Interesting data about South American exposure to China in the light of the coronavirus.
Sagil, an asset management company based in London, has a special expertise in investing in South America. The firm recently sent us their latest newsletter, which includes a really interesting article about the the expent to which South American countries trade with China.
Sagil’s newsletter kicked off by noting that China is also the largest trading partner for many emerging market countries and Latin America is no exception. The article then explored the importance of Chinese exports for specific Latin American countries, as well as their views on the implications for domestic economies and stocks.
According to the newsletter, all of the major countries in Latin America run a negative current account balance, but in most cases trade balances with China are actually positive. The one clear exception is Mexico, which imports far more than it exports, as industrial components from China are often assembled in Mexico for re-export into the United States. This is a key reason why the new USMCA has such a significant focus on rules of origin as the Trump administration has tried to reduce direct and indirect imports of Chinese products.
In other Latin American countries, the situation is very different, with China being the most significant importer of commodities globally. The chart to the right shows that, based on 2019 data, China makes up more than a third of exports for Brazil, Chile and Peru. Colombia and Argentina also export significant quantities of oil and agricultural products to China and the prices achieved in other export markets are also heavily impacted by Chinese demand.
In the charts below, Sagil highlighted the nature of exports to China for each of the largest economies in Latin America. Most exports are commodities and include copper ore, refined copper, iron ore, crude oil, wood pulp, zinc ore, soya beans and precious metals.
Sagil noted that the charts above show that any sustained downturn in Chinese demand for copper, oil, iron ore and soybeans would have a major impact on Latin American economies.
Of greater concern to Mexico would be whether a sustained period of disruption would affect the supply chains of its export industry (although in the longer term Mexico might even benefit from substituting Chinese imports to the US).
Although financial markets have been supported by the recent significant injection of liquidity (Sagil notes that there was the largest one-day liquidity injection by the PBOC on 3 February of US$174bn), this is not as easily transmitted to the real economy and to commodity purchases.
Supply/demand outlook for commodities
Oil: One clear loser from the outbreak of the virus has been oil demand. Numerous flights have been cancelled, cities quarantined and workers encouraged to work from home. Satellite footage confirms that many busy roads in China are now deserted and travel data (as shown in the chart to the right) has collapsed compared to the corresponding Lunar New Year holidays in 2019. It is estimated that China is consuming three million barrels per day less than it was before the virus. There are also knock-on implications for important regional tourist destinations where the virus has emerged including Thailand, Hong Kong, Japan and South Korea.
Some of the lost demand will never be recovered again – demand lost from fewer commuting days and vacations spent at home will not always be recovered later (unlike, for example an infrastructure project that can be performed at a later date). As a result, overall consumption growth of oil is likely to fall in 2020. As always in the oil market, price could also be affected by supply decisions. So far there has been no cut from OPEC, but a response would be expected if the demand shock is protracted. Sagil noted that it has seen large increases in allocations to commodity funds from financial investors which has mitigated what would otherwise have been a sharper fall in oil prices than already seen.
Within Latin America, the country most affected by oil demand and prices is Colombia. Brazil is also a major exporter of oil to China, but the country also imports a significant amount of diesel and gasoline, which reduces its net exposure to oil price movements.
However, Petrobras may be affected by some logistical issues in the near term. If oil prices remain depressed, this will have a negative impact on terms of trade for Colombia and could widen its already high current account deficit even further. This could be a headwind for regional currencies too.
Soybeans Brazilian soybean producers have enjoyed extraordinary growth in recent years, for several reasons:
1) Strong growth in emerging market demand for animal proteins (especially in China), combined with more feed formality has driven an enormous increase in import demand. Brazil, meanwhile, has been expanding its agricultural frontier, increasing planted areas and improving yields, while new and cheaper logistics solutions have emerged, especially in the North of the country; and
2) Brazil has enjoyed positive weather conditions, while Argentina (in 2018) and the United States (in 2019) have struggled with weather and yield issues; and
3) The trade war has caused Chinese buyers to drastically reduce purchases from the United States, with Brazil the main beneficiary.
