Two Latin American Bond Buyers Make their Predictions for 2019
How will political change impact investments in the region in 2019?
Bryan Carter: At a broad level what’s quite exciting is that the majority of the governments in South America, in the large countries at least, are now very pro-market. We already had that in Argentina, while new governments in Brazil, Colombia, Peru and Chile are very market-orientated. That’s really exciting, you’d have to go back to the 1980’s or 1990’s to when that was last the case. So, it should bring economic dividends. In Brazil you have a pro-market, pro-reform, pro-investment government that should cut taxes and regulation and release growth. Meanwhile in Colombia and Chile you will see a resumption of the investment and consumption that was put on hold because of elections – so you’re at the beginning of the investment cycle in these countries.
In Argentina you could actually see some market momentum if Macri manages to regain support between now and October. One positive aspect is that Argentina now has a more standardised model of primaries than it used to, so we should know a lot more by the time the primaries are over. It will mean there is less volatility than we saw with the Brazilian elections because the new Argentine system lends itself to a more orderly revealing of knowledge.
Alfredo Mordezki: First, after very widely publicised and contested elections, we will see a reduction in uncertainty, as teams get appointed and start managing the economy, affecting the business climate. The weak investment landscape associated with election uncertainty is expected to recover, particularly in Brazil.
Regarding the outcomes of the election, market expectations are for a very pro-business approach in Colombia and Brazil and a more uncertain landscape in Mexico. We also need to keep in mind the issue of governability with respect to the ability to have significant pieces of legislation approved through Congress. With this in mind, Brazil is still a big question mark, even if the first steps, such as the appointment of the speaker of the house, raise positive expectations.
People compare Bolsonaro to Trump; is it an accurate comparison?
BC: In Brazil, Bolsonaro believes in responsible economic policy and wants to balance the budget and make social security sustainable – unlike the US. He’s extremely economically orthodox – he’s literally reading the textbook. Perhaps more worrying is his social policy. He has some strong views on minorities, individual rights, freedom of expression and rule of law. It will be a test of Brazil’s nascent institutions, in a democracy that is just 35 years old, to see if they can withstand that. But his biggest challenge is that he doesn’t really have a mandate. Yes, he won the popular vote and lots of people want him to clean up the dysfunctional Brazil created by years of PT rule and the calamity of the Temer interim government. But knowing Brasilia to some extent – I worked for the US State Department there – it is hard to get stuff done without a majority in congress. The market seems to have priced in immediate action – ie a satisfactory pension reform that stabilises debt ratios and balances the budget. It could happen but I think it’s less likely than the market thinks.
In Brazil, Bolsonaro believes in responsible economic policy and wants to balance the budget and make social security sustainable – unlike the US…
AM: There are some similarities however there are many more factors that are Brazil-related and reflect long-running social and economic issues in Brazil. I actually think that regardless of Bolsonaro the economic cycle in Brazil calls for a pick-up in growth. We have had two years of a very tough recession, followed by a weak recovery. Never in Brazilian economic history have we seen a recovery with growth of just 1.8%. The reason is that during the recovery the financial institutions were still very much on hold in terms of lending. There were lots of economic reasons to start lending but it was restricted because of the uncertainty surrounding the election. If you look at consumer leverage, non-performing loans and the retail sector they all point to a recovery in lending but that didn’t happen. So, I think that there is a pent-up bounce back waiting to happen.
Something similar happened on the industrial side. If you look at the Brazilian companies that have been repairing their balance sheets over the last few years, they were ready to make investments in 2018 but because of political uncertainty they decided to remain on hold. That capital regeneration allows for a stronger deployment of capex, so we should expect lending to resume. Of course, it helps that we have a market-friendly government with a well-respected team but I think the recovery comes from deeper economic factors.
‘AMLO’ has sent mixed signals to the market; how will Mexico fare in 2019?
