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Latin America: writhing without rhythm

The Latino dancers may have lately lost their rhythm. Parts of the South American region remain under intense pressure as macro headwinds continue to deepen current issues. Even some of Brazil’s towns and cities, which are famous for their carnival celebrations in February, were forced to abandon the annual revelries as the country faced its worst recession since the 1930s.

That is not to say the party is over for Latin America. It’s arguably a case of postponement, so maybe we shouldn’t fold up the fancy dresses and feathery floats just yet.

Feeling the squeeze

It was a difficult 2015 for Latin America, and 2016 brought little relief as the region fell deeper into recession territory. Headlines remained unremittingly gloomy as South American nations continued to suffer from an economic slowdown among its key trading partners. These countries were also met with lower commodities prices and persistent domestic challenges.

The outbreak of the mosquito-borne Zika virus hardly helped matters, and the flippant among us might argue that it is the only thing flourishing in a region currently characterized by political and economic dysfunction.    

Brazil and Venezuela were in the most precarious positions, while the 2015 appointment of Mauricio Macri as Argentina’s president has raised Argentine growth prospects over the medium term. Tighter economic policy alongside weaker currencies should help to narrow currency account deficits across much of the region, although this will hinder the progress of an economic recovery going forward.

Oil: a slippery slope

The price of oil remains volatile and is a key character in this unfolding story. Why is oil such an important factor? While cheaper oil can be a boon for oil-importing nations as it drips through to consumers, Venezuela derives 95% of its export earnings from it, so depressed prices can clearly spell economic disaster.

The good news is that economists are forecasting a price increase over the medium-to-long term. If it does, Latin America and the economies for which oil accounts for a significant share of gross domestic product (GDP), exports and fiscal revenues, will stand to benefit.

Currency crunch

Currencies have also come under intense pressure. Weakening local currencies are a direct reflection of the high levels of uncertainty in global financial markets and sharp falls in commodity prices. Brazil was the clear underperformer last year as political strains grew, while sovereign rating downgrades and persistent fiscal deterioration prompted a 33% depreciation of the Brazilian real.

But there is evidence to suggest that Latin American currencies may now be stabilizing. The Brazilian real had a very strong March, up 10.5% against the U.S. dollar. The recent uptick in global commodity prices should provide some breathing space before currencies really begin to feel the positive effects from a forecasted increase in export revenues.

...there is evidence to suggest that Latin American currencies may now be stabilizing.

The China syndrome

The story of China is an interesting one. Many market commentators would suggest that China’s slowing economy is the main reason for the drop in commodity prices. This has certainly played a part. After all, China is the largest consumer of raw material. But we believe the slowdown may have more to do with the market becoming aware of excess supply, coupled with no imminent pick-up in demand from China, which has caused commodity prices to fall.

We acknowledge that waning Chinese demand remains a risk for Latin American exporters, but it is important to distinguish facts from fiction. And the fact is that oil demand from China has not been anywhere near as weak as markets might suggest (see chart below).

Oil prices vs. China’s oil imports

Source: JP Morgan, Bloomberg, January 2016.

A turning tide?

Encouragingly, Latin America’s situation is also not as dire as many perceive it to be. Latin American equities outperformed developed and emerging market equities benchmarks in the first two months of the year, according to research by JP Morgan. There are a number of challenges, there’s no denying that, but a crisis? Not really. Or certainly not to the extent some market commentators are portraying it to be.

Brazil and Venezuela have some grueling issues to overcome, but even these two South American nations have positive stories to share, not least because recent market volatility has lowered valuations to attractive levels. These levels made assets more affordable for foreign investors.

It has also been encouraging to see that a number of countries who have been so reliant on China’s boom are starting to adjust to new realities. Governments are implementing structural reforms and diversification strategies, rather than simply waiting for a shift back to more favorable macro conditions and higher commodity prices. While Latin America’s economic growth outlook remains on the weaker side, this year should fare better than last for many economies with a positive upward trend forecast thereafter.

Macri brings renewed hope in Argentina

Argentina’s President Mauricio Macri has been a busy man since taking office in December. The former mayor of Buenos Aires already implemented a number of reforms, including the country’s return to international capital markets. Part of this involved the settling of a decade-long legal dispute with the country’s holdout creditors in the U.S. This was something his predecessor, Cristina Kirchner, failed to do during her tenure.

The country sealed a $16.5 billion sale of government debt, the largest ever bond issue from an emerging market economy. Macri had clearly been given maximum credit by global bond investors. The deal was three times over-subscribed with almost $70 billion of demand.

But there’s a long way to go before Argentina can truly say it’s turned its fortunes around. With a long list of challenges including tackling inflation of near 30%, a very complex fiscal deficit of almost 8% and the significant devaluation of the Argentine peso, there is plenty of work to be done. Economic data remains mixed. Other new government policies will take time to deliver their promises. External threats also remain as Brazil’s recession deepens.

On the contrary, the weaker peso is expected to boost exports, and a swap agreement with China will beef up the Central Bank’s coffers. Growth this year is expected to be flat as the economy braces itself for a 3.3% acceleration in 2017.

