September 8, 2016

South America: Soon to see some light at the end of the tunnel? Opportunities for bold investors

Several factors have undermined in in recent years. The slump in commodity prices, the slowdown in global trade and the Chinese economy, and numerous political problems have given the region a rough ride. We note that and have been particularly hard hit. However, the situation now appears to be improving, with the help of encouraging political reforms. Things are looking brighter for the years ahead, for South America and for investors who take an interest in this region.

Since 1990, the average annual real GDP growth of Graph 1 – In the past two years, growth has lagged well below the as a whole has been close to 3.0%. However, historical average Ann. var. in % Ann. var. in % after years of fast economic growth fuelled by a commodity Real GDP growth – Latin America and the Caribbean 7 7 boom, South America1 has recently been languishing in 6 Average, 1990–2015 6

the doldrums (graph 1). The slump in commodity prices, 5 5

soft Chinese demand, high largely caused by 4 4

depreciation in South American currencies against the 3 3

U.S. dollar, and numerous political problems have even 2 2

driven a few countries (Brazil first and foremost) into 1 1

. For the first time in 30 years, South America 0 0

seems to be on the verge of having two straight years of -1 -1 contraction in real GDP, in 2015 and 2016. This economic -2 -2 reversal is being observed in a few countries of the region 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 (graph 2), but particularly in Brazil which, with around 3% Sources: and Desjardins, Economic Studies of global GDP based on purchasing power parity (PPP) Graph 2 – Most of the countries of South America have in 2014, carries a good deal of weight. experienced a slowdown in recent years

Ann. var. in % Ann. var. in % GROWTH THAT IS DEPENDENT ON GLOBAL Real GDP 14 2013 14 CONDITIONS AND THE COMMODITIES MARKET 12 2014 12 10 2015 10 The weakness of the Brazilian economy in particular and of 8 8 6 6 the South American economies in general is partly due to 4 4 the slowdown of the global economy. The slower growth in 2 2 0 0 imports in most of the advanced nations, and in emerging -2 -2 -4 -4 countries like China, has done considerable damage -6 -6 Weight within global GDP based on purchasing power parity in 2014: -8 -8 (graph 3 on page 2). 2.89% 0.56% 0.49% 0.35% 0.33% 0.16% 0.06% 0.06% 0.05% -10 -10

Brazil Argentina*

1 * The World Bank does not calculate GDP based on purchasing power parity for Argentina. This report mainly discusses the major countries of South America. Sources: World Bank and Desjardins, Economic Studies However, some data released by international institutions such as the World Bank and the International Monetary Fund cover Latin America (which also includes the countries of Central America, including Mexico) and In fact, the rise of the Chinese economy since the beginning the Caribbean. We published an analysis on Mexico in May 2016, www. of the 2000s has had major negative consequences on the desjardins.com/ressources/pdf/pv160505-e.pdf?resVer=1462452919000.

François Dupuis Benoit P. Durocher 514-281-2336 or 1 866 866-7000, ext. 2336 Vice-President and Chief Economist Senior Economist E-mail: [email protected]

Note to readers: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively. Important: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of services. The data on prices or margins are provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein are, unless otherwise indicated, those of the document’s authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright © 2016, Desjardins Group. All rights reserved. Economic Viewpoint September 8, 2016 www.desjardins.com/economics

Graph 3 – Growth in exports from the emerging countries of Latin Graph 4 – GDP per capita has also deteriorated in some countries America is keeping pace with the global cycle of the region

Ann. var. in % Ann. var. in % Ann. var. in % Ann. var. in % In real terms PIB réel per capita 35 35 Growth due to the 30 30 4 4 depreciation of Latin 25 25 American currencies 20 20 2 2 15 15 10 10 0 0 5 5 0 0 -2 -2 -5 -5 -10 -10 -4 -4 -15 -15 Average, 2000–2013 -20 -20 -25 -25 -6 Average, 2014–2015 -6 2000 2003 2006 2009 2012 2015 -8 -8 Exports from the emerging countries of Latin America

