June 11, 2004

Latin America Funds Rising, But Outlook Cloudy

June 8, 2004 -- Mutual funds investing in Latin America have racked up handsome gains lately. For the one-year period ended in April, the average fund in the category gained 33.6%, versus 22.9% for the S&P 500-stock index. In calendar 2003, Latin American funds soared 63.1% on the back of a global economic recovery, outperformance of commodity stocks, benevolent monetary policies, and renewed investor appetite for higher-risk securities.

However, bearing in mind that these are emerging markets, investors must take into account the inherent risks and volatility of Latin America. Indeed, the region represents only a portion of the emerging markets, a volatile asset class itself that generally makes up just a small part of an overall portfolio. In addition, the picture in Latin American markets appears to be somewhat cloudy going forward despite some interesting growth prospects.

In truth, investors in Latin America actually put the lion's share of their money into two countries: Brazil and Mexico. Together, they account for more than 80% of all Latin markets by value. The two giant economies drive the direction of markets south of the border, and each is vastly different from the other. Although smaller Latin markets have recently performed very well, they are typically plagued by misfortunes such as poor liquidity (Colombia and Peru), grinding debt loads (Argentina), or endless political turmoil (Venezuela).

While many international and emerging markets portfolios keep significant stakes in Latin American stocks, there are relatively few "pure" Latin funds, that is, funds mandated to invest at least 80% of assets in the region (see table below). Here is a look at recent market performance, and where managers are now finding opportunities.

Mexico: Bouncing Back in 2004

Although Mexico gained an outsized 44.2% in 2003, it lagged its Latin peers, with Brazil and Argentina each doubling in value over the year. Mexico under performed last year due to some weak economic data, lack of progress on tax reforms, and fears that Mexico would lose some export share to China.

This year, however, Mexico has sparkled as Brazil weakened. Buoyed by a stronger domestic economy, firm earnings, high liquidity, low interest rates, low financing costs, increased foreign direct investment, and a strengthening U.S. economy, the Mexican Bolsa index is up a healthy 14.8% through May.

"The Mexican economy usually lags the U.S, by a few months. As we saw a strong pick-up in the growth of U.S. markets at the end of 2003, we are now seeing good growth in Mexico this year," notes Michael Reynal, portfolio manager of the Principal International Emerging Markets Fund/A (PRIAX), which currently has 27% of its assets in Latin American stocks.

"Given the continued high oil prices, we are pretty bullish on Mexico this year," Reynal explains. "Consider that the Mexican budget was set assuming an oil price of only $22/barrel, you can imagine the excess revenue on the fiscal front with oil currently at around $40/barrel. Part of this revenue is going into an infrastructure development fund, which will generate jobs growth and benefit the Mexican economy long term."

Indeed, many investors have apparently taken profits in Brazil and Argentina -- big gainers in 2003 -- and moved assets into the safer refuge of a stable Mexico. Reynal is focusing on Mexico's booming housing and construction market, including homebuilders Consorcio Ara S.A. de C.V. and Corporacion Geo S.A. de C.V.

Francisco Alzuru, managing director for Latin America and a portfolio manager at Hansberger Global Investors, likes Mexican stocks such as Coca-Cola FEMSA S.A. de C.V. (KOF), a beverage distributor that he believes has not been rewarded by investors for successfully streamlining its operations.

Alzuru, a strictly bottom-up stock picker, also favors Grupo Financiero Banorte S.A. de C.V., one of Mexico's leading banks that boasts "attractive growth opportunities," as well as CEMEX S.A. de C.V. (CX), the largest cement producer in the Americas. "As the U.S. reaffirms plans to invest in infrastructure in this country, Cemex will be a great beneficiary," he noted. "Cemex also dominates the Mexican market where it has around a 50% share."

Brazil: Sliding After Stellar 2003

After three consecutive negative years, Brazil's stock market surged 97.3% in 2003, fueled by an improved domestic economy and greater confidence in President Luiz Inacio Lula da Silva's fiscal policies. Utilities and telecoms -- sectors subject to heavy regulation -- led the pack.

However, with the arrival of the new year, markets have soured in Brazil: Sao Paulo's Bovespa Index declined 12.1% through May. Concerns about the government's monetary policy, some disappointing economic data, high interest rates, pervasive inflation, and a political corruption scandal involving one of Lula's top officials have weighed on the markets.

However, all is not gloom in Brazil. At best, the economy presents a mixed bag. On the plus side, the government enjoys a healthy budget surplus, the currency is competitive, GDP grew 1.6% in the first quarter and exports, particularly to commodity-hungry China, are soaring. These positives, however, are offset by some dark clouds: Brazil's debt-to-GDP ratio is nearing 60% (a large chunk of which is U.S. dollar linked), interest rates are unlikely to come down as inflation remains high, and there are fears China's economy may slow down this year.

"Brazil needs to cut interest rates to generate growth," said Reynal. "If they can't generate growth, they'll have to do something drastic, like raise taxes."

Eswar Menon, portfolio manager of the Loomis Sayles International Equity Fund/A (LIERX) thinks that even if the U.S. boosts interest rates, Brazil will not be hurt too much due to its "increasing trade surplus and better fiscal management." Menon adds that, unlike previous rounds of rate hikes in 1994 and 1999, emerging markets like Brazil are now better suited to withstand negative impacts since "debt levels are lower and growth is better."

Among Brazilian stocks, Alzuru is bullish on exporters like mining group Companhia Vale do Rio Doce (RIO), which enjoys competitive advantages and recently signed a $5-billion deal to supply iron ore to China.

Latin America's Great Growth Prospect: Telecom

Of particular interest to Latin America investors is the burgeoning telecommunications industry, which typically shows up as the top sector in Latin American mutual funds.

"Relative to other emerging markets, Latin America has a low telecom penetration rate," Alzuru said. "Subscriber growth should be phenomenal in the next few years, and top wireless operators like Mexico's America Movil S.A. (AMX) and Brazil's Tele Norte Leste Participacoes S.A. (TNE) are well-positioned to exploit this growth."

Despite sanguine prospects for growth in Latin American telecoms, investors should exercise caution when considering any emerging market. Risks should be weighed against one's investment goals and tolerance. Typically, no more than 5% or 10% of a portfolio's total assets are kept in the emerging markets for the average investor. A large bet on Latin America, essential Mexico and Brazil, would be a bold move.

As the table demonstrates, "pure" Latin American funds uniformly have low Standard & Poor's Star rankings due to their longer-term underperformance and high volatility. Expenses can also run higher than those of the average emerging markets portfolio.

FUND One-Year Return Through 4/30/04 (%) Three-Year Annualized Return Through 4/30/04 (%) S&P Ranking Turnover Rate (%) Standard Deviation (%) Expense Ratio (%)**
Fidelity Latin America (FLATX) 39.9 6.9 2 Stars 28.0 27.53 1.31
Merrill Lynch Latin America Fund/A (MDLTX) 39.4 6.6 2 Stars 57.9 27.54 2.07
Morgan Stanley Latin American Growth/A (LATAX)* 36.3 4.8 1 Star 78.0 26.35 2.43
Scudder Latin America Fund/A (SLANX) 26.3 N/A Not Ranked 24 N.A. 2.14
T Rowe Price Latin America Fund (PRLAX) 33.0 5.7 2 Stars 27.4 26.55 1.55

Source: Standard & Poor's. Total returns include reinvested dividends. Data as of 4/30/04.

*Closed to new investors.

**Versus 2.08% for the peer group.

Contact Robert F. Keane with questions or comments at:

bkeane@ia-mag.com.

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