We are cautiously optimistic about the prospects for the region over the next few years. With the notable exception of Mexico, growth in Latin American markets should improve, and reform momentum also remains favorable, with market-friendly administrations at the helm in most investable countries. The Brazilian market was up strongly in 2016 while Mexico was the laggard, and we are positioned for that trend to continue. We are overweight to Brazil, largely because we have identified several good stock-specific opportunities here, while the macro environment is also encouraging. Mexico, on the other hand, is likely to bear the brunt of the uncertainties over the likely course to be taken by U.S. President-elect Trump's administration, given its strong trading and other economic links with the U.S. We are as underweight to Mexico as we have been since the current portfolio manager took over the Latin America Equity strategy in 2014. By contrast, we are increasingly positive on the Andean region (Chile and Peru in particular) and mildly optimistic on Argentina. Overall, we have high conviction in our ability to add value for investors by leveraging our extensive research platform and investing in good-quality companies trading at reasonable valuations that can grow over time.

We Retain a Large Underweight to Mexico Given Increased Political and Economic Uncertainties

From a top-down perspective, while the rhetoric directed at Mexico during the U.S. presidential campaign might not fully translate into policy actions, we believe the uncertainty brought about by Trump's victory will increase indecision and risk aversion. This in turn will likely have an impact on Mexico's economy and increase political risk ahead of the country's own presidential election in 2018.

The link between Mexico and the U.S. is strong, for instance, the U.S. is the market for more than four-fifths of Mexico's non-oil exports, remittances from the U.S. account for 2% of Mexico's GDP, and around half of foreign direct investment (FDI) in Mexico comes from the U.S. Our main concern is over the effect the uncertainties about a Trump presidency will have on consumer and investor confidence and FDI. For example, NAFTA renegotiation is set to weigh on sentiment, while potential U.S. tax reforms could be another source of uncertainty. The cheap peso may attract investments over time, but a "wait and see" mind-set will probably prevail in the short to medium term, especially in light of Mexico's presidential elections in mid-2018, where we believe that the likelihood of a victory for the populist left has now increased. Furthermore, growth is slowing, inflation is going up, and monetary and fiscal policy are being tightened. Overall, while equity valuations have become more reasonable since the sell-off, they are not yet cheap, in our view, and we have reduced positions in a number of our holdings. Having said that, we have positions in several high-conviction Mexican names - in areas of the market such as consumer-related businesses, real estate, and infrastructure - and we took advantage of the recent pullback to add to some of these positions over the period.

• We increased our holding in retail chain operator Walmart de Mexico (Walmex), taking advantage of some share price weakness. In the wake of the U.S. election result, we see Walmex as being particularly well positioned from a defensive perspective given its limited operational leverage. Our thesis of healthy same-store sales growth supported by a recovering consumer, a solid e-commerce presence, strong store execution, and effective pricing and communication continues to play out.
• Our position in Arca Continental - the Mexican manufacturer and distributor of Coca-Cola Company beverages, which also has exposure to Argentina, Ecuador, and Peru - was topped up. We expect the firm to continue to drive modest profit growth from its core business through robust volumes and efficiency gains, while a franchising opportunity in the U.S. via a recent acquisition should provide additional support.
• We trimmed our position in FEMSA, a conglomerate that consolidates, among other interests, a 20% equity stake in Heineken and a 48% stake in beverage company Coca-Cola FEMSA. We revised earnings estimates downward as profit margins across key businesses look squeezed and as expenses are growing at a faster rate than expected. Valuations look less attractive from here, and while we retain a small position, we are now substantially underweight relative to the benchmark.
• We sold some of our position in Grupo Financiero Santander, one of Mexico's largest banking groups, as the risk/reward ratio of the stock no longer looks sufficiently compelling to us. We have concerns about future credit demand and a potentially deeper credit cycle should Mexico's central bank continue to hike rates. Grupo Financiero Santander is particularly sensitive to this given its above-average cyclicality.
• The portfolio closed its position in Fibra Uno, Mexico's largest real estate investment trust, as we see increased headwinds facing the business and prefer high-quality peer Fibra Danhos. We view Fibra Uno's high exposure to industrial property as a potential risk, while the stock is also exposed to the uncertainty surrounding Mexico's post-U.S. election climate, in which investment confidence and FDI are being affected.
• We trimmed our holding in metals and mining business Grupo Mexico, selling on strength. After the recent rally in the share price, the valuation now looks full, in our view, and we fail to see the necessary catalysts to drive longer-term, sustainable growth.

