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The recent sell-off of Latin American currencies presents
an interesting opportunity for the US dollar-based real
estate i...
Diversification benefits at play, with less volatility than might be expected
THE IMPORTANCE OF CURRENCY TO LATIN AMERICA ...
Diversification benefits at play, with less volatility than might be expected
THE IMPORTANCE OF CURRENCY TO LATIN AMERICA ...
Diversification benefits at play, with less volatility than might be expected
THE IMPORTANCE OF CURRENCY TO LATIN AMERICA ...
Diversification benefits at play, with less volatility than might be expected
THE IMPORTANCE OF CURRENCY TO LATIN AMERICA ...
Diversification benefits at play, with less volatility than might be expected
THE IMPORTANCE OF CURRENCY TO LATIN AMERICA ...
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Jamestown Latin America | Trends + Views | Currency Analysis

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In this note, we discuss the topic of currency from the perspective of the real estate investor in the region. Currency risk is frequently cited as an important factor when considering a real estate investment in Latin America. Over the past half decade, returns for foreign investments allocated to Latin America have been enhanced by the appreciation of currencies such as the Brazilian real, the Colombian peso, the Chilean peso, and the Peruvian sol.

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Transcript of "Jamestown Latin America | Trends + Views | Currency Analysis"

  1. 1. The recent sell-off of Latin American currencies presents an interesting opportunity for the US dollar-based real estate investor in the region. Year to date, currencies in Brazil, Colombia, and Peru have all depreciated by a significant amount and in the specific case of Brazil, the real has lost 1/3 of its value since April 2011. For the dollar-based investor however, the weakening currencies increase the purchasing power of assets in local economies. Furthermore, future currency risk in our view is somewhat minimized as currencies such as the real have moved from a position of overvaluation to a fairer value. Given that the real is no longer viewed as one of the most expensive currencies in the world, the risk of a major depreciation is lessened, if not already in the rear-view mirror. Meanwhile, the US dollar-based investor can acquire an asset at a substantial discount, compared to 2010-11, when currencies in the region were expensive and there was perhaps excessive froth in the financial markets of certain countries in the region. In this note, we discuss the topic of currency from the perspective of the real estate investor in the region. Currency risk is frequently cited as an important factor when considering a real estate investment in Latin America. Over the past half decade, returns for foreign investments allocated to Latin America have been enhanced by the appreciation of currencies such as the Brazilian real, the Colombian peso, the Chilean peso, and the Peruvian sol. For example, an investment in Brazilian real estate would have added an annual internal rate of return (IRR) of 7.5% from currency alone if the investment had been made on the last day of 2008 and exited exactly three years later.1 Currencies in Latin America have benefited over the past several years from a combination of a number of factors, namely: 1) Favorable terms of trade (reflecting stronger prices for Latin American exports relative to its imports), as the prices of a multitude of key commodities for the region, such as oil, soybeans, iron ore, copper, gold, and others enjoyed multi-year rallies and in many cases reached all-time highs, thanks in part to robust demand from China; 2) Easy monetary policy in the developed world, led by the U.S. Federal Reserve’s quantitative easing program. With interest rates at or near zero in the G-3, capital shifted to those countries where “carry” could be earned, i.e., the higher yielding currencies of Latin America.2 3) A positive economic growth differential between LatinAmerica and much of the rest of the world, especially developed countries; 4) Improved economic fundamentals in the region, as inflation rates fell, fiscal deficits were reduced, and governments for the most part adopted relatively market friendly policies. However, the tides have turned somewhat in recent months. Terms of trade for LatinAmerica are no longer as favorable. Interest rates in the developed world, namely the United States, have been rising, which presumably will attract capital back into the U.S. and away from Latin American markets. Due to these developments, growth in Latin America is slowing, suggesting that the region’s PAGE 1 Diversification benefits at play, with less volatility than might be expected THE IMPORTANCE OF CURRENCY TO LATIN AMERICA REAL ESTATE INVESTORS 1 Based on data provided by Bloomberg, the real ended 2008 at 2.31 versus the US dollar, and finished 2011 at 1.87. At its low during the 2008-09 financial crisis, the real reached a 2.51 closing level on December 8, 2008. Its strongest point during the last years was 1.54, on July 26, 2011. 2 The August 10-16, 2013 edition ofThe Economist provides commentary on this factor, in an article titled “Carry on trading,” suggesting that high yields have been a prime determinant of currency returns. Currency has been an important component of overall returns for the dollar-based Latin America real estate investor.
