There have been any number of somewhat nebulous arguments advanced over the last year about why emerging markets such as Latin America sold off, which never made sense. But with a somewhat improved global economy, particularly in the U.S., investors’ new confidence in emerging markets is showing why Latin America has always been a crystal clear opportunity (See Chart A).

And this development is consistent with our long-term thesis that Latin America’s long-term fundamentals are strong given its rising middle-class and incredible bounty of natural resources. Not to mention – as the region largely missed the financial crisis – consumers have not had to work through debt overhangs as in developed economies, and thus will have an ever-increasing disposable income as these economies continue to grow.

In fact, the middle class in Latin America has more than doubled over the last 30 years, from 120 million to 274 million. According to a UK Foreign & Commonwealth Office report, “Latin America had a larger middle class than China (183m) and India (18m) combined in 2005, the most recent year for which data is available. The middle class now account for 48% of the Latin American population, up from 32% in 1981.”

 Chart A: Latin America has Outpaced the Broad Emerging Markets Indices

Created with Y Charts

Furthermore, the expansion of the middle classes has occurred concurrently with a reduction in poverty, which has decreased from 25% to 15% of the population – evidence that the lower middle classes have expanded due to the poor rising up the income ladder.

According to the UK government report, the middle classes are mostly situated in the emerging powers in Latin America, particularly Brazil and Mexico. Brazil accounts for about 40% of the Latin American middle classes, and Mexico accounts for 25%. There are also significant middle class populations in Argentina, Colombia, Peru, Venezuela, Chile and Costa Rica (See Chart B).

Moreover, the World Bank and the Brookings Institute estimate that the middle classes in Latin America will increase by 60-70% over the next 20 years. “On our figures, this would mean a Latin American middle class of around 450m in 2030, which verges on the current EU population,” concluded the UK’s government report.

Chart B: The Economic Story in Latin America is about the Rise of the Middle Class

Source: UK Foreign & Commonwealth Office

 
That last fact has not escaped the world’s luxury retailers that are expanding into the region–telecom players wanting to offer new cable and satellite TV options, for example. And the recent liberalization of energy markets such as in Mexico offers great new potential investment opportunities in both home grown and international firms.

But before delving into these growth areas, we focus on the main drivers of recent investor interest (or the new economics of investing in Latin America) and briefly review why many of the arguments against Latin America as an investment have fallen flat in the last year. 

Deal of the Century

As noted above, the opportunity now exists to get in on Latin America growth at historical lows, and even the big money managers are paying attention. JP Morgan Asset Management, in news reports, has said they were bullish about the emerging economies based on the “extremely cheap” nature of the emerging market shares right now. JP Morgan, in press statements, has noted that the MSCI Emerging Markets index has a price-to-book ratio of below 1.5. This is the lowest level in seven years.

Moreover, JP Morgan noted that whenever the valuation dropped below that mark since 1995, the equities have returned over 10% over the next one year. Following intense selling pressures, the emerging market equities had returned 27% and 30% over a year in July 1996 and Nov 2002, respectively. A Bank of America-Merrill Lynch fund manager survey also shows that fund managers are less cautious on emerging markets. Only 13% took underweight positions in May as opposed to 31% in March.

Fund tracking firm EPFR Global reported inflow of $4.2 billion into the emerging market equity and bond funds for the week ending April 2. A week after, $4.9 billion flowed in. That helped inflows into emerging market funds reach a 61-week high. Emerging market equities also witnessed the first fund inflow in 22 weeks the week of April 2, according to press reports.

This is in sharp contrast to the beginning of the year, as previous data quoted by various news sources showed $40 billion worth of fund outflow from emerging market equity funds in the first quarter. The outflow had in fact more than doubled from first quarter of 2013.

Of course, there is the usual chorus of detractors (or emerging markets bears) who believe the rally will be short-lived. But we believe these market analysts have failed to truly understand the long-term fundamentals.

When the Federal Reserve Chief Ben Bernanke made his tapering comments last spring – and many investors fled emerging markets investments anticipating an increase in treasury rates – we argued then that developed economies such as the US were still too weak for such an initiative and investors would lose on this bet.

Then again in December 2013, when the Fed did announce tapering, we continued to warn that investors would be sorely disappointed as there was no evidence of enough growth (or inflation) to support rate increases in the U.S.

This view was born out when in April the U.S. government estimated that the economy had grown at a tepid 0.1 percent in the first quarter – only to be revised significantly downward on new data that finds the U.S. trade deficit shrank less than expected in March. The trade gap narrowed 3.6 percent in March to $40.38 billion. But the Commerce Department baked in a larger drop for its initial estimate of first-quarter growth, according to news reports. 