Imports by the advanced countries Brazil Chile Peru Bolivia Ecuador Uruguay Paraguay Imports by Asian emerging countries Venezuela Argentina Colombia

Sources: CPB Netherlands Bureau for Economic Policy Analysis and Desjardins, Economic Studies Sources: World Bank and Desjardins, Economic Studies

South American manufacturing sector. According to the Graph 5 – The South American countries lag far behind in terms of income per capita World Bank, Chinese competition caused a shortfall of over In US$* In US$* Gross national income per capita in 2015 6% in Brazilian exports of manufactured products between 60,000 60,000 2001 and 2011. For the rest of the region, that shortfall 50,000 50,000 is between 3% and 7%. On the other hand, China’s fast development has boosted exports of agricultural products by 40,000 40,000 over 10%, and products by 20%. Not only do global 30,000 30,000 economic conditions, primarily those of China, clearly 20,000 20,000 influence the volume of exports from South America, but 10,000 10,000 they also dictate the type of its exports. 0 0 Peru Chile Brazil States United Bolivia Canada Ecuador The commodities market has become increasingly important Uruguay Paraguay Venezuela Euro zone to the South American economies during the latest upward * According to purchasing power parity. cycle. Oil prices in particular are key to the exports and Sources: World Bank and Desjardins, Economic Studies of Columbia, Ecuador and Venezuela. Brazil, It represents 42% of Latin America excluding Mexico. As Chile and Peru are also highly dependent on commodities, a result, the swings of its economy greatly affect the other especially in the mining and agricultural sectors. countries of the region. Brazil receives the lion’s share of the exports of Argentina, Bolivia, Paraguay and Uruguay But we must not overlook the influence of currency (graph 6). At the same time, we note that despite its size, movements on trade, especially when they are intense, as Brazilian demand is far less important to the countries on has been the case in recent years. Consequently, despite the continent’s Pacific coast. For Venezuela, Colombia and global growth that was still slow in 2015, Brazil’s real Ecuador, the primary export destination is the United States. exports climbed by 6.1% last year, thanks to depreciation For Chile and Peru (as well as for Brazil), it is China. by its own currency, the real. Graph 6 – Brazil is an important destination for many South POVERTY IS STILL VERY PREVALENT American countries In % Exports to Brazil as a % of total exports In % Despite the progress of recent decades, poverty is still Average, 2011–2015 35 35 rampant in South America, and the situation has deteriorated 30 30 in recent years with downturns in real GDP per capita in Venezuela, Brazil and Argentina (graph 4). We also note 25 25 that national income per capita is still extremely low in 20 20 South America compared with the advanced countries 15 15 (graph 5). But most of the major countries of the region find 10 10 themselves better off than China or India. 5 5 0 0 Peru Chile

CLOSE-UP ON BRAZIL Bolivia Ecuador Uruguay Colombia Paraguay Argentina Boasting the seventh largest GDP in the world based on Venezuela . PPP, Brazil is by far the largest economy of South America. Sources: International Monetary Fund and Desjardins, Economic Studies

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The Brazilian economy has done well in the 2000s, apart Graph 8 – A falling currency and rising inflation have led the Bank from 2008–2009 when the global economy collapsed of Brazil to tighten its monetary policy (graph 7). Between 2000 and mid-2013, it recorded average Ann. var. in % In % 12 16 real growth of 3.6%. Its exports particularly benefited 11 15 14 from rising prices for commodities (iron, oil, etc.) and 10 13 9 agricultural goods (, sugar, , etc.). It has also 12 benefited from the general development of the emerging 8 11 7 10 9 countries, in particular by being a member of the BRIC 6 8 5 block (Brazil, Russia, India and China), that new pole of 7 global growth. In fact, foreign investment has expanded 4 6 3 5 fairly quickly, reaching an average annual change of 19.6% 2010 2011 2012 2013 2014 2015 2016 between 2000 and 2013. A relatively expansionist budgetary policy throughout the period has also supported growth. Consumer price index (left) Bank of Brazil’s SELIC key interest rates (right)