BC: As for Mexico, it is the only major economy in Latin America that has not gone more pro-market. It is no accident that our forecast for Mexican growth is the only one in the entire region that has been marked down. We have lowered our 2019 and 2020 growth estimates as a result of the uncertainty about Andrés Manuel López Obrador’s policies. Ironically, he does have a mandate and unlike Bolsonaro he can easily get legislation passed. But investors have been disappointed by some of his decisions, such as the cancellation of the airport project. His administration has had the chance for a few, easy early wins but it has chosen not to take them. It seems happy to disappoint investors, which is never a good strategy long-term because it leads to higher interest rates and a weaker currency.
AM: Many investors were disheartened by his decision to cancel the Mexico City airport but I think that move was well telegraphed. It was one of his main campaign promises so we can’t claim to be surprised. Ultimately, it’s down to investors to have realistic expectations of a new leader.
I think his presidency will be market-friendly but investors will have to enforce some discipline. Indeed, I think that is already happening. If you look at the state oil company Pemex it is trading at 300 bps over the government and has a much wider spread than its Brazilian counterpart, Petrobras, despite being three notches above in terms of credit rating.
All governments make clumsy first steps so I don’t think we should read too much into the beginning of this presidency. However, it is true that in Mexico, the government is speaking through many voices, as MORENA is a political movement involving grassroots organizations and is not a typical vertical political party. So, even though the outcome of the election gives the president a comfortable majority, governability entails finding a single voice which may take some time to be build.
Average GDP growth across Latin America has been weak in recent years; how will it fare in 2019?
BC: Brazil will be the main motor of growth in the coming years. Its economy makes up 40% of total Latin American GDP. It grew at 1.8% in 2018 but that will rise about 3% in 2019. It could possibly go even higher, depending on what happens in Brasilia. That will deliver an immense contribution to regional growth. Colombia and Chile, which both struggled in recent years, will also pick up and will be growing by 1% to 2% higher by the end of 2018 than they were in 2019. They are important economies, indeed Colombia is now the third-largest in the region, so if they expand then, regardless of what’s happening in Mexico, we will see increased growth in Latin America.
AM: We expect an improvement overall for the region on the back of better prospects for Brazil, Colombia and Peru, and in spite of weaker growth in Mexico and Chile. It’s clear that we are not going back to the high growth rates of six years ago. Indeed the Santander Asset Management macro department expects Latin America to grow by 2.3% in 2019. That is lacklustre but better than the 1.7% that we saw in 2019. We are assuming that the stronger recovery in Brazil is driving this pick up. Also, there are pockets of higher growth, for example Chile, Peru and Colombia are 3% and 4%, which is good on a relative basis compared to the rest of the world. But even if growth rates are not amazing, if you select an asset class like corporate fixed income you can get some excellent yields from companies with very solid earnings. So, there is a valuation argument despite growth not being that compelling.
What Latin American economies do you expect to outperform in 2019?
BC: We see a pick-up in activity in Colombia, Peru and Chile. Meanwhile Argentina has gone into recession which impacts Uruguay. Of course, if things go well, they could recover much more sharply because they are high-volatility economies. But overall, Colombia is the standout economy. It was expanding at 2.5% in 2018 and that will be 4% in 2019, which is the most exciting growth story in the region that we can point to with any certainty.
AM: The market that I will risk mentioning is Argentina, even though I know it’s a forbidden land for many investors in 2019 because of the elections. I think it makes sense to be present in Argentina because it will surprise investors if they can stabilise the economy which they seem to be doing. The way the country has managed the crisis has been impressive and the companies that we have been looking at are in good shape for 2019 and 2020. But investors need to see materially lower inflation to recover faith, so interest rates could go significantly lower.
I believe that the chances of a government that is completely the opposite of the current administration are very low. I also think that in terms of currency adjustments we already went a long way in 2018 and the situation has improved. I think there were a lot of international investors in Argentina for the first time that took a big hit last year and have left. So now it’s a more committed investor base looking deeply at the fundamentals and the companies. It’s noticeable that even after the devaluation we didn’t see such a strong deterioration of credit quality in Argentina, so we should see fundamentals prevail.
What’s your outlook for key commodities such as oil, copper, iron ore and soy in 2019?
