UNTAPPING LATAM’S POTENTIAL
Although scenes of economic and political uncertainty still blight Latin America’s economic story, we are looking out for signs of an opportunity to revisit the region’s narrative and position portfolios for a less-pessimistic next chapter.
In the midst of its worst economic crisis since the Lost Decade of the 1980s, the Latin America (LATAM) economy is expected to grow at a lacklustre rate of just 0.8%1 this year. However, the region is no stranger to crises and has shown a great propensity to bounce back from adversity. But before any bounce can occur, there must be a bottom; and speculation is increasing about when the inflection point will occur.
In our search for light at the end of the LATAM tunnel, we are looking out for key drivers that could signal that the worst is over. Here, we outline our ideas of what that ‘light’ might look like:
Oil and commodities break the secular downtrend
Once oil and commodities break out of their current oversupply malaise, LATAM currencies, along with risk assets across the region, should begin to stabilise.
The USD breaks its uptrend
A strong US dollar (USD) implies reduced liquidity across the globe, which hampers appetite for risky assets. While USD has recently begun to weaken against major currencies, it has not yet broken the uptrend of the last three years2. When it does, we could see a turnaround in demand for LATAM securities.
A daring monetary policy in the region
LATAM currencies have continued to weaken regardless of how high real interest rates have become. Central bankers across the region must now, in our view, take a more aggressive approach to cutting interest rates, while managing inflation. This will send a clear signal to the market that the region’s authorities are making growth a priority over the singular goal of meeting inflation targets.
Yield curves that point to recovery
The shape of the government bond yield curve is often a key indicator of the market’s expectations for the economy. As a result, it is important to keep an eye on the spread between the long and short end of the curve. A wider spread would suggest a recovery as it would reflect an improvement in short-term liquidity, which is necessary for growth in these economies.
Credit spreads begin to tighten
By monitoring demand for corporate paper of LATAM issuers, we are in a position to identify when a contraction of the high spreads may signal an easing of the negative sentiment towards the asset class.
…However, there is a ‘but’
While we remain poised for signs of a turnaround in the region, we are by no means blind to the obvious threat of Brazil. There is no denying the severe economic pressure under which the country is under. With its economy predicted to shrink 2.5-3%3 this year, we acknowledge the risk for the region and its recovery to be weighed down by the woes of its largest economy.
Emerging opportunities: portfolio positioning considerations
Along with the rest of the emerging markets (EM), the main economies of LATAM have, for several years, been languishing on the wrong side of the global rebalancing process as developed markets have brought a proportion of their manufacturing needs back home. However, there are signs that this economic adjustment is nearing its completion and, with it, the de-rating of emerging market risk assets to their developed counterparts. In addition, while the monetary easing cycle in the developed world is maturing – stoking fears that less liquidity in the west will hurt EM – we must not overlook the fact that the tightening cycle within EM economies is similarly maturing.
A well-advanced global rebalancing process, together with a maturing easing cycle in the west and a maturing tightening cycle in EM lends increasing support to the view that – once oil prices and USD start to stabilise – it could signal an opportune time to shift portfolio allocation back towards a more neutral EM position.
Going local: a view on EM debt
As a consequence of the challenges surrounding the asset class today, EM dollar-denominated bond spreads over US Treasuries are attractive relative to their five-year history4.
There has been visible progress in the way that many EM governments agree and implement policy, with increased independence between governments and central banks. In addition, exchange rates for half of EM countries are free-floating, and the challenging environment for commodities is expected to create more dispersion within the EM complex. This should generate opportunities for investors in the local currency space who are willing to take an active, long-term view. As we remain poised for the slow completion of the bottoming-out process, we see potential value in moving allocation from low-yielding developed market sovereigns into the EM local currency debt space.
Where now for the next chapter?
- The stabilising USD and oil markets supported our positive view on EM government bonds (in local currency). EM currencies have slightly rebounded but remain more than 20% undervalued against the USD5.
- Over recent weeks, spreads between the two government bond markets have tightened on the back of higher US yields, while EM yields remain stable (around 6.5%, as at 16 March 2016).
In light of this trend, we believe there is opportunity to rebalance fixed income exposure towards emerging market local debt.
1 OECD Economic Outlook
2 Bloomberg, 17 March 2016
3 OECD Economic Outlook
4 Bloomberg, 17 March 2016
5 Bloomberg, 17 March 2016
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