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Emerging-market enthusiasts got a jolt in early January when Venezuela's Hugo Chávez revealed a penchant for taking over foreign companies.
The move by Latin America's latest Fidel Castro-wannabe quickly shaved more than 20% off Venezuelan stocks.
Since then investors have calmed down, taking comfort in the fact that there are plenty of emerging-market opportunities outside of Venezuela. "We can find good bargains in more stable countries, so why take that risk?" says Mark Mobius, who manages the Templeton BRIC Fund (TPBRX), which targets companies in Brazil, Russia, India and China.
Indeed, only two diversified emerging-market funds have more than 1% of their holdings in Venezuela, according to Morningstar (MORN, news, msgs). So your risks of getting hit by fallout from the Chávez effect may seem pretty low if you get your emerging-markets exposure through funds.
But this may just be whistling past the graveyard. Emerging-market experts -- including Mobius -- acknowledge that you need to keep an eye on Chávez and his brand of "21st century socialism," because there are several ways it could nip your emerging-market gains.
Watch commodities trends
Risk scenario #1: A downturn in commodity prices hurts economic growth, helping Chávez spread his brand of socialism.Countries like Ecuador under President Rafael Correa and Bolivia under President Evo Morales are already in the Chávez camp. But other investor-friendly countries like Brazil, Chile, Colombia, Peru and Mexico could lurch to the left if a slump in global commodity prices saps economic strength in the region -- creating higher unemployment and political unrest.
"If you see a sharp turnaround in price of commodities like copper, iron or gold, that will have implications politically," says Michael Reynal of the Principal Funds International Emerging Markets Fund (PIEBX). The disaster scenario: More countries join Chávez in ramping up social spending programs, which would bring back inflation and derail economic stability. Or worse, some embrace his brand of nationalizing foreign holdings.
Giving a hint of what could happen, even without a push from an economic downturn, Argentine President Nestor Kirchner last week pledged to deepen ties with Venezuela, snubbing U.S. diplomatic efforts to neutralize the Chávez effect in the region.
Risk scenario #2: Flush with cash, the investor-friendly Latin American countries take a page from the Chávez book and implement their own brand of his socialism.
Leaders in Brazil, Chile, Colombia and Peru didn't miss the fact that Chávez was re-elected in a landslide victory last December. To shore up their political base, they may be tempted to use some of their oil and commodity wealth to put generous social programs in place that cause inflation and destabilize their economies.
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This would also satisfy a growing feeling among many in Latin America's resource-rich countries that foreigners are extracting too much wealth that should go to the people -- a feeling sparked in part by Chávez rhetoric.
If Latin American politicians lose the discipline on spending, that could bring back inflation and send investors heading for the exits. One particular risk: the fixed income investors in what's called the "carry trade." They are borrowing money at cheap rates in Japan and reinvesting in debt in countries like Brazil where they can earn much higher rates. "If inflation begins to pick up in Brazil and expectations that they will cut rates go away, you will get a lot of people dumping the carry trade and you have a big problem on your hands," says Don Elefson, the portfolio manager of the Excelsior Emerging Markets Fund (UMEMX).
Ecuador, Venezuela and nationalization
Risk scenario #3: Chávez saber-rattling upsets investors.The U.S. has clamped down on the shipment of military hardware to Venezuela, but that hasn't slowed down Chávez's military spending. He's continued to arm his country by purchasing weapons from Russia. Any hint of a military confrontation with the U.S. -- even if it's only rhetorical -- could spook the markets.
Risk scenario #4: Chávez's anti-U.S. rhetoric encourages Ecuador to default.
Ecuador is already at "significant risk of default" on its debt because the political system is so fractured it's hard for the country to make progress on economic reforms, says Lisa Schineller, the director of the sovereign ratings group at Standard & Poor's. If Chávez's rhetoric helps push the country over the edge and into default, that would rock markets throughout the region. It's never good to have an entire nation not paying its debts.
Risk scenario #5: Nationalization takes a turn for the worse.
To date, Chávez has compensated U.S. companies when nationalizing their holdings in Venezuela, even if it hasn't always been at a market price.
He's offered Verizon (VZ, news, msgs) $572 million for its 28.5% stake in Compania Anonima Nacional Telefonos de Venezuela (VNT, news, msgs) -- significantly less than the $676.6 million offered a year ago by Mexican billionaire Carlos Slim. AES Corp. (AES, news, msgs) got $740 million for its 82% percent stake in Electricidad de Caracas, a Venezuelan electric utility. And CMS Energy (CMS, news, msgs) was given $106 million for its 70% stake in Seneca, another power company.
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But all this could change. "The next round of re-nationalization might not happen at market price," cautions Cristina Panait, emerging-market strategist at Payden & Rygel Investment Management.
Besides outright takeovers, Chávez or other Latin American leaders could change the terms of contracts and joint ventures. Energy companies operating in the region are particularly vulnerable -- like British Petroleum (BP, news, msgs), ExxonMobil (XOM, news, msgs), Chevron (CVX, news, msgs) and ConocoPhillips (COP, news, msgs).
2 reasons to stay, and 4 stocks
All that said, there are at least two reasons why it still makes sense to own shares in Latin American countries -- as long as you avoid Venezuela and the two countries where leaders are in the Chávez camp, Ecuador and Bolivia.First, there are no big elections on the horizon. "We are through the cycle; 2006 was the year of the elections," says Julian Mayo of Charlemagne Capital. "Political risk is lower because you have the electoral uncertainties out of the way."
Second, the wealth from commodity and energy sales has built up the region's economic strength and spread to other sectors. "We are aware of this Chávez wave taking hold, but what strikes me more is how healthy the rest of the region is," says Reynal. "Inflation and debt levels are under control, interest rates are falling and economies are thriving."
Reynal says the way to play this is to own companies that are catching the rising tide of middle class wealth, like Banco Bradesco S.A. (BBD, news, msgs), a Brazilian bank; Cemex (CX, news, msgs), a cement company in Mexico that's a play on housing and infrastructure growth; and America Movil (AMX, news, msgs), a play on increasing use of cell phones in the region. Elefson likes Uniao de Bancos Brasileiros (UBB, news, msgs), a Brazilian bank that he thinks could be a takeover target.
At the time of publication, Michael Brush did not own or control shares of any of the companies mentioned in this column.
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