As for economists’ forecasts, JPMorgan Chase analysts now predict GDP contracted 0.8 percent in the first quarter. Macroeconomic Advisers projected a dip of 0.6 percent, Barclays Capital a 0.2 percent decline and BNP Paribas a 0.1 percent slide, according to The Wall Street Journal. 

That’s why we would again argue that emerging markets as an investment is a good counter balance or hedge against possibly future mixed economic readings in developed economies such as the US, as the global recovery continues to be weak and there could be some missteps along the way.

Further, given that the Federal Reserve, according to statements by Fed Chair Janet Yellen, will continue to be accommodative for some time, Latin countries’ efforts to manage overheating of their economies through increased short-term rates also continue to offer compelling fixed income alternatives. Meanwhile, the IMF predicted in early April that the Federal Reserve would not start raising interest rates from their range of 0% to 0.25% until late in 2015.

But whatever one’s reasons for investing- it should always be remembered that emerging markets will be a rational choice in the foreseeable future because almost every economic forecast (from the IMF to the World Bank) predicts that emerging markets will grow faster than developed economies (albeit at lower rates of growth than predicted a few years earlier). 

The Organization of Economic Co-Operation and Development (OECD) in early May cut its global growth expectations from its November outlook from 3.6 percent to 3.4 percent for 2014, although it kept its forecast for 2015 at 3.9 percent.  China will grow 7.4%, down from a previous projection of 8.2%. The Inter-American Development Bank, for its part, has projected economic growth in Latin America at 3% in 2014 and 3.3% in 2015.

In contrast, the U.S economy is expected to grow by 2.6 percent in 2014 and 3.5 percent in 2015, while the Euro zone is forecast to notch up growth of 1.2 percent this year.

The IT Growth Phenomenon

Analyst have noted with awe how Latin America has continued to beat the current global trend of emerging market weakness in the IT sector, though currency weakness in the region could still derail the growth trend in dollar terms, some IT analysts have said.  

According to technology analysis group IDC, in press statements, total IT spending – including hardware, software and services – is expected to reach $139 million in the region this year, up 8.4% compared to the same period in 2013.

Mobile devices such as tablets and telephones, IT services, storage and packaged software will be key growth drivers in the region, IDC said in a separate release. However, the weakening of Latin American currencies against the dollar in recent quarters may negatively affect IT spending growth in the region in US dollar terms, as previously noted.

There are various ways to take advantage of this trend. As smart phones and tablets become more ubiquitous in Latin America there will be various regional telecom companies and one U.S. firm that stand to benefit by providing the broadband backbone to these digital offerings.  

Famed Mexican billionaire Carlos Slim’s telecom firm America Movil, S.A.B. de C.V. (NYSE: AMX) and its subsidiaries provide wireless, fixed line voice, broadband, pay television and directory products and services. Its wireless products and services include prepaid cards, postpaid plans, international roaming services, data services, and push-to-talk services, for example.

The company, which dominates the Mexican market, operates in many countries in Latin America and the Caribbean, giving investors’ maximum diversification -namely Jamaica, the Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, Peru, Argentina, Uruguay, Chile, Paraguay, Puerto Rico, Colombia, and Ecuador under the Claro-named subsidiaries. AMX is a Buy up to 24 

Then there is Telefónica, S.A. (NYSE: TEF) a Spanish broadband and telecommunications provider in Europe and Latin America. Operating globally, it is the third largest provider in the world. The company is the former public monopoly of telecommunications in Spain. Created in 1924, as Compañía Telefónica Nacional de España (CTNE), until the liberalization of the telecom market in 1997, Telefónica was the only telephone operator in Spain and still holds a dominant position (over 75% in 2004). Since 1997, the Spanish government has privatized its interest in the company. Telefonica offers even more diversification than America Movil as it operates in many more markets around the world, from Europe to markets in Latin America. TEF is a Buy at 18

Finally, AT&T’s (NYSE: T) proposed acquisition of DirecTV (NASDAQ: DTV) would give the U.S. wireless provider a major foothold in Latin America, and would be a great way to play developed and developing economy growth simultaneously.

DirecTV, with its 18 million subscribers in Central and South America, is the biggest pay TV provider in Latin America where, as noted, the market for such services is already growing at a much faster rate than the mature U.S. market. In fact, DirecTV’s Latin American operations account for 95 percent of its subscriber growth, but just 20 percent of its revenues. We believe given increased consumer income projected in the coming years in Latin America, this is a great opportunity for the region to become potentially a larger part of the new larger AT&T’s earnings pie, should the merger go through. T is a Buy up to 35.

