Why Latin American Stocks Could Get Hot

Domestic demand looks promising, unless the developed world pulls emerging markets under.

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There's an emerging group to watch in emerging-market hotspot Latin America: a swelling middle class.

This population shift is an important development for investors, especially those with a longer-term horizon. No longer will the economies of Brazil, Mexico, Chile, and their neighbors have to rely primarily on strong global demand for commodities grown and mined in the region. Now, the investment story is shifting toward the improved income of a relatively young population. These days, many emerging countries have relatively low levels of unemployment and a better fiscal position compared with their developed counterparts.

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"Concerns about the global outlook have weighed on Latin American stocks, but we believe that rising living standards and a rapidly growing middle class will continue to drive long-term economic growth even if market volatility remains high in the near term," says Jose Costa Buck, manager of the T. Rowe Price Latin America Fund (PRLAX), in a commentary.

Investors should note that the region's slow-if-steady shift from dominant resource provider to technology-driven economy is already underway, with firms such as Mexican financier Carlos Slim's America Movil SAB de CV and its competitors. The company is expanding data and voice communications capabilities throughout the region. E-commerce firm MercadoLibre Inc. also looks poised to get a lift from growing domestic consumer demand.

Of course, risks remain. Although there is a drive to improve infrastructure and business practices in Latin America, there can be a degree of regulatory and technological limitations.

In Latin America, "the onus is still on the policy makers to rise to the occasion and to adopt deep-cutting structural reforms that could increase productivity growth and potential GDP growth in the near future," says Alberto Ramos, managing director and co-head of Latin America Research at Goldman Sachs, in a video commentary on his firm's website.

[See top-rated Latin America funds ranked by U.S. News Mutual Fund Score.]

Plus, although most economists look for the globe's emerging markets to lead growth in the next few years, these regions are at risk that a double-dip recession in the developed world will pull emerging markets down, too.

The United Nations in early December cut its forecast for world growth from 3.6 percent to 2.6 percent for 2012 because of the euro-zone debt crisis. The UN expects 3.2 percent global growth in 2013. This forecast is conditioned, however, on containment of the euro-zone debt crisis and a halt to further moves toward stringent fiscal austerity in developed countries, according to the UN World Economic Situation and Prospects report.

Developing countries, led by China, Brazil, and India, are predicted to continue pulling the world economy forward with average growth of 5.4 percent in 2012 and 5.8 percent in 2013. That is down from 7.1 percent in 2010. Brazil's 2012 growth is estimated at 2.7 percent, down 2.6 percent from an earlier forecast.

"Near-term risks include continued inflationary pressures in Brazil, evidence of fragility in the U.S. recovery, and signs of a slowdown in China, the region's biggest trading partner," Costa Buck says.

Brazil, which is the region's largest economy, remains the more established investment destination. But policymakers there appear well aware of the balancing act facing emerging markets as the developed world struggles. Brazil's central bank cut its key interest rate to 11 percent in late November, the third reduction since August as policymakers hope to help insulate Latin America's largest economy from the negative global effects from Europe's economic and credit woes. The launch of a rate-loosening campaign initially surprised some market observers because inflation remained above the bank's 6.5 percent comfort zone. The bank has predicted that inflation could ease to 4.5 percent in 2012.