May 5, 2017

Latin America: a brighter outlook

by Fathom Consulting

Latin America looks set to emerge from two years of recession, with GDP growth rebounding sharply this year and accelerating into 2018. Large exchange rate depreciations led to above-target inflation, but that has peaked, leaving economies more competitive than before. Stronger economic growth in the US, destination for a significant share of Latin American exports, alongside a China-driven rise in commodities prices, will help. As with emerging markets more broadly, equities and exchange rates in the region are attractively valued relative to other assets, offering scope for further returns.

After contracting in 2015 and 2016, Latin American (LA) GDP looks set to rebound over the next two years, with a modest recovery in Brazil, the region’s largest economy, coupled with resilience in its second largest, Mexico. Indeed, the region will benefit from dual tailwinds. The US economy is set to accelerate. Meanwhile, China’s stimulus will help boost the price of non-oil commodities, aiding metals exporters in the region. But a new normal means the recovery will be modest and growth weaker than it was pre-crisis. Risks around US trade policy remain high but do not materialise in our central scenario.

Playing catch up with the rest of the world

After a 0.8% contraction in 2016, we forecast that LA will emerge from a two-year recession with GDP growth of 1.5% this year and 2.0% in 2018. The fall in commodities prices that started in 2014 negatively affected many economies, but the concerted effort by Chinese authorities to ‘double down’ on investment-led growth has helped reverse some of those price declines. This will benefit exporters such as Chile and Peru. Demand will also come from the US, destination for almost half of LA’s exports. Specifically, we are above-consensus in terms of Mexican GDP growth this year, due to a rapid increase in exports to its northerly neighbour.

LA’s recession was triggered by falling commodities prices, which acted as a negative terms of trade shock. In most cases, that was compounded by ‘risk-off’ sentiment among investors, resulting in large currency depreciations which fed through to above-target inflation, particularly in Brazil and Colombia. But inflation rates have since declined rapidly as base effects have dropped out of the twelve-month comparison and nominal interest rates have been tightened.

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Improved competitiveness after depreciation

Sharp exchange rate declines have helped many economies move towards external balance. As the chart below shows, the real effective exchange rate in four out of five of LA’s largest economies remains around 10% below its start-2010 level. That improved competitiveness will help to encourage export-led growth. Stronger US demand in particular can be seen in Colombian and Mexican exports (in USD), which are rising at annual rates of 31% and 11%, respectively. Current account balances have improved too. Indeed, the average current account balance in the five countries shown in the chart below has improved by more than one percentage point of GDP since 2014.

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Peak Lat Am populism offers equity returns

Through its modern history, LA has been beset by populism. But deep recessions have sobered minds, and electorates in the region have shown increased favour towards politicians with a more pro-market perspective. In Brazil, corruption allegations against former president, Dilma Rousseff, aided this process. As the chart below shows, equity markets have rewarded favourable political developments in Brazil (Michel Temer), Colombia (FARC peace deal), and Peru (Pedro Kuczynski). Mexico, despite a more recent recovery, shows how populist leaders abroad (Donald Trump) can have negative spillover effects. Politics, long a drag on LA assets, has moved in its favour, in contrast to developments in some advanced economies.

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Lat Am, like EMs, appear attractively valued

As with the EM class as a whole, many LA equities appear attractive on a relative basis. The regional forward price-to-earnings ratio is 13.2. While that is 7% higher than its ten-year moving average, it is much less than the premiums attached to many equity markets in the advanced world. Moving forward, we anticipate further gains in non-oil commodities as well as stronger earnings growth on the back of improved macroeconomic fundamentals to drive prices higher.

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US trade policy a big downside risk

In our view, the biggest risk facing EM economies stems from a reversal in globalisation, and increased trade barriers. That is particularly true for LA. The most likely catalyst would be if the US adopts restrictive trade policies. Colombia and Mexico, who currently have the most to gain from a resurgent US in our central scenario, would also be the most negatively affected from any such veer towards isolationism. The US accounts for 30% of Colombia’s exports and 82% of Mexico’s.

Mexico is particularly exposed. At US$63 billion, its trade surplus with the US is the fourth largest, placing it worryingly near the top of Donald Trump’s targets. Reportedly, the US President has considered withdrawing from the North American Free Trade Agreement (NAFTA) altogether. However, we expect NAFTA renegotiation to lead to cosmetic changes without severe new restrictions. If we are wrong, and the US severely increases trade restrictions on its southern neighbour, Mexico’s economy and asset markets would suffer considerably.

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Viva Latin America?

Over the past two years, LA has been severely affected by the decline in international commodities prices and the sluggish US recovery. Those dual headwinds now look to be tailwinds, with pro-growth stimulus by authorities in both China and the US likely to lift demand for LA exports. With that in mind, and considering that many LA economies are at an early stage of the cycle and enjoy a favourable political backdrop, regional equity markets appear attractive as do some currencies. But risks remain around US trade policy, something that could prove acute, particularly for Mexico.

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