How do you say Posh in Spanish?

Though the Asia-Pacific is a larger area for luxury when considering the epic profit margins the region produces, Latin America is starting to get into the bling in a serious way. Last month, Euromonitor reported that both sales growth and the number of luxury outlets that opened in Latin America in the last two years rose by almost a quarter, which is the fastest growth on the planet, see Chart C. 

And it appears Brazil is not the ultimate destination for luxury retail, as one would expect, though it was and is still a very big market. In 2012, it was overtaken by Mexico as Latin America’s biggest luxury goods market, according to Euromonitor.

“The region’s second biggest economy – and the fifth largest emerging economy in the world after the BRICs with a GDP of $1.2tn – will more than double its current number of high income earners to 952,000 by 2030,” according to a report by the Financial Times.

“With a young and booming middle class that spent over $4bn last year on apparel, accessories and wine, wealth is now spreading into secondary and tertiary cities and international brands have been expanding their local footprint accordingly.

“Brands are starting to stray beyond the confines of upmarket department stores to open boutiques and offer home delivery services to broaden product availability to new consumers,” the FT report said, adding that Chile, Brazil, Colombia, and Peru are not far behind in spending on luxury.

Chart C: Latin America is one of the Fastest Growing Luxury markets

Source: Financial Times

Given the difficulty in finding true pure plays on Latin America in luxury (as most of these firms are global behemoths), we view these growth figures as yet more evidence of the incredible potential purchasing power that is occurring in Latin America and would invest in a broad measure of the economy – proxies that will benefit from increases in consumer spending.   

The Aberdeen Latin America Equity Fund (NYSE: LAQ), managed by the US arm of Aberdeen Asset Management, a money manager based in Scotland with $295 billion in assets under management, is one of those funds that offers a more balanced exposure to Latin America’s diversified economies. The fund’s top holdings are in financials, consumer staples and energy. Aberdeen has a total of 11 closed-end funds, with this one and the Aberdeen Chile Fund (NYSE: CH) covering Latin America.

For veteran exchange traded fund (ETF) investors, the annual expense ratio of 1.17 percent might seem high, but whereas some open-end funds charge 1 percent, it means regional funds are generally in the same range.

Given the weaker commodities’ emphasis in the portfolio—both Aberdeen funds weathered the emerging markets sell-off last year much better than their commodity-heavy fund counterparts—we have long expected they would rebound quickly as investors pile into the sector.

Aberdeen Latin America Equity Fund and Aberdeen Chile Fund are buys up to 36 and 15, respectively.

One other broad ETF that we would recommend is the IShares MSCI Emerging Markets Latin America (Nasdaq: EEML), which we highlighted earlier in the story and which has outpaced its broad, global emerging markets indices cousins. EEML is a Buy up to 48

Mexican Energy Reform A boon to US Energy Firms

As we reported in Personal Finance and in the Global Investment Strategist, earlier this year, Mexican President Enrique Pera Nieto recently passed legislation that overhauls Mexico’s energy policy, allowing Mexico’s national oil company, Petróleos Mexicanos (Pemex) and foreign oil companies to engage in profit-sharing activities.

For the first time in seven decades, North American energy companies could be allowed to operate in Mexico. While these reforms won’t allow foreign oil companies to tap Mexican oil, they would grant them a share of the profits.

Oil field services giants Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB) are best positioned to capitalize on Mexico’s new energy policy, we said last year, and continues to be in our view one of the best way to play this trend.

Halliburton and Schlumberger are two of the world’s largest oil field services operators, with market caps of $46 billion and $115 billion, respectively. These companies provide technological solutions to oil and gas exploration and production companies across the globe.

Both companies have a footprint in over 80 countries. Along with Weatherford International (NYSE: WFT) and Baker Hughes (NYSE: BNS), they comprise the giants in the industry, also known as the “Big Four.” Mexico allows only large oil field services companies with strong balance sheets and proven experience to operate within its oil and gas properties. These criteria impose a barrier of entry for small and medium-sized oil and gas drilling companies to winning profit sharing contracts with Pemex.

Mexico’s allowance of only profit sharing contracts combined with big oil’s demands for access to oil and gas assets puts large oil service sector companies in a prime position to win lucrative deals with Pemex.

Halliburton and Schlumberger have extensive experience working with the Mexican government. Their high-level contacts and proven track records in the country make them far more likely to win contracts than other large oil service sector companies such as Baker Hughes. HAL is a Buy up to 60, and SLB is a Buy up to 105