As we look forward into 2006, we must ponder the risks: will the upcoming political cycle end the multi-year rally we have enjoyed?
The only region in the emerging markets for which we are comfortable in forecasting falling rates is Latin America, primarily on the back of falling inflation and strong fiscal surpluses. Brazil in particular has already benefited from sharp cuts. With nominal rates at 18.50 per cent, and real rates at 12.50 per cent, Brazil has a long way to go. Mexico, meanwhile, is also following a pattern which goes against US rate moves.
Some 15 elections in the region, however, introduce uncertainties. Mexico’s election will be contested between three parties .The likely candidate for the PRI is Roberto Madrazo who will struggle to unite the PRI behind him. The leader of the PRD, Andres Manual Lopes Obrador (AMLO) has a history of populist rhetoric which scares the market. The PAN has now chosen Felipe Calderon to follow President Fox. Recent polls put AMLO, Mr Madrazo and Mr Calderon much closer together, leading to a tighter race than originally forecast. The Mexican economy is likely to struggle with the US slowdown, and any wobbles on the political front will certainly damage recent market buoyancy. A clean fight, however tight, will be welcomed by the markets. A dirty fight, on the other hand, would lead to a sharp sell off.
For Brazil, the most important issue is the strength of the real this year which has been the strongest currency in the world in 2005, justified in part by a large trade surplus, high exports to GDP and high real interest rates. Is the real too strong? Are the terms of trade changing? Combined with political risks ahead of next year’s elections, should we expect the market to sell off? As for the elections, the most likely outcome is for a PSDB victory (probably led by centrist Jose Serra), or a possible PT win, again led by a weakened lula. The fear is that the political battle takes focus away from economic activity.
Elsewhere in the region, the political scenario, while active, is less explosive. Growth should remain strong, with the regional outlook at over 3 per cent for 2006, one of the highest in the world. Corporate earnings remain high, though commodity earnings expectations are falling. Valuations remain relatively low, and profitability high. ROE for the region, at 18 per cent, is significantly higher than for the rest of the world.
Mike Reynal, portfolio manager and co-head of emerging markets, Principal Global Investors (Europe).