The agreement between China and the United States on a first phase to the trade deal required that China should dramatically changes its purchases of agricultural commodities.
On a recent conference call to trading company ADM’s CEO Juan Luciano, the CEO stated that he believed that China intends to comply with the Phase one conditions of the deal which would come at the expense of Brazilian exports..
The death of around 40% of China’s pigs from African Swine Fever in 2019 reduced feed demand and, although more formal feed rations will favour a higher ratio of soybean meal to swill in aggregate feed demand, it is also likely that China will continue to migrate to animal proteins such as fish and chicken that have lower feed to animal protein requirements.
Sagil therefore expects demand growth to slow in China, while Brazil’s future exports could actually reverse (in contrast to the optimistic views in the domestic market). The newsletter stated that under normal circumstances it would be expected that food and agricultural products to would have lower demand sensitivity to economic events.
However under the current circumstances, activity in port, rail and road logistics have slowed considerably and high frequency data has indicated that fewer ships with soybeans have headed from Brazil to China than the same time last year. Sagil has also heard disturbing accounts that animals have not been provided feed as logistics operations have been frozen.
While the company expects overall demand for agricultural products to recover in China once the situation normalises, there is a risk of short term disruption for Brazil, but as the longer term factors set in, this could simply accelerate the trend towards a lower level of demand growth for Brazilian soybean exports.
Copper Although copper has played a major part in the significant expansion of China’s infrastructure, the commodity is still expected to remain well demanded as the world transitions to renewable electricity away from burning fossil fuels. The outlook for copper has been tightening as supply additions have been challenging. In the very short term, there are reports that China is requesting delays of copper cargoes, as its ports struggle to deal with the logistics issues and short term demand is uncertain.
At least one copper smelter in China has also declared force majeure on copper concentrate purchases, as there is apparently a lack of buyers of sulphuric acid produced from the smelting process, causing acid storage issues. Produced copper can be stored relatively easily at warehouses or mines and delivered when the situation normalises, but the considerable uncertainty in this market has already sent copper prices sharply lower.
Iron ore Iron ore prices have been elevated since the huge supply disruption caused by the collapse of Vale’s Brumadinho mine’s tailings dam. Unlike copper, iron ore is not as easy to store, being a bulky, lower value product, but many blast furnaces in China have continued to operate during this period.
In time, Sagil expects demand for Brazilian iron ore to decline as:
a) China moves towards more consumption and high-tech manufacturing and away from excessive reliance on infrastructure spending; and
b) China moves to use more scrap in steel making (similar to other more developed countries), away from imported iron ore.
In the very short term, the market has remained relatively tight on weak Brazilian exports (on heavy rains) and some anticipated disruption from a cyclone approaching Australia.
Other commodities Sagil has heard reports that China has turned fruit exports from Chile and that the largest buyer of LNG in China (CNOOC) has declared force majeure on certain cargoes. These exporters need to try to find alternative destinations (and this is likely to come at the expense of lower prices).
While there are hopes in financial markets that the infection rate is starting to stabilise in China, that progress on a cure or vaccination is being made, and that the government is acting to minimise economic consequences, there are still significant market concerns.
There are concerns that the effects of this virus will be greater on Latin American economies even if the situation improves in the very short term (i.e. downside to consensus GDP growth). On the other hand, if the situation does not improve rapidly, there could be significant downside.
Sagil noted that it had tactically reduced exposures to some of the sectors that have more risk if this situation worsens in Latin America. The company sold their entire position in ports and waterway cabotage company Log-In as well as most of their position in logistics operator JSL. It has also changed its convertible bond position in airline company GOL from an outright position (with downside protection) to delta hedge the equity exposure.
At a portfolio level, Sagil reduced its net exposure from 44.1% (32.5% excluding fixed income and precious metal hedges) at the end of December 2019 to 30.5% (20.0% excluding fixed income and precious metal hedges) at the end of January 2020.