the rest of the Pacific Alliance as they follow a similar free-trade strategy.

Another country that grew considerably in 2012 driven by foreign direct investment was Peru, at a 6 % rate. Colombia did not impress as much but, with a 4.2 % GDP growth, it was still over the lackluster Latin American average of 3 %, according to the IMF.

In my opinion, if the region is not surprised by remarkable negative events in the rest of the globe, it is reasonable to expect similar growth rates for these two countries in 2013, while the regional average will probably raise to within a 3.5 to 4 % range as a result of the aforementioned improvement in Brazil and other Mercosur countries.

The investments discussed are held in client accounts as of January 31. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.

Author profile

Andy Djordjalian
Andy Djordjalian
Andy is a private investor living in Buenos Aires, Argentina. He believes that the markets are generally efficient, but that occasional inefficiencies can be identified with significant research and market knowledge. He has developed knowledge about the companies and countries that only a local could gain, with an understanding of which companies are “investor friendly” and which have been problematic.