  2. 2. Diversification benefits at play, with less volatility than might be expected THE IMPORTANCE OF CURRENCY TO LATIN AMERICA REAL ESTATE INVESTORS growth differential against the rest of the world may shrink. Consequently, while factor #4 from the above paragraph remains generally intact, points #1-3 have shown signs of reversal, pressuring Latin American currencies. Instead of fighting “currency wars” and the relentless appreciation of their currencies, officials now face weakening currencies, and in some cases have carried out interventions in the market to prevent further weakness.3 How should a real estate investor in the region deal with currency risk in this changing climate? With the macro outlook shifting globally, the types of returns that currency exposure generated over the last half decade are unlikely to be repeated. However, the moves in the Brazilian real (12% weaker year to date through August), the Peruvian sol (-10%), the Colombian peso (-7%), and the Chilean peso (-6%) also imply that currencies are closer to fairly valued than 9-12 months ago. While judging fair value of a currency is an inexact science, one of the most popular measures – The Economist magazine’s comparison of the prices of McDonald’s Big Macs across the globe – provides clues of overvaluation. Another quantitative way to judge overvaluation is via trends in the current account deficit. In the aforementioned four countries, current account deficits have widened, as strong domestic demand, aided by appreciating currencies, has raised import bills. For example, even with somewhat favorable terms of trade, Peru’s current account deficit ended 2012 at -3.5% of GDP; in 2005-07 it ran surpluses. Chile’s current account deficit was also -3.5% of GDP last year, its highest since 1998. Potentially these large current account deficits were signs of overvaluations of these countries’ currencies. A more qualitative way to judge currency valuation is the “smell test.” Brazilians flocking to the 5th Avenue shopping district in New York and lugging massive boxes to JFK Airport on their way home seems like a sign of overvaluation. Indeed a growing line item in Brazil’s current account deficit has been the one for foreign travel. This has repeatedly hit record levels, i.e., Brazilians spending much more abroad than foreigners do within Brazil, with this deficit exceeding US$1 billion per month. Conversely, American travelers to Brazil have complained for several years about the high costs of cities such as Sao Paulo and Rio de Janeiro, where quality hotels and restaurants cost more (until the recent depreciation of the real) than in almost any major American city. Assuming that Latin America’s currencies are currently more aligned with fair value, real estate investors in the region may actually benefit. Better to enter Brazil with the real at 2.30 than at 1.60, as each dollar buys proportionately more assets, while the risk of a mega- depreciation has likely fallen if overvaluation is less of a concern. But, beyond this, we wanted to look at other considerations for real estate investors in the region. We examined daily data, from the first day of 2008 through mid-August 2013, to try to assess any particular trends in currencies that might have implications for someone investing in hard assets in the region in 2013. By sifting through calculations of correlations and volatilities, we draw the following conclusions: • The five major currencies in the region all have positive correlations with each other, over the time period examined. For example, the correlation of daily returns between the Brazilian real and the Mexican PAGE 2 Signs of overvaluation of certain Latin American currencies are disappearing. 3 The term “currency wars” was coined by Brazil Finance Minister Guido Mantega, where he blamed the developed world’s lax monetary policies for the relentless appreciation that the real experienced in 2009-11.
