As emerging markets investors try to regain a footing amid global turmoil, South America appears healthy and the mood in some zip codes is downright optimistic. Relatively clean – allegedly subprime-free – balance sheets, a commodities windfall and the best fundamentals ever for many countries should continue to draw buyside allocations. But some inconvenient developments dog the continent.

Inflation – specifically from food – and a freefalling dollar dominate the concerns of governments. The response has involved a series of unorthodox policies. An extraordinary FX intervention from Chile, a block on portfolio flows to Peru, and a 50 basis point hike in Brazil to 11.75% are among April events that will shape the way investors approach the continent in coming months.

Until recently, the tendency was to be long local currency assets. But investors may now be rethinking that strategy, say economists.

The need to adjust comes at a time when global investor appetite for risk appears to be ticking higher. “The most important thing we’re seeing now [among EM investor clients] is a recovery of risk aversion,” says Pablo Goldberg, head of EM fixed income strategy at Merrill Lynch. Investors are still waiting for signs of strength in the region’s economic data, but have cash to put to work, he adds.

Evidence of this is seen in a VIX volatility index drop, recovery in US credit assets – such as high grade corporate bonds and the ABX index of asset-backed securities – and a selloff in Treasuries, says Goldberg. EM sovereign spreads flared mid-March and have since had a good run, he says, noting Merrill’s IGOV sovereign bond index gained 1.4% between April 1 and April 17.

“I think this can continue,” says Goldberg, pointing to the expectation that commodities will remain strong and fundamentals will not deteriorate.

However, finding reliable returns is complicated by shifting expectations for growth, inflation, FX and equities across the region. More than ever, investors must evaluate each country individually.

Chile Starts to Wobble
Juggling rising prices and a strengthening currency that weakens exports is a thankless task, especially when done amid an energy shortage and Fed easing. Chile’s central bank was forced into currency intervention, which it says will reach $8 billion through 2008, allegedly to build up liquidity and dollar reserves.

This was the first intervention by the central bank in five years, say strategists, who attribute the decision to political pressure from exporters. Four days after the announcement, the Chilean peso had depreciated 4%, showing how the measure appeared to benefit.

“The market believes in the central bank, and therefore the currency will continue to depreciate,” says Drausio Giacomelli, head of EM strategy at Deutsche Bank. “While that’s happening, we don’t like [the peso,]” he adds, noting within a few months, investors could become accustomed to the central bank’s new participation in the FX market, which may stem the depreciation trend. If that happens, fundamental metrics such as copper prices and US dollar weakness will once again become the main drivers of the peso. Until the announcement, a strong local and offshore bid helped the currency appreciate 13% in 2008 versus the dollar.

On Wall Street the move was not well received, and economists took it to mean the central bank was shifting its focus away from inflation. On the same day as the intervention announcement, the central bank opted to keep rates unchanged, despite higher than targeted price rises.

“I’m in disagreement with some of these recent decisions,” says Alonso Cervera, head economist for LatAm excluding Brazil at Credit Suisse. He adds that the central bank has been complacent on inflation and should have tightened. “Intervening only puts more pressure on inflation, which is already high,” he notes, comparing the 8.5% inflation rate over the past 12 months to the central bank’s official target of 3.0%.

“And it could be a lot higher if the peso weakens by a lot,” says Cervera. He adds that the central bank’s reputation has been tarnished by its actions.

 Perhaps the Chileans see something others miss, as the mood on the ground – as in São Paulo – is quite different. “People are bullish down here,” said Giacomelli on a call from Santiago during an April visit. The robust outlook for copper is helping drive this enthusiasm.

But with food prices through the roof thanks to a rare and long lasting drought that constrains agricultural and energy supply, Chile’s vulnerability and dependence on metals are exposed. Sound institutions and a long track record of fiscal and monetary responsibility will help investors keep the broader picture in mind as they try to discern policy direction.

“The safest thing to do in Chile is to buy UF [inflation linked] paper,” says Giacomelli, adding that wherever investors choose to be on the inflation-linked curve, they will be fine. “That will be strong for at least a month until we have a better idea of the direction of things,” he says in a late April interview.

Halting Portfolio Flows
Peru meanwhile enjoys some of the highest growth with the lowest inflation seen in the world. In 2007 it expanded 13.1% with CPI at 3.9%. But the menace of food inflation is real, prompting a 25 basis point hike in Peruvian interest rates to 5.5% on April 10, and a jump in the reserve rate for banks to 25% from 20%. The preemptive move was applauded by Wall Street, where many analysts are forecasting a pickup in inflation of more than 5.0% this year.