Dilemma for Dilma

Latin America’s largest economy continues to plough deeper into recession territory. High inflation, large fiscal imbalances, political bedlam and corruptions scandals have now dominated Brazil’s economic news. Investors are under no illusions that the state of the domestic economy is not in great shape, and the 2016 outlook remains bleak in comparison to some other Latin American nations.

Is it all that bad, though? Well, yes and no.

On the negative side, Brazil’s slump from Latin American stardom has stemmed from three key causes. The first being a sharp drop in global commodity prices, which significantly impacted Brazil’s export revenues. Analysts reported a fall from a peak of $170 billion in 2011 to around $110 billion in 2015. This equates to the income equivalent to around 2.5% of gross domestic product (GDP).

Second was the necessary tightening of fiscal policy thanks to overspending in the boom years. When the recent commodity bust arrived, the underlying vulnerabilities were exposed. With interest rates already being hiked aggressively last year, the government now wants (and arguably needs) to introduce some unpopular budgetary measures.

One of these is the reintroduction of a tax on financial transactions (known as the CPMF) that was scrapped in 2007 after protests from business. These kinds of ostracized reforms will be necessary in order to bridge the widening fiscal gap. There is light at the end of the tunnel, but it looks like it could be a long one.

Finally, there’s Brazil’s political predicament. The country is in a transitional stage in the midst of outgoing President Dilma Rouseff’s long and drawn out impeachment battle. Corruption scandals surrounding the Lava Jato probe and dishonesty among other political figures added to investors’ concerns. Such distractions may have prevented a coordinated policy response to the economic crisis, muddying an already negative outlook. But it is easy to get drawn into the political conundrum without acknowledging the positive stories emanating from Brazil.

While the economy has a long road to recovery, there is reason to believe that Brazil’s current issues may be levelling off as the Brazilian real continues its rally. A true fiscal fix in the short term is unlikely, but the bleeding is expected to stop as political noise subsides. Inflation, which has been above the Central Bank’s target over the last few years, is forecast to fall next year. That would bring it comfortably back within the target. It can also herald a powerful rate cutting cycle. We expect anywhere from 300-500 basis points (bps) in rate cuts over the next two years. 

Economic headwinds will remain, but with some tough fiscal measures and reform (and perhaps a bit of good fortune on the macro front), Brazil can hopefully return stronger.

Fracas in Caracas

Now on to Venezuela, which we believe should be treated with caution. The country is in the midst of a serious economic crisis as it tops the Global Misery Index for the third consecutive year. Inflation could surpass 700% in 2016, according to the International Monetary Fund (IMF). The scarcity of basic goods, even water, is expected to worsen drastically and could fuel major social tensions. Much of the country is grappling with sporadic power cuts as economists forecast a contraction of around 5% in GDP this year, although a rebound to a small positive return is expected in 2017.

Venezuela’s President Nicolás Maduro has been locking up businessmen for conspiring to undermine his chaotic government and has tried to rally support among oil producing nations in an attempt to persuade Saudi Arabia to cut crude oil production. Crude oil accounts for 95% of export revenues, and falling prices, combined with years of mismanagement, have crushed the economy. Economists are warning that default is almost inevitable.

Maduro had to devalue the currency and raise gasoline prices, but even this is measure was far too little, far too late. While the move helped to ease pressure on public finances, the economic measures are nowhere near to what is required to tackle the burgeoning budget deficit. Despite this, Maduro has made it a priority to meet payments on sovereign debt, even if that means squeezing imports further. With a total of $10.5 billion due this year, the government will be raiding its dwindling foreign reserves once again. Its once hefty stock piles of gold are wearing thin. The government could turn to China for more loans, although the patience of the Chinese will surely be tested as a result.

With the current economic dynamics as they are, an orderly default – if there is such a thing – could arguably be the best bet for Venezuela. It may also mean that the nation’s politicians confront the issues head on. Default would cast doubt over the regime’s existence. But much like Brazil, the good news is the only path from here is up.

Mexico top despite being Trump’d

Donald Trump may have belittled Mexico and called for a “great, great wall” to be built along its border with the U.S., but the country has been a relatively strong performer in Latin America. GDP grew 2.5% last year.

Still, like many of its peers, Mexico’s economy is largely dependent on oil and will continue to face headwinds, especially on that front. Additionally, despite a recent rebound, there has been mounting pressure on the peso, which led the Central Bank to raise interest rates by 50 bps to 3.75%. This happened as the government announced another round of budget cuts. A recent slowdown in the U.S. industrial sector may also dampen progress this year, although a weaker currency could boost exports. A strong services sector will also remain supportive as economists again forecast 2.5% GDP growth this year, with 2017 seeing a greater expansion to 3.1%.

Fasten your seatbelts

The economic prospects for this year aren’t particularly inspiring. Subdued commodity prices will remain a key concern in the near term, and China’s slowdown (however necessary and controlled it may be), will continue to play its part.

Still, the opportunities are there. Tactical regional and intra-country allocation may be necessary for investors invested in or looking to invest in the Latin American region. Latin America can still produce some very good investment opportunities for the long term. We recognize that it’s likely to be a bumpy road ahead. Then again, investing in Latin America has never been a smooth affair.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

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