  3. 3. Diversification benefits at play, with less volatility than might be expected THE IMPORTANCE OF CURRENCY TO LATIN AMERICA REAL ESTATE INVESTORS peso is 62% (see the below table). However, while the correlations of returns are always positive, they also vary. For example, the correlation of the Peruvian sol with the Brazilian real is just 27%, implying that there is some diversification benefit to holding soles in a portfolio of real- denominated assets.4 This is not surprising given the mechanisms the Peruvian central bank uses to take an active role in managing the volatility of its currency. Real estate investors in the region should note that diversification benefits can be earned by holding a basket of Latin American currencies, that holding assets in Peru, Chile, Colombia, etc., can help offset Brazilian real risk for example. • The U.S. stock market has a high correlation with currency returns in the region. Over the time period examined, the SP 500 index, one of the best proxies for the U.S. equities market, displayed a 56% correlation with the real and a 66% correlation with the Mexican peso. Hence, on a day-to-day basis Latin American currencies historically followed the SP, but this relationship has shifted in recent months.Year to date the correlation between the real and U.S. equities has fallen. But over a longer-term time horizon, the region’s currencies, considered by the market to be “risk assets,” are not much of a diversifier against U.S. stocks, also viewed as risk assets. • Latin American currencies are often considered “commodity currencies.” Indeed the correlations here are positive, as all five currencies display positive correlations between 26% and 47% against the CRB Index, a proxy for commodity prices. But interestingly, Mexico a major oil producer had a 34% correlation with oil prices, while Chile, a copper giant, saw its peso only 29% correlated with the daily returns of that metal. While commodity prices matter, they are perhaps not as important a determinant of Latin American currency returns as many might perceive. • What about China? If one correlates the Shanghai stock market and Latin American currencies, the correlations are positive, but low. • From a portfolio management standpoint, it appears that Latin American currencies do provide some diversification against other classes but this benefit can be limited depending on the asset composition of one’s portfolio. Currencies in the region tend to appreciate, based on the data, when commodity prices rise, U.S. equities rise, U.S bond yields fall, market volatility (as expressed by the VIX index) is low, and when Chinese markets are performing well. None of this should be surprising but what might garner interest is the degree to which each of these other assets classes does or does not match currency returns in the region. PAGE 3 4 If the correlation between two currencies is 100%, there would be no diversification benefit to holding that second currency.The lower the correlation the better the diversification benefits. Correlations between Latin American currencies and commodities prices are lower than might be expected. Holding a basket of Latin American currencies provides important diversification benefits.
  4. 4. Diversification benefits at play, with less volatility than might be expected THE IMPORTANCE OF CURRENCY TO LATIN AMERICA REAL ESTATE INVESTORS • We also examined the correlations of the region’s currencies with other major currencies, dating back to 2000. We note that the Latin American currencies tend to have low correlations with the world’s major currencies such as the yen (negative in fact), the euro, and the pound. Correlations are higher with other EM currencies, such as the South African rand and the Australian dollar. This is to be expected given that these economies share similar traits with Latin America, namely a large portion of their exports are commodities. Correlations with the Chinese yuan are low, likely reflecting the management of the CNY