Sources: Banco Central do Brasil, Datastream and Desjardins, Economic Studies Graph 7 – Up until the recent period of weakness, the Brazilian economy had shown fairly strong growth

In % In % This state of affairs has greatly affected the mood of Real GDP 12 12 economic agents. Both business and consumer confidence 10 10 8 8 indexes in Brazil have dwindled (graph 9). 6 6 4 4 2 2 Graph 9 – Confidence has eroded considerably in Brazil 0 0 -2 -2 -4 -4 Index Index -6 -6 120 70 -8 -8 -10 -10 65 110 -12 -12 60 -14 -14 100 -16 -16 55 2000 2002 2004 2006 2008 2010 2012 2014 2016 90 50 Quarterly ann. var. in % Ann. var. in % 45 80 Sources: Central Statistical Organisation and Desjardins, Economic Studies 40 70 35

60 30 But this virtuous circle has been replaced with a far more 2010 2011 2012 2013 2014 2015 2016 difficult situation. The slump in commodity prices, political Consumer confidence (left) Business confidence (right) Sources: Fundacao Getulio Vargas, Brazilian National Confederation of Industry and financial scandals (affecting Petrobras in particular, and Desjardins, Economic Studies Brazil’s largest company), the slowdown in Chinese demand and a new wariness on the part of international markets towards the emerging economies, have all conspired to FAIR WEATHER ON THE HORIZON rock the Brazilian economy. It now finds itself in a recession On the bright side, we note that the Brazilian economy from which it has yet to completely emerge. Real GDP appears to be nearing a turning point. Many indicators, has pulled back by 7.9% between the cyclical peak of the such as confidence indexes, have begun heading up since first quarter of 2014 and the beginning of 2016, recording the start of the spring. The annual changes in sales seven quarters of contraction during the period, including and industrial production are still broadly negative, but the six in a row. The World Cup of soccer in 2014 and the downturns are already less severe. The monthly economic Rio Olympics this summer do not seem to have managed activity index compiled by the National Bank of Brazil has to give a boost to the Brazilian economy. As mentioned risen in two of the past three months. earlier, the currency’s depreciation, losing nearly half of its value against the U.S. dollar since 2013, has provided Since the beginning of the year, many commodity prices some support for exports. However, the internal cost of that have been stabilizing or increasing, giving support to depreciation has manifested itself in rising inflation and this improvement in the Brazilian economy. For example, falling foreign investment. Moreover, the Bank of Brazil international prices for , the country’s main export, has been forced to react by tightening its monetary policy have soared by 39.8% since the start of the year. Coffee several times, raising the main key interest rate by 700 basis prices are up by 28.2%, oil prices by 25.2%. prices points (from 7.25% to 14.25%) since 2013 (graph 8). have risen more slowly over the summer, but this comes on the heels of a spike of 31.7% in the first half of 2016. Since the start of the year, we nevertheless note a gain of 10.6%.

