LatAm Secular Outlook: Investing in the Age of Transformation
- Though Latin America’s economic outlook is delicate, we see investment opportunities in countries poised to benefit from the move to clean energy, with leaders committed to addressing endemic social strains with orthodox policies.
- Latin America faces a raft of structural challenges, including high debt levels and inflation, low productivity growth, and political uncertainty, leaving it vulnerable to potential shocks.
- China’s slowing trend growth will likely hit hardest on the non-energy commodity exporters, particularly those that specialize in key industrial metals used in construction, such as iron ore.
Latin America faces a raft of structural challenges, including high debt levels and inflation, low productivity growth, and political uncertainty, leaving it vulnerable, in our view, to potential shocks. Yet while the economic outlook for the region as a whole appears delicate, we see attractive investment opportunities in select countries poised to benefit from the secular transformation to clean energy, where leaders are committed to addressing endemic social strains with orthodox policies.
We discussed the impact of the green transition, the growing pressure to share economic gains more widely, and China’s slowing economy on the outlook for Latin America (LatAm) with Arminio Fraga, former president of the Central Bank of Brazil, and Alfonso Prat-Gay, former president of the Central Bank of Argentina, at our latest Secular Forum (read more in our latest Secular Outlook, “Age of Transformation”). Here, Pramol Dhawan, head of emerging markets (EM) portfolio management, and Gene Frieda, global strategist, talk with Barbara Clancy, head of Latin America and Caribbean Client Management, about the panel