Tonight sees the opening ceremony of the Rio Olympic games. As a result, investors can expect to see plenty of headlines favouring the investment prospects of the Latin American giant.

However, rather than being blinded by the sporting stage, given all the political upheaval it has been through, investors need to approach the emerging market with caution.

The case for Latin America

At the start of the year, we expected the Federal Reserve to hike interest rates, there were concerns over the Chinese economy and it seemed emerging markets would be faced with a balance of payments crisis.

However since then those same concerns have all but disappeared and Latin America has benefitted from the improved financial conditions.

Thomas Smith, manager of the Neptune Latin America fund, explains that Brazil has seen a huge improvement in the political landscape.

In May, Congress proceeded with the impeachment of President Dilma Rousseff and her Vice President Michel Temer took over as interim president. The impeachment will be voted on this month but it looks very likely the Senate will vote to confirm the impeachment.

Smith says: “Temer’s appointment of a market-friendly cabinet has helped support the rally in the equity market and the currency. We have seen huge outperformance from those emerging markets pursuing a reform agenda in recent years.

“Mexico was one of the first in 2012 with the election of Enrique Pena Nieto, followed by India and Indonesia in 2014 with Modi and Jakowi, and most recently in Argentina with the election of Mauricio Macri in October 2015. Brazil is now getting increasing attention from investors and the reform story is moving forward.”

Inflation peaked at nearly 11% in December, but it seems Brazil has reigned this in and Smith says this could fall to less than 7% by year end to approach the Central Bank’s target range for the first time since December 2014.

The Brazilian real has strengthened by nearly 30% against the US dollar since January and the current account deficit has also begun to close.

He adds that consumer confidence is rising and the economic and political environment, along with an acceleration of the government’s infrastructure program, “should lead to a ramp up in investment and help lift Brazil out of recession next year”.

The graph below from FE shows how MSCI Brazil has fared in comparison with MSCI Emerging Markets Latin America and the MSCI World index, year-to-date.

‘Despite Latin America market euphoria, we urge caution’

Olympic host nation Brazil has been in dire straits, suffering from gross economic mismanagement, poor governance and it’s been plagued by corruption scandals. As a result, Brazil’s been an investment basket for the past six years.

Jason Hollands, managing director, business development and communications at Tilney Bestinvest, acknowledges that Latin American markets, led by Brazil have surged on a wave of exuberance around political change.

At the prospect of impeachment, the MSCI Brazil Index has rocketed 86% over the last six months in sterling terms. However despite the market euphoria about a shift in political leadership and encouraging signs of economic reform, Hollands urges caution to any investors considering piling into specialist Latin America regional funds on the back of such a steep rally.

He says it would be naïve to expect a quick fix to the deep problems of the Latin American economies. Brazil, the region’s largest economy, faces considerable economic challenges such as a huge public debt problem and inflation of nearly 7% at a time when inflationary pressures around the globe are weak.

Hollands says: “Markets have an unfortunate habit of being overly bullish in their expectations around the pace of change that will stem from political developments. Markets move quickly but politics is a grinding process of debate, alliance building and compromises.

“We have seen this mismatch in market expectations and political delivery in recent years with Abenomics in Japan, the high hopes for the BJP-led administration in India and to a large extent China which held out the lofty goal of rebalancing its economy toward the consumer but has reverted back into yet more credit-fuelled stimulus.”

He adds that other external factors could abruptly arrest the ecstatic Latin American equity rally, such as a reversal in the commodity rebound that took many investors by surprise in the first half of the year.

“But perhaps the key risk for investors contemplating jumping on the Latin America bandwagon at this stage could come from the US Federal Reserve, which has dilly-dallied throughout 2016 over when it might hike rates again. For now markets are assuming a more dovish scenario, which has helped soften the dollar and in so doing provide some respite for emerging markets.

“But if the Fed decides to slam the brakes on more aggressively than anticipated as it concludes systemic risks from doing so have abated, then the like resulting spike in the dollar could prove quite ugly for emerging markets, especially those which have spiralled higher so rapidly on a carnival of hope around political reform.”

Investors should also consider one other factor – Donald Trump’s presidential race.

Hollands says: “Even if you discount the plausibility of Trump’s outlandish claim that he will build a wall to seal the US border with Mexico (and ask the Mexicans to pick up the tab), his protectionist stance and commitment to repatriate manufacturing jobs to the US would be damaging for Latin America if given effect as the region plays an important role in the supply chain for US businesses such as the automotive industry.”

He concludes that investors should enjoy the sports and hope that Latin American will claw its way out of its malaise, but from an investment perspective “don’t get carried away”.

The graph below shows the volatility of the MSCI Brazil over the past six years (in dollar terms). Source MSCI. 

What’s the best way to access Latin America?

If you are considering investing in the region, Hollands says it may be wise to do so via global emerging market funds or investment trusts, rather than specialist regional funds.

“Bearing in mind Brazil accounts for just 7.2% of the MSCI Emerging Markets Index, vehicles which have overweight positions include JP Morgan Emerging Markets Investment Trust (12.4%) and Templeton Emerging Markets IT (12%).”

For Smith, the banking sector and companies with bond-like characteristics such as property and infrastructure are set to benefit the most.

Smith says: “The private banks such as Itau and Bradesco are also benefiting from an improved competitive environment as the public banks over extended themselves in recent years trying to stimulate the economy and are now having to take a step back. Spreads have been rising and return on equity has risen well above 20% at Itau. This combined with a significant fall in the cost of equity should lead to a strong rerating, from the depressed levels of around 1x price to book in the first quarter for Itau, and below 1x for Bradesco.”

He adds the drought-induced water crisis in Brazil, together with the prospect of electricity rationing, caused share prices to decline with the MSCI Brazil Utilities Index falling by over 80% from its 2011 high.

“As Brazil emerges from the water crisis and reservoir levels normalise, and as the outlook for much more constructive regulation towards the sector, earnings are expected to recover along with share prices.”