Market speculation about the timing and calibration of the normalization of Federal Reserve (Fed) monetary policy is driving down Latin American sovereign debt valuations. Government bond yields have been steadily rising in many markets across the region in response to quickening inflationary pressures stemming that were fueled by local currency depreciation, dampening domestic demand and slowing the pace of advance of Latin American economies.
Latin American currency weakness lowers the cost of domestic goods and services sold abroad, thus improving the competiveness of local companies, which should eventually cushion the downside to macroeconomic activity by mitigating the ill-effects of debilitating consumer spending and business fixed investment. Yet, persistently low prices of key commodities – owing to fragile global demand – is restraining the output of extractive industries and inhibiting the growth in foreign currency reserves, which are crucial for servicing the national debt and paying for imports in a timely manner.
Latin American sovereign fixed income markets will remain at the mercy of market speculation over U.S. interest rate trends for the foreseeable future – not so much since the region’s economies are edging closer to recession, but more importantly because a disproportionate share of their national debt is denominated in the U.S. dollar. Even though the magnitudes of external borrowings in the U.S. currency last year vary from country to country, the fact that outstanding debt in U.S. dollar terms is estimated to have ranged from 77.2 to 87.8 percent should continue to worry any investor – whose portfolio has exposure (irrespective of magnitude) to the overall bond issuance of Latin American nations and most especially to the share denominated in the U.S. currency.
Whether the Fed commences the restoration of normality to its credit policy via gradual increases in its key overnight lending rate in June, September or early next year remains uncertain. Nevertheless, dollar strength – combined with trepidations about the first and subsequent Fed funds rate hikes in addition to an increasingly deteriorating regional economic atmosphere – could make it difficult for many regimes to service their debt – all of which could spell trouble for Latin American currency trends in the months ahead. A possible consequence may be currency and funding mismatches related to an unwinding of “carry trades” (in which investors borrowed U.S. dollars at low interest rates and invested in high-yielding emerging market local currency products, in particular Latin American investment vehicles of varying duration).
Stock and bond market performance throughout Latin America has already discounted the prospectively dire adversities that many regional economies will have been or will be experiencing on both the economic and financial fronts in the near future. Indeed, continued weakening of bond and equity markets is evident in recent returns data, mirroring the current plight of the economies of the region and expected hardships they will likely endure in the coming months.
Only Chile is defying the ongoing erosion of equity and debt market performance. Still, it too cannot possibly escape the headwinds battering other markets regionally, with potentially severe negative implications for the Chilean peso in view of widespread corruption allegations and an influence-peddling scandal that has taken a huge toll on President Michele Bachelet’s public support (down nine points in the latest poll to twenty-nine percent). Although the scandals do not appear to have derailed her campaign to achieve national legislative approval of her landmark educational, labor and constitutional reform proposals, Bachelet’s rapidly dwindling popularity could postpone their consideration for some time.
However, to her credit, her having ordered every cabinet member to resign might help her somewhat in the opinion polls. Even so, rising joblessness in the face of a projected improvement in domestic economic patterns as well as low, albeit stabilizing, copper prices will limit momentum to the upside and threaten the peso with a hastier rate of depreciation bilaterally vis-à-vis the U.S. dollar and on a trade-weighted basis.
The near-term fate of the Brazilian real rests in the dubious hands of policymakers and prosecutors alike in Brasilia. Ongoing investigations of alleged corruption (a money laundering operation designated “Operation Carwash”) involving some officials of Petrobras, the state-owned oil company, will proceed to weigh negatively on public confidence in President Dilma Rousseff and her administration, diluting much-needed legislation for contracting the expanding fiscal deficit that Bloomberg consensus projections see ballooning to 5.2 percent of nominal GDP this year. Moreover, a separate, though related, inquiry into the financial activities of Rousseff’s political party is concentrating on her highly respected predecessor, Ignacio Lula da Silva.
With the macro-economy expected to decline one percent and inflationary pressures forecast to accelerate to eight percent in 2015, Brazil desperately needs disciplined public policies to redress the rising fiscal shortfall and the broadening economic recession weighed down by an aggressive run-up in credit costs engineered by the Banco Central do Brasil. Distractions arising from the corruption inquiries will only postpone resolute remedies to the country’s deteriorating economic maladies, requiring investors to short or avoid real investments entirely.
While progress in the implementation of industrial reform programs envisioned by Mexico’s President Enrique Pena Nieto has been quite promising, social and economic developments will continue to divert policymakers’ attention from the primary agenda of the current administration. The staggering criminal transgressions of the illicit narcotics cartel operating in Mexico will remain a significant distraction to Pena Nieto’s administration until his government trains its sights on reducing the nation’s rocketing homicide rate through comprehensive measures at combating the illegal drugs trade and eradicating pervasive government corruption at the federal, state and local levels.
Until the rule of law is re-established everywhere in Mexico, its citizenry and foreign visitors will remain hostage to the indiscriminate violence and lawlessness carried out by the criminals in the illicit narcotics business. Economically, Mexico seems on course to achieve a steady speedup in real GDP growth through 2017, accompanied by lower joblessness and moderate inflation, thanks to higher fixed capital formation stimulated by the Bank of Mexico’s accommodative monetary posture. Nonetheless, what is at stake is Mexico’s hard-fought battle to remain competitive internationally, and insecurity will undermine it unless the authorities confront it and restore security once and for all. Global Markets Intelligence (GMI) remains optimistic with respect to the prospects for Mexican equities, but recommends investors to hedge their peso positions fully.
Colombia’s long-term outlook will remain very much dependent on the strenuous, yet excruciatingly drawn-out, efforts of the nation’s re-elected president, Juan Manuel Santos, to negotiate a lasting peace accord with the Revolutionary Armed Forces of Colombia (FARC) and end the longest-running guerrilla insurgency in Latin American history. Having staked his entire presidency on bringing the struggle to conclusion, Santos is facing numerous roadblocks to ultimate success including the plausibly insurmountable FARC demand for amnesty from extraditions to the U.S., which an American delegate is expected to assure FARC will not take place if it comes to terms with Bogota.
Peace negotiations aside, the tempo of the Colombian economy is expected to slow from last year’s 4.6 rate of growth due to weak worldwide demand for oil and other natural resources. A high 9.1 percent unemployment rate will complicate government efforts to revive domestic demand. Widening budget and external deficits as well as speedier price pressures counteracted by a tight credit policy should postpone an economic recovery until late next year or early 2017. Given the protracted peace discussions and an inauspicioius prognosis for the domestic economy, investors are advised to hedge their peso exposures completely.
Avoiding Venezuelan and Argentine investments, except those well beyond Caracas’ and Buenos Aires’ reach, is advisable for investors seeking higher yielding potential rewards than those offered elsewhere. Venezuela’s slide toward authoritarianism renders it an expressly unattractive market for foreign investors because of the vulnerability private sector firms and foreign investments to expropriation by the leftist regime of President Nicolas Maduro. GMI adjudges any investment in Venezuela a risk too high to take.
In Argentina’s case, President Christina Fernandez cannot run for re-election, but Daniel Scioli – a purported acolyte of the president – has pulled ahead of his likely opponent, Sergio Massa, in public opinion polls that gauge popular support for both candidates. The former would probably follow the same approach as that adopted by President Fernandez in debt negotiations with holdouts.
Progress in negotiating a resolution of the disagreement between bond holdouts and the government remains as elusive as ever. The October 25th general election is more than five months from now, which should give Massa enough time to close the gap with Scioli and present an alternative policy platform that could unlock billions in postponed investments if a deal can be attained with holdouts to the original agreement.