However, foreign investors who until then had enjoyed a profitable trade accumulating short-dated assets denominated in soles, were whacked by a jump in the marginal reserve requirement to 120% from 40%. That means investors must keep 120% of the value of their investment with a local institution, but agree to earn income on only 100% of that amount. The move, which makes purchases of short term bank notes far less attractive, was designed to discourage portfolio flows that helped strengthen the sol by 10% in the year to April 18.

That may not be enough to stem the currency appreciation. Sturdy commodity backed fundamentals draw hefty FDI flows, which are not subject to stringent reserve requirements. “In our view, dollar inflows coming from the trade surplus and FDI should remain strong and, thus, we do not expect sharp movements in the nominal exchange rate,” notes Credit Suisse, whose analysts see frequent FX interventions by the central bank – $8.4 billion through early April – as helping a gradual, rather than sudden, appreciation.

“It’s a reasonable thing to do,” says Carola Sandy, Credit Suisse’s economist for the Andes. “Those two measures together should help the central bank achieve its goals to control inflation and prevent a strong appreciation.

Still, further sol strength is on the cards, says Goldman Sachs, which believes the currency is still undervalued. The shop forecasts the sol at 2.60 to the dollar by year-end 2008 and 2.55 in 2009. April 18, it was at 2.68, versus 2.98 at the start of the year.

Ecuador, Darling
For all of the lurid political headlines, investors appear to have taken a liking to Ecuador sovereign bonds and finance minister Fausto Ortíz. Through mid-April, Ecuador performed best of all EM credits in JPMorgan’s EMBIG and Merrill’s IGOV indices, which track performance in sovereign bonds.

The rally could continue for the Andean country, as the likelihood of a default seems to shrink with each passing month, although willingness to pay remains an issue. A call of the high yielding sovereign 2012 bonds has long been anticipated, but analysts say the probability of that happening is low, given political constraints on diverting funds away from social spending.

Locals take a different view. Analytica, a brokerage and banking boutique in Quito, sees growing expectations of a debt restructuring this year or next. An improved credit rating and relatively attractive refinancing rates may lead the government to seek better terms on existing debt. One option, says Analytica, is to conduct an exchange through the call. However, Ortíz tells LatinFinance that liability management is not a top priority.

As for Ecuador’s unruly Bolivarian uncle, Venezuela, things appear to be decidedly on a downward turn, according to locals. “The economy is decelerating,” says Abelardo Daza, a partner at ODH Consultores, a research shop in Caracas. “We expect the economy will grow around 6% this year, from 8% in 2007 and 10% in 2006,” he adds, noting some sectors will not expand at all this year.

Headline Risk
Further south, Argentina’s economy continues to expand at breakneck pace, though with more recklessness than in the first Kirchner administration. Analysts say heterodox policy, uncertainty about inflation, corruption, the energy crisis and legacy of holdout bondholders will help drive the sovereign back towards crisis.

Walter Molano, economist at BCP Securities, was vocally optimistic about his hopes for the new administration, but admits that four months into Cristina de Kirchner’s tenure, he feels nothing but disappointment. “From a fundamental standpoint, this should be the golden period for Argentina,” says Molano, citing an improved balance sheet following the restructuring, a strong consumer base and high flying soft commodities.

But despite having the wind at its back, Argentina’s management of the economy is deteriorating, says Molano. “Cristina de Kirchner is opening up old wounds, pitting traditionally opposing forces against each other.” Molano cites feuds between provinces and the capital, as well as between the industrial and agricultural sectors. A heavy handed tax on exports also hit the agricultural sector hard, he notes.

From an investor perspective, this all leads to one conclusion. “Argentina and Venezuela are among the providers of the biggest headline risk, and investors are tiring of trying to decipher the messages coming from those governments,” says David Becker, a local markets strategist at Merrill. Argentine assets have suffered and issuers in Argentina have, for the most part, been shut out of markets thanks to a high risk premium assigned to the zip code.

Relative Value
As investors look at ways they can approach LatAm local market assets, they are increasingly differentiating between country stories and taking comparative views both within the region and across all EM, say strategists. “Last year, it was everything against the dollar,” says Becker. “Clients are now more willing to take relative [FX] trades,” he notes, adding countries with low liquidity and poor economic policies are the ones to especially avoid going forward. Relative value plays within LatAm – such as a long Brazil real-short Colombia peso trade – as well as long LatAm duration versus short Asian duration are among the types of trades investors are looking at, according to Merrill.

Inflation protection is popular across EM as the risk of global price rises remains high. In EM, only LatAm offers inflation-linked bonds, save for Turkey and Israel in EMEA. This includes Brazil’s NTN-B, Mexico’s M-UDI and various kinds of swaps in Chile, says Merrill.

In coming months South America’s main economies will continue to chart their own courses as they grapple with inflation, growth and liquidity. As investors emerge from safe havens, opportunities in LatAm will be at the top of their list. The region, with a few exceptions, boasts an undeniable backbone of stability. LF