by the authorities. PAGE 4 BRL MXN CLP COP PEN SP UST VIX CRB EUR COPPER OIL SHANGHAI BRL - 0.62 0.41 0.42 0.27 0.56 -0.27 -0.47 0.47 -0.42 0.26 0.36 0.12 MXN 0.62 - 0.37 0.32 0.23 0.66 -0.33 -0.57 0.41 -0.45 0.25 0.34 0.11 CLP 0.41 0.37 - 0.44 0.28 0.33 -0.17 -0.32 0.43 -0.34 0.29 0.33 0.18 COP 0.42 0.32 0.44 - 0.35 0.27 -0.16 -0.26 0.39 -0.31 0.23 0.32 0.17 PEN 0.27 0.23 0.28 0.35 - 0.18 -0.10 -0.16 0.26 -0.18 0.12 0.20 0.13 SP 0.56 0.66 0.33 0.27 0.18 - -0.47 -0.76 0.44 -0.38 0.26 0.41 0.08 UST -0.27 -0.33 -0.17 -0.16 -0.10 -0.47 - 0.45 -0.31 0.16 -0.20 -0.29 -0.04 VIX -0.47 -0.57 -0.32 -0.26 -0.16 -0.76 0.45 - -0.37 0.34 -0.21 -0.36 -0.08 CRB 0.47 0.41 0.43 0.39 0.26 0.44 -0.31 -0.37 - -0.46 0.43 0.81 0.18 EUR -0.42 -0.45 -0.34 -0.31 -0.18 -0.38 0.16 0.34 -0.46 - -0.22 -0.37 -0.10 COPPER 0.26 0.25 0.29 0.23 0.12 0.26 -0.20 -0.21 0.43 -0.22 - 0.30 0.15 OIL 0.36 0.34 0.33 0.32 0.20 0.41 -0.29 -0.36 0.81 -0.37 0.30 - 0.18 SHANGHAI 0.12 0.11 0.18 0.17 0.13 0.08 -0.04 -0.08 0.18 -0.10 0.15 0.18 - TABLE 1: CORRELATIONS OF DAILY RETURNS FOR LATIN AMERICAN CURRENCIES VERSUS A OTHER PROMINENT ASSET CLASSES, JANUARY 2008-PRESENT BRL: Brazilian real; MXN: Mexican peso; CLP: Chilean peso; PEN: Peruvian sol; SP: SP 500; UST: U.S. 10 yearTreasury yield; VIX: VIX Index; CRB: CRB index of commodities prices; EUR: Euro; Copper: Copper spot price; Oil: WTI spot; Shanghai: Shanghai Stock Exchange Composite Index. BRL COP MXN CLP PEN JPY -0.11 -0.08 -0.17 -0.03 -0.04 EUR 0.24 0.19 0.25 0.23 0.09 GBP 0.23 0.17 0.26 0.20 0.07 INR 0.16 0.24 0.18 0.22 0.16 CNY 0.01 0.05 0.02 0.08 0.01 ZAR 0.38 0.26 0.47 0.30 0.14 RUB 0.23 0.27 0.31 0.31 0.16 IDR 0.06 0.13 0.05 0.12 0.07 AUD 0.38 0.29 0.43 0.35 0.17 TABLE 2: CORRELATIONS SINCE JAN 1, 2000 JPY: Japanese yen. EUR: euro. GBP: British pound. INR: Indian rupee. CNY: Chinese yuan. ZAR: South African rand. RUB: Russian ruble. IDR: Indonesian rupiah. AUD: Australian dollar.
  5. 5. Diversification benefits at play, with less volatility than might be expected THE IMPORTANCE OF CURRENCY TO LATIN AMERICA REAL ESTATE INVESTORS • Over the most recent five year period, we note that the correlations are higher than for the period since 2000: • We also note that over the last year, the correlations have fallen somewhat, especially for the BRL versus the EUR. This is a function of the depreciation that has occurred in recent months for Latin American currencies: • Regarding the volatility of LatinAmerican currencies, it may be surprising to some observers that the region’s currencies, in general, exhibit similar volatility to that shown by the world’s major currencies. The standard deviation of daily returns of the real since 2000 was 1.05%, highest in our group of five Latin American currencies. The other countries displayed standard deviations ranging from 0.27% in the case of Peru to 0.68% for Mexico. Interestingly, the same calculation for the euro delivers a standard deviation of 0.65%, implying the euro experiences nearly the same daily volatility versus the dollar as the Chilean peso (0.63%) and the Colombian peso (0.65%). • If we extend the analysis to compare Latin American currencies to other major currencies in the developed world and emerging markets, we see the following: PAGE 5 BRL COP MXN CLP PEN JPY -0.21 -0.11 -0.24 -0.09 -0.07 EUR 0.42 0.31 0.44 0.34 0.18 GBP 0.39 0.27 0.42 0.28 0.14 INR 0.23 0.29 0.24 0.30 0.19 CNY 0.02 0.07 0.04 0.11 0.01 ZAR 0.60 0.37 0.65 0.39 0.22 RUB 0.34 0.35 0.38 0.40 0.21 IDR 0.10 0.18 0.08 0.19 0.12 AUD 0.60 0.39 0.60 0.46 0.23 TABLE 3: CORRELATIONS SINCE JAN 1, 2008 JPY: Japanese yen. EUR: euro. GBP: British pound. INR: Indian rupee. CNY: Chinese yuan. ZAR: South African rand. RUB: Russian ruble. IDR: Indonesian rupiah. AUD: Australian dollar. BRL COP MXN CLP PEN JPY -0.18 -0.03 -0.02 0.01 -0.08 EUR 0.20 0.20 0.37 0.20 0.10 GBP 0.12 0.08 0.29 0.19 0.00 INR 0.00 0.26 0.15 0.25 0.22 CNY -0.05 0.03 0.02 0.01 0.06 ZAR 0.40 0.18 0.54 0.31 0.21 RUB 0.23 0.41 0.41 0.47 0.31 IDR 0.09 0.07 0.11 0.11 0.07 AUD 0.36 0.22 