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08/03/2011

Peru (Part II): Currency and Equities


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CURRENCY: SHEDDING LIGHT ON THE NUEVO SOL | ACCESSING PERU'S EQUITIES | PERUVIAN EQUITY PERFORMANCE | EQUITIES, LOOKING FORWARD

Part I of Worldview’s Peru coverage discussed Peru’s recent macroeconomic history and political economy, noting that Peru has been an impressive economic story that has stayed largely under the media radar. The recent election of Ollanta Humala, a candidate with a history on the far left of the political spectrum has cast the future performance of the economy into question, even if—as part of his runoff campaign—he has promised to govern the country from center-left policies rather than the far-left of Peru’s political spectrum and his base coalition. This piece examines the performance of Peru’s currency and equity markets and considers the attractiveness of the asset markets going forward.

CURRENCY: SHEDDING LIGHT ON THE NUEVO SOL

Peru’s currency is the Nuevo Sol, a name originally derived from the Roman gold “solidus,” but Sol also translates as “Sun,” replacing an earlier currency, the Inti, Inca word for “Sun.”

Peru’s economy is partially dollarized, which means that prices in Peru can be quoted in Nuevo Sols or dollars, with the two currencies operating more or less in parallel. Partial dollarization was used as a method to control inflation and reassure consumers and investors of the seriousness of keeping it brought under control. Partial dollarization has the advantage of instilling some financial security and trust while providing the central bank some latitude to pursue independent monetary policy when needed.

Figure A: Peru’s Nuevo Sol (PEN) versus Two Major World Currencies

Peru Nuevo Sol versus Two Major World Currencies

Source: Bloomberg (accessed 28 July 2010)

Figure A shows the strength of the Peruvian Nuevo Sol (PEN) versus the US Dollar and the Euro. It illustrates three important features of the Sol. Firstly, the Sol has tended to strengthen relative to the USD, which not surprising for an economy linked to the commodity sector at a time of rising commodity prices. Secondly, this strengthening partly reflects the ongoing depreciation in the USD relative to many world currencies. Indeed, the Sol exchange rate versus the Euro has actually been more stable (albeit noisy) since 2004.

This degree of PEN/EUR stability is unusual, given that dollarization programs usually tries to keep to the PEN/USD rate both smooth and stable. Peru appears to be keeping the dollar exchange rate smooth, while trying to keep the Euro exchange rate stable.

Conceptually, the Sol can be grouped with the commodity currencies such as the Canadian and Australian Dollars, Chilean Pesos, and the Brazilian Real. In policy, President Humala has just reappointed Julio Velarde from the previous administration to continue as president of Peru’s central bank. Local markets surged on this announcement, since it offers some concrete evidence that Humala intends to honor his promise to respect the recent market reforms and economic integration policies of his predecessors. Should this pattern continue, then it is likely that the currency will continue to strengthen and provide a currency boost to foreign investors in Peru.

In recent years, the Sol has been appreciating a little more than 3% per year against the USD and about 1.5% against the Euro. Barring a capital strike from investors due to a dramatic change in policy, the Sol remains likely to continue this trend, and may be an attractive currency in which to take exposure.

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ACCESSING PERU'S EQUITIES

Peru’s stocks are traded primarily on the Bolsa de Valores de Lima (BVL), which World Federation of Exchanges (WFE) reports as having a market capitalization of US$ 103 Billion at the end of 2010.

One concern in Peruvian equities is the relatively low turnover rates, suggesting that there is substantial liquidity risk. For example, WFE records just under $5 billion USD in share turnover for 2010, approximately 4.8% of market value. Similar WFE data for the NASDAQ/OMX and NYSE/Euronext exchanges in the United States show a (combined) market value of around $17.3 trillion in 2010 and turnover of $30.4 trillion, about 175%.

Even though the WFE data warns that non-electronic trade volumes are not yet available for years after 2009, the turnover difference (5% vs 175% annually) and implied liquidity differences are still substantial. Non-electronic trades could be double the quantity of electronic trading (which would be high compared to pre-2009 totals) and the turnover rates would still be very small compared to developed markets.