BC: We don’t have views on what commodity prices will be in the future. We prefer to focus on what we’re good at, which is the balance of payments, overall growth and the value of investments in an economy. What we can say is that oil price crash has not yet reverberated through the oil economy, so that will be a headwind for Ecuador during the next few quarters. In Chile copper prices are very low – not quite a crash but low – and that will hold back an otherwise excellent economy. With the old government back in power, Chile is making some exciting progress. Colombia is more diversified and after the super-cycle succeeded in restructuring its economy to some extent. And although commodities like oil and iron ore are important the export basket is more diversified than other countries in the region. As for Argentina, it used to be a soy story but now there is so much other stuff going on, with monetary tightening, extremely high interest rates, the IMF programme and the cessation of the monetisation of the deficit. Those factors are now driving the economy and are the reasons why it’s in recession – not soy prices.
We are cautiously optimistic with oil prices providing the trade war is addressed and there is no recession in the US…
AM: We are cautiously optimistic with oil prices providing the trade war is addressed and there is no recession in the US. Copper is in a similar situation. Both have weakened substantially in the last months. Iron ore, in contrast, is still at high levels so it is more vulnerable for a correction. Lastly, agricultural commodities, such as soy, suffered as China stopped buying from the US, switching to other providers including Brazil. Avoiding a trade war and normalising US-China relations can help recover soy prices.
I think lots of the South American economies, like Chile or Colombia, have been successful in diversifying away from a dependence on commodities for GDP growth. However, that hasn’t happened on the fiscal revenue sise. So, when a commodity related to an economy falls, you see a fiscal pinch.
How will external factors, such as rising US interest rates or a China slowdown, impact Latin America in 2019?
BC: I think US rates are now more important than China for Latin America. People talk about how China is much more important in the region than it was 20 years ago. That’s true but in the last five years most Latin American economies have been working to cut their exposure to China. When the supercylce collapsed they realised that being a commodity exporter and overleveraged to China was detrimental to their long-term growth and stability. We’ve seen a move to diversify exports and create more resilient economies, which necessarily makes China less important.
On the other hand, and counterintuitively, the US has become more important. Capital flows from US or developed economies, which are shaped by the US interest rate cycle, can drive the availability of credit. In 2018, when spreads skyrocketed in the first half of the year, and issuers were not able to come to market, that exacerbated the economic slowdown and was a more important factor than China. So, if we went through another bout of high interest rates in the US, either because of the Federal Reserve choosing to hike or being forced to by inflation, it would dry up liquidity and financing for the region. Indeed, Latin America is particularly exposed to this.
Our house view is that the Fed will increase rates twice in 2019 but in the second half of the year. We think that in the first six months the Fed will be inactive to help restore confidence. So that will be smooth sailing for Latin America. However, by summer the Fed will think that growth is fine and will implement rate hikes At, the moment investors in Latin America appear to be pricing in no more rate hikes so they could be in for a shock. Really it all depends how it happens. If there is a surprisingly strong piece of US economic data, or a shock spike in inflation, then that would trigger an unexpected rate hike, which could cause a credit crunch and devaluations in Latin America. Remember, it doesn’t have to be outright panic. If there is just enough doubt to stop investors from financing new Latin American issues then it can cause funding problems in the region. If the rate hikes happen in an orderly, signalled way then there is less chance of that.
AM: I’m not 100% against Bryan’s answer but it’s about magnitude of movement. if interest rates go 300 basis points above where they were then companies will need to refinance. Not in short term but in two-years’ time, so it will cause problems. But if you think about the 2015/6 pressure on iron ore and oil a lot of the increases in leverage that people were pointing to were actually just Ebitda going down because commodities fell. With the exception of Petrobras, there wasn’t an increase of leverage in the market. So China clearly plays an important role in that. Our main scenario is positive because with think China will grow at 6.3%. If there was a China hard landing it would always take a toll on commodity prices and Latin America in for sure.
If you look at the start of 2018, there was optimism for high growth in every region in the world. Now we are starting the year in a much more cautious environment. Yet there are interesting valuations in Latin America, which is attractive because the fundamentals for these companies hasn’t weakened. Of course, there are points of warning. We don’t want trade wars because Latin America is an open economy that depends on trade. In fact, it’s leveraged play on trade in some ways. But overall, I think we are set for a very positive year for select asset classes in Latin America.