Strong Stock-Specific Potential in Brazil; Recovery, Rate Cuts, and Reform Progress Key Drivers for Market

The portfolio's largest position by far in absolute terms is in Brazil, and we are also overweight on a relative basis. This is largely due to bottom-up factors (most of the Latin American stocks we believe will perform best this year are listed in Brazil), and we initiated a number of positions over the quarter. However, we also favor Brazil from a top-down perspective, despite the fact that valuations look expensive on a 12-month forward P/E basis when compared with recent years and the currency looks to be fairly valued, particularly when contrasted with the multiyear low for the Mexican peso. Nevertheless, Brazil is slowly coming out of its worst recession in a century, interest rates are set to fall significantly over the coming year, and inflationary pressures are easing. Furthermore, the country has been presented with a "once in a lifetime" opportunity to pass reforms that, if successful, would put it on a more sustainable growth path, leading to a lower risk premium and higher valuations. We are mindful of some risks such as the ongoing "Lava Jato" investigations, which could implicate prominent members of the government, and the possibility that President Michel Temer fails to pass the reforms he is promoting. However, Temer has increased support from Congress and our view is that, in a scenario where reforms are blocked, the market will quickly remind Brazil of what needs to be done - the country has run out of good alternative options and pension reform in particular is essential to the "self-help" story.

• We bought a position in Brazilian insurance and pension plan business BB Seguridade Participacoes, which was spun off from Banco do Brasil in 2013. The stock is structurally attractive, in our view, with strong, multiyear earnings growth underpinned by efficiency gains and the growth of its term life business. The stock's valuation is currently appealing, and its high dividend payout ratio looks sustainable.
• We initiated a position in Localiza Rent a Car, Latin America's largest rental car company, which is headquartered in Brazil. The business has been making steady market share gains in an industry that continues to consolidate, while earnings and return on capital look strong on a near and longer-term view. The market is currently discounting the firm's ability to take market share, and a pullback in the stock price provided a good buying opportunity during the quarter.
• Another position we opened was in Odontoprev, the principal private dental insurer in Brazil, which is particularly shareholder friendly, returning 100% of free cash flow to its stockholders via dividends, share buybacks, or interest on capital. We took advantage of an attractive entry point during the quarter as cyclical pressures weighed on the stock price; we see the business continuing to compound earnings, with growth supported by a still underpenetrated dental insurance market.
• We took some profit on Itau Unibanco, a high-quality Brazilian bank, following a significant year-to-date rally in the share price. We retain our significant overweight, however, given our strong conviction in the group's growth prospects.

Remain Underweight Chile Due to Stock-Specific Factors, Although We Are Positive on Macro Backdrop

While we are constructive on Chile from a top-down perspective (with the economic and political backdrop providing reasons for optimism), we remain underweight. We struggle to find good-quality companies with exposure to Chile and the broader Andean region, which also have adequate levels of liquidity. One of the exceptions to this is retailing group Falabella, which has operations in areas including department stores, home improvement outlets, supermarkets, consumer credit, and retail banking. While we have trimmed our position following a recent rerating of the stock, we remain invested. Falabella is executing well in the Chilean market, which accounts for the lion's share of its earnings, and we believe it is also well placed to benefit from a potential recovery in consumer spending in other Andean countries.

Credit Growth Set to Fuel Sustainable Growth in Argentina

We retain a significant off-benchmark position in Argentina given the improving domestic macroeconomic environment and stronger business confidence engendered by President Mauricio Macri's reform-minded administration. One of our main holdings in this market is Grupo Financiero Galicia, a financial services holding company that is well positioned to benefit from rising growth and returns. It owns Banco de Galicia, one of the largest private sector banks in Argentina, which has a strong consumer loan business. Bank credit penetration is low in Argentina, and we believe pent-up demand for credit could drive substantial real loan growth over a multiyear period.

Peru Benefiting From Relatively Favorable Domestic Economic Conditions

The portfolio is overweight to Peru, where the economic backdrop is relatively supportive. The country's mining industry is rebounding, and Peru is on track to become the world's second-largest copper miner. Our main holding here is Credicorp, the country's largest financial services holding company and the dominant player in one of the most structurally attractive banking markets in Latin America. Peru's banking sector is the most concentrated in the region, with the top five companies controlling well over 80% of loans and deposits. Credicorp's capital position has strengthened and we believe it has good prospects over the medium term as it should capture the attractive loan growth potential of an underserved banking market.