Smaller investors can access Peru’s market through EPU, the iShares ETF that tracks the MSCI All Peru Capped Index (referenced in the section below). As of 1 August 2011, the iShares Peru ETF page shows EPU as having a market capitalization of just over $508 million.

To the extent that the EPU ETF is a representative sample of the stock index, Figure X shows that public equities are dominated by the materials sector (60%) and financials (19%), with the remainder divided amongst a smattering of companies in consumer staples, industrials, utilities, and energy. Thus, equity index exposure is—like Russia—very much a play on the global boom in commodities.

Figure X: Industry Exposure of Peru Equity ETF

Industry Exposure of Peru Equity ETF

Source: Black Rock iShares website (Accessed 1 August 2011)

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PERUVIAN EQUITY PERFORMANCE

Figure B shows the time series performance of the MSCI all-cap Peru equity index compared to regional neighbors and global benchmarks over the period from 1 January 1999 to 22 June 2011. All indexes and calculations in Figures B through D as well as Table B reflect total returns before taxes and are calculated based on weekly returns. The equity curves are normalized to a starting value of 100 on 4 January 2004, the first year-start for which there is data on all indexes in the chart (the MSCI BRIC index begins in November 2003).

Figure B: MSCI Equity Index Curves for Peru and Comparables: 1999-2011

MSCI-Equity-Index-Curves-for-Peru-and-Comparables-1999-2011

Source: Bloomberg (accessed 28 July 2010); cash returns on 90d Treasury bills calculated from Fed data (FRED, accesed 30 July 2010).

In absolute returns, two countries stand out in Figure B—even by emerging markets standards: Peru, and Brazil. Both countries are impressive before and after the 2008 market crash. During the crash, Peru’s stock returns took a correspondingly substantial hit, collapsing by over 67% from its previous peak in April 2008.

Like Brazil and several other emerging markets, Peru’s 2008 stock decline tracked the collapse in global commodity prices more than the later banking crisis in the United States, although that hurt as well. By 22 July 2011, as this article is written, Peru’s index has recovered and advanced nearly 330% from of its post-crash low (October 2008), delivering courageous enough investors an annualized return of about 70% for nearly three years running. Obviously, perfect timing is an unrealistic demand of any investor, but even a rough approximation of the opportunity would have been handsomely rewarded.

Figure C: Peru’s Nuevo Sol (PEN) versus Two Major World Currencies

Returns-vs-Total-Risk-for-Indexes

Source: Bloomberg (accessed 28 July 2010); cash returns on 90d Treasury bills calculated from Fed data (FRED, accesed 30 July 2010).

Figure C puts Peru’s all-cap index and other benchmark returns in a risk-adjusted framework, showing the average annualized return versus total annualized risk (measured as standard deviation) using weekly returns from 1 Jan 1999 to 22 June 2011. Over this period, the emerging markets have outperformed the MSCI ACWI world and US indexes generally, and the Latin American indexes have outperformed MSCI’s broad emerging market index (as well as China).

Peru stands out on this chart even among the Latin American countries for delivering exceptionally high returns for its level of volatility. The Sharpe ratio captures this performance numerically: Peru’s Sharpe ratio for the period as 0.789, versus 0.609 for Brazil, 0.355 for China, and 0.084 for the United States, as shown in Table B. If one were to lever down an exposure to Peru to deliver volatility similar to the US market, a dollar-based investor in Peru would have averaged around 17.9% annually, versus to 14.4% for Brazil, 9.5% for China, and only 4.2% for the United States.

Figure D: Returns vs MSCI ACWI Beta

Returns vs MSCI ACWI Beta

Source: Bloomberg (accessed 28 July 2010); cash returns on 90d Treasury bills calculated from Fed data (FRED, accesed 30 July 2010).

Figure D plots the security market line of country returns versus their beta to MSCI’s ACWI world equity returns. This shifts the focus to the non-systemic or “alpha” portion of returns, i.e. returns from sources that cannot be replicated by adjusting world index exposure. Ultimately it is the alpha returns that would justify overweighting a country like Peru versus its weight in the world benchmark, and Peru has delivered just over 20% in annual alpha.

