Over the past couple of years, the Global Emerging Markets team have developed a convincing investment thesis on the Peruvian economy and Peruvian stock markets. In a recent trip to Peru, they put their thesis to the test. The investment thesis seems simplistic, even reductive, but they found it, thousands of miles away from the hubbub of Lima, to be pretty convincing. Kunjal Gala, Global Emerging Markets Lead Portfolio Manager, and Chris Clube, Senior Analyst, outline the findings from the trip.
We are invested in Peru because we believe that the Peruvian economy is ultimately driven by the price of copper, and we believe that this is likely to be to Peru’s advantage over the next decade.
Copper supply needed to match rising demand
Copper prices will remain moderately high for the coming 5-10 years. On the one hand, the economy will become increasingly copper intensive as we decarbonise: more electricity in industry (electric arc furnaces, electric motors), in homes (heat pumps) and in transport (EVs) and more investment in renewable energy generation and the grid investments necessary to bring this electricity to the consumer.
On the other hand, due to a decade of austerity in the mining industry and increasingly stringent environmental licensing conditions, there is an almost complete scarcity of projects to supply copper to match this increased demand. As copper projects will take somewhere between 5-10 years to develop, this absence of projects today coupled with growing demand means that prices are likely to stay high for the best part of a decade.
Peru steps up
Peru, a country of around 30m people, produces roughly 10% of the world’s copper (equivalent to Saudi Arabia’s position in the oil market). Copper makes up at least 30% of its total exports (gold another 15%), and as such is a crucial swing factor in the country’s economy.
We observe strong correlations between the country’s currency and the copper price, as well as levels of investment in the economy. As the copper price strengthens, the currency tends to do so as well. This means that disposable income of consumers tends to increase, and inflation tends to fall. As disposable income increases, consumers can afford more and domestic demand rises, meaning local production capacity tends to get filled up and we get more investment from local business, more employment and more credit growth.
Meanwhile, high copper prices indicate a requirement for greater supply of copper, and indeed incentivises mining investment. A large copper project might cost well over 5bn USD to develop and may well include power plants, roads, trainlines, ports and dams. The dollars spent will have multipliers in the local communities, as those workers involved in these projects in turn spend the money they earn.
On top of this, high copper prices result in significantly higher local and federal government revenues as tax revenues from highly profitable mines arrive in the treasury. This money finds its way into the economy too. Ultimately then, high copper prices mean stronger growth and a stronger currency. However, the expectations for economic growth priced into share prices today suggest to us that either the market does not understand this transmission mechanism or believes that it is broken.
Patience is key
Our conversations in Peru suggested that some mechanisms are not working as they should: there have been no substantial increase in exploration investments despite higher copper prices and no new greenfield projects announced, and so our hoped-for investment boom does not appear to be here just yet. Similarly, although government revenues have surprised substantially, spending has disappointed. The local governments lack the capacity (at the moment) to spend the money that the higher copper price is providing them, meaning another feedback loop is not quite working as it should. However, the conversations we had also suggested that we will be rewarded for our patience.
We noted from our conversations that mining executives seem much more certain that high copper prices are here to stay than they were even a year ago. It is this faith in high prices that will see projects given the go-ahead in the future. Mining projects in Peru are often held up because local communities and mining companies are unable to reach an agreement which provides the miner with a ‘social license to operate,’ we heard from an expert on this topic that with higher prices many of these disputes could be resolved, as miners can disburse more money to communities and still achieve an acceptable return on investment. In some of the smaller miners we spoke to, investment levels seem to have been affected by issues around historical environmental liabilities, mine closure costs or leverage levels. High copper prices today provide the cashflow for these miners to resolve some of these issues, and therefore freeing them up to increase spending on mine expansions or exploration.
Finally, we heard anecdotally that there has been a pick-up in the number of mining companies ‘looking for business’ in Peru, either looking to enter partnerships to develop projects, or even M&A. In short, we believe that it is a matter of when, not whether, the investment boom that we predict will happen. We do not believe we will have to wait too long.
Given what we know today, we believe that the currency and equity markets are both very cheap and will provide investors with good long-term returns (even after a good start to the year). We think in time, others will recognise that Peru is a major beneficiary of the megatrends that are much discussed in the media (EVs, Renewables etc), and we’re glad to be invested there ahead of the crowd. Of course, Peru is not only about copper, there is plenty more to speak about in what it is a dynamic emerging economy, but that is an article for another day