0.48 0.37 0.20 TABLE 4: CORRELATIONS LAST 52 WEEKS JPY: Japanese yen. EUR: euro. GBP: British pound. INR: Indian rupee. CNY: Chinese yuan. ZAR: South African rand. RUB: Russian ruble. IDR: Indonesian rupiah. AUD: Australian dollar. SINCE JAN 2000 LAST FIVEYEARS Brazilian real 1.05% 1.16% Mexican peso 0.68% 0.94% Colombian peso 0.65% 0.78% Chilean peso 0.63% 0.73% Peruvian sol 0.27% 0.30% Euro 0.65% 0.72% Japanese yen 0.65% 0.74% British pound 0.58% 0.68% Indian rupee 0.39% 0.56% Chinese yuan 0.08% 0.10% South African rand 1.13% 1.24% Russian ruble 0.46% 0.70% Indonesian rupiah 0.70% 0.63% Australian dollar 0.87% 1.10% TABLE 5: STANDARD DEVIATION OF DAILY RETURNS FOR MAJOR LATIN AMERICAN AND WORLD CURRENCIES Source: Bloomberg and Jamestown Latin America calculations.
  6. 6. Diversification benefits at play, with less volatility than might be expected THE IMPORTANCE OF CURRENCY TO LATIN AMERICA REAL ESTATE INVESTORS Overall, with the exception of Brazil, Latin American currencies exhibit volatility that is similar to the euro and yen. For example since 2000, the Chilean peso, Colombian peso, and Mexican peso, as can be viewed above, displayed almost the same daily movements, on average as the other G-3 currencies. • The real displays the highest standard deviation of the major currencies in the region, but is still less volatile than the South African rand. One should keep in mind however, that for the most part the real, as well as most other Latin American currencies, have been freely floating. In contrast, currencies in countries such as India and China see greater levels of intervention and control by the authorities, which reduces their daily movements. • It is particularly noteworthy that the Australian dollar exhibits very similar volatility to the real over the last five years. • Volatilities over the last five years are higher than for the entire period since the start of the century, as the former period is more impacted by the volatility that followed the Lehman bankruptcy in 2008. • We believe that volatility of Latin America currencies compares favorably with the rest of the world because economic fundamentals in the region have improved, markets have become more liquid, and central banks hold arsenals of reserves to offset major currency moves. As a result, the region’s exchange rates have been less susceptible to wild swings over short time horizons. In a future piece we will examine how real estate can serve as a hedge against inflation and currency movements. During times of depreciation, for example we can expect that certain owners of office space can adjust their rents in real terms, thus maintaining the dollar-adjusted value of the property. In conclusion, currency performance can be a prime determinant of returns for the real estate investor in Latin America. The steadfast appreciations of the past years are unlikely, in our view, to be repeated. But, by holding assets in a group of countries within the region, some diversification benefits can be achieved. Volatilities for Latin American currencies are comparable to most developed markets currencies, and central banks are actively involved to prevent major swings in currencies, which could further the case against hedging. Purchasing a two-year hedge on the real for example costs approximately 18% (2.73 for a two year NDF versus 2.31 for the current spot rate). The investor relinquishes approximately 9% per annum in return for currency protection. While we wouldn’t try to predict where the real will be in 24 months, we do know that the central bank holds reserves totaling US$375 billion, which it can use to prevent further weakness. PAGE 6 Central banks in the region hold plenty of firepower to offset further depreciation pressures. JAMESTOWN LATIN AMERICA Real Estate Private Equity www.jamestown-latam.com Contact: Bret Rosen – Managing Director, Research +1 212-652-2141 brosen@jamestown-latam.com Rio de Janeiro • Bogotá • Atlanta • New York

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