All emerging markets in this small sample perform well on this measure, and Latin American markets tend to do even better. Peru and Brazil are still the most outstanding performers over this time period. Peru actually delivers approximately 1% more alpha than even Brazil. And, unlike Brazil, Peru’s long term beta to the ACWI is close to 1, meaning that the systemic risk of Peru exposure not much different from the world market as a whole. In contrast, Brazil’s systemic risk is substantially higher, about 50% higher. It should be noted, however, that Peru’s beta has been creeping slowly higher in recent years, approaching 1.3 for the period since 2009.

Figure E: Decomposition of Index Returns vs ACWI

Decomposition of Index Returns vs ACWI

Source: Bloomberg (accessed 28 July 2010); cash returns on 90d Treasury bills calculated from Fed data (FRED, accesed 30 July 2010).

Figure E breaks down historical returns into three components: 1) the time value of money, or returns achievable through cash investments; 2) returns from beta, or those that come from correlations to world equities; and 3) returns from alpha, those that come from other sources. Again, Peru and Brazil stand out, but the separation of systemic and non-systemic return sources is easier to see in this figure. Also note that the United States delivered negative alpha over the period; largely a result of the financial crisis and housing bubble.

Table B: Return, Volatility, Correlation, and Alpha data for Selected Indexes

Quantitative Statistics on Indexes

Source: Bloomberg (accessed 28 July 2010); cash returns on 90d Treasury bills calculated from Fed data (FRED, accesed 30 July 2010).

Table B presents further quantitative figures based on weekly returns over the same time period (1 Jan 1999—22 June 2011). Much of the data has been presented in previous graphics, but two additional points are worth mentioning. First, the table shows that Peru benefits from a relatively low correlation to world markets, compared to other countries and indexes. It is thus a good diversifier as well as a return enhancer. Chile, a neighbor with similar export industries has a similar degree of correlation, but lesser alpha. Secondly, the relatively high information ratio shows that Peru’s alpha returns can be accessed with less additional volatility risk, compared to the alpha offered by other countries in the table.

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EQUITIES, LOOKING FORWARD

Naturally, past performance is no guarantee of future results, but given the past outperformance, is there reason to believe that Peru will continue to perform as well into the future? One key data point from Table B is that Peru’s correlation to equity returns in China (r=+0.425) is actually lower than the correlation with any other index in the table.

This data flies in the face of conventional wisdom, which attributes Peru’s performance to China’s almost insatiable demand for commodities, particularly copper. The low correlation offers evidence that China and Peru are not quite as tightly coupled as investors might fear, and Peru may, in fact be an excellent diversifier for a portfolio that includes China, and positive returns in Peru need not track China’s economic fortunes that closely.

It seems likely that forward looking returns in Peru’s stock market will not be quite as spectacular as they have been in the past, but will still be generally attractive to investors. Part of this has to do with policy uncertainties following Humala’s election, and part has to do with the fact that alpha related returns were quite high in the early part of the historical sequence, and that more recent returns, while still high in alpha, are increasingly related to beta instead of alpha, suggesting that investors are slowly “discovering” Peru. The last 12 months has not produced substantial alpha, given the turbulence of the election; nonetheless, there is still a reasonable dose of potential remaining.

Shortly after President Humala’s victory in Peru’s runoff election, Lima’s stock market index dropped suddenly by about 12.5%, as investors panicked over the prospects of a leader with strong connections to the far left. Obviously, this fear and this volatility reflects that Peru is not without risks, and it is very likely that economic growth and the returns to capital will be at least somewhat reduced by new, more socially motivated policies. However, the flip side of a market crash is that—to the extent that business profits are not seriously undermined—future returns should increase to reflect new levels of perceived risks. Indeed, in less than two months, the Lima stock market has regained virtually all of its post-election losses. If Humala is serious about keeping the major features of an open market intact, then Peru really is likely to continue delivering attractive returns comparable to its performance in recent years.

–Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Consulting, an independent consulting firm specializing in quantitative, emerging-market, and SRI research and strategy.

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