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This fairly generalized upward movement in the prices of Yet, the growth rate in 2015 still reached an enviable 3.2%. Brazilian exports is also one of the factors that have enabled One of the positive factors for the Peruvian economy is the currency to appreciate by 29.5% since the January low. the soundness of its institutions, especially where the Furthermore, Brazil’s main stock market index has boomed management of the economy is concerned. The recent by 60.3% since last January’s low, whereas it had contracted election of Pedro Pablo Kuczynski as President, over the by 39.4% since its peak of 2014. right-wing populist candidate Keiko Fujimori, should mean that this sound and prudent management of the Peruvian POLITICAL SUPPORT FOR GROWTH economy will continue to promote growth. In Brazil: One of the factors that are helping Brazil glimpse some light at the end of the tunnel is the change in the In Colombia: In this country it is not so much a change of country’s leadership. To make way for the parliamentary government that could support economic growth, but rather impeachment process, President Dilma Rousseff—in the recent peace accord between the government and the office since January 2011, and re-elected in 2014—was revolutionary army that have been waging war for 52 years. temporarily removed from power in May 2016. She was If it is endorsed by the population through a referendum then permanently impeached by the Senate on August 31. to be held on October 2, this permanent cease-fire should The numerous political scandals linked to the Rousseff promote investment and tourism. administration and to the Brazilian ruling class in general (especially those associated with the Petrobras oil company) But not yet in Venezuela: Venezuela is still in the throes were factors underlying the deteriorating confidence and of a serious recession, in fact a real economic crisis. decline in investment of recent years. The government Real GDP reportedly contracted by 3.9% in 2014 and by led by Vice-President Michel Temer has been welcomed 5.7% in 2015. In April, the International Monetary Fund very favourably by the markets, notably thanks to high- (IMF) was forecasting a slump of nearly 8.0% in 2016 and calibre appointments to important economic positions. another, of 4.5%, in 2017. Obviously, it is falling oil prices It remains to be seen whether the progress achieved by that are to blame for these economic woes. That market Mr. Temer’s administration will continue. represents nearly 95% of Venezuela’s exports, with the United States, India and China as the main destinations. In Argentina: Argentina has also experienced serious Public finances are a complete mess, inflation is hovering economic, financial and political problems in recent around 800%, the currency has totally collapsed and power years. However, the replacement of the populist regimes outages and problems in the distribution of essential goods of Christina Fernandez and, before that, her husband are commonplace. For the time being, the government is Nestor Kirchner by the reformist government led by receiving financing from China, but great political and Mauricio Macri is generating a good deal of optimism. economic uncertainty prevails. In the very short term, the reforms could be harmful to economic growth, because the government is trying to INVESTMENT OUTLOOK regain financial credibility by reforming a system that is Times have generally been tough for the South American largely based on subsidies and state-sponsored waste. economy in recent years, in particular for Brazil and the However, we are already seeing reductions to import trade countries that have close trade ties with it. However, the barriers and export taxes. In the longer term, if these efforts stabilization of the commodities market and the moderate are not curtailed through legislative action by supporters continuation of price increases should give a lift to the of the former regime, they should bear fruit and accelerate economy of the entire region. Some indicators are already Argentina’s economic growth. We already note that the showing this, and it is reasonable to assume that this new government has managed to return to the international trend will continue. In fact, the IMF’s forecasts are calling financial markets with its first bond issues after 15 years of for such improvement (graph 10 on page 5). Despite a “exile”. One of the challenges that remain to be tackled is downward revision of nearly all the growth scenarios due the necessity of easing the Argentinian inflation rate, which to concerns relating to the Brexit vote (which actually still stands at around 35%. Investments in infrastructure, should not affect this region much), that organization has especially in the energy sector, will also be needed to revised its forecasts for Latin America upwards slightly generate more stable and lively economic growth. (+0.1% in 2016 and in 2017). The IMF is now predicting a 0.4% contraction of real GDP in this region this year, and In Peru: Although it is not terribly dependent on the a 1.6% gain next year. The upward revision mainly affected Brazilian economy, the Peruvian economy nevertheless Brazil. This economic spurt should promote the renewal of has slowed due to the weakness of Chinese demand and faster growth in the domestic market, and in investment, the slump in commodity prices, especially that of . in Brazil and Argentina. The IMF’s forecasts for the

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Graph 10 – The years to come are looking brighter for Argentina Graph 12 – Price/earnings ratios are not showing any major and Brazil overvaluations

Ann. var. in % Ann. var. in % Ratio Ratio Real GDP Price/earnings ratios 2 30 30 6 25 25 4 0 20 20 2

-2 15 15 0 10 10 -2 -4 Average, 2013–2016 5 5 -4 Average forecast, 2017–2021 0 0 -6 -6 2010 2011 2012 2013 2014 2015 2016

Peru Chile Brazil Bolivia Ecuardo Paraguay Uruguay Colombia Argentina Venezuela Brazil Argentina Chile Colombia Peru United States

Sources: International Monetary Fund and Desjardins, Economic Studies Sources: Institutional Broker’s Estimate System, Datastream and Desjardins, Economic Studies other countries do not really change things, but they were Graph 13 – Forecasts of long-term, average, annual growth of earnings per share prepared last April based on rather pessimistic forecasts Ann. var. in % Ann. var. in % about commodity prices. Forecast, August 2016 60 60

STOCK MARKETS 50 50

South American stock markets, which have been depressed 40 40 throughout the slowdown and contraction phase, have started picking up in recent months. Since the beginning of the 30 30 year, the main stock indexes have seen very strong growth 20 20 that looks even better when expressed in U.S. dollars (with 10 10 the exception of Argentina). Peru comes out on top in this 0 0 department: its stock market has boomed by almost 60% so United Canada Chile Colombia Brazil Argentina Peru States far in 2016 (graph 11). However, these gains come on the heels of some fairly large contractions in 2015. Actually, Sources: Institutional Broker’s Estimate System, Datastream and Desjardins, Economic Studies the price/earnings ratios do not appear to be exaggerated, For Canadian or U.S. investors, the upswing in the South and they generally stand below what is observed in the American stock markets has been inflated by currency United States (graph 12). If the economy keeps improving exchange trends. The sharp appreciation of the currencies and confidence recovers, higher profits should materialize of many emerging countries since the beginning of the year as the stock indexes keep rising. Indeed, the outlook on is not likely to continue, however. The relatively strong profits is relatively good, similar to that of the United States inflation rates in some countries of the region, especially or Canada (except for the spike in Peru) (graph 13). It has Brazil and Argentina, should prevent the currencies of those generally been improving in recent months. countries from advancing further. The prospect of another Graph 11 – Stock markets have been booming in South America key interest rate hike by the Federal Reserve represents since the beginning of the year another constraint on the appreciation of emerging Var. in % Var. in % Stock index growth since the start of 2016 currencies, one that could even lead to an outflow of capital. 70 70 In local currency We cannot rule out the possibility of more optimistic 60 In US$ 60 confidence supporting both the economy and the currencies 50 50 but, in the short or medium term, those factors should not 40 40 inflate the stock market value when calculated in Canadian

30 30 or U.S. dollars to the same degree as they have been doing.

20 20

10 10 CONCLUSION After some difficult years, it is undeniable that a gentle 0 0 United Canada Chile Colombia Brazil Argentina Peru breeze of optimism is starting to blow over South America. States Many of the global and national impediments that had been Sources: Bloomberg and Desjardins, Economic Studies undermining economic growth in recent years have started to fade away. It is too early to talk about a new momentum, but things are not as gloomy as they were. First and

5 Economic Viewpoint September 8, 2016 www.desjardins.com/economics foremost, the political landscape seems more conducive, especially in Brazil and Argentina, to a sustainable renewal of confidence that could attract more domestic and foreign investments.

However, the problems have not all disappeared, and the South American economy remains fragile and vulnerable to the ups and downs of the international commodities market and of demand from China and the advanced countries. That fragility also stems from long-term weaknesses such as endemic poverty, persistent income inequality and major corruption problems. To all those we must add more recent phenomena like the zika virus crisis, which is likely to hinder tourism.

But attractive opportunities do exist for these economies in the medium term. To take advantage of them, it will be necessary to undertake or continue reforms, especially those pertaining to the transparency of public institutions. Improved productivity, through education and more developed infrastructures, is key to enable the countries of South America to reap greater benefit from global growth, especially since such growth is likely to stay relatively slow, compared with previous cycles. Improved intracontinental trade via the zone (the common market of the south) will have to continue, and agreements will need to be reached with other parts of the world. On this point, the Trans-Pacific Partnership (TPP) represented a good opportunity for Peru and Chile (along with Mexico), which were planning to participate, but political pressures, particularly in the United States, are such that it probably will not see the light of day.

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

Francis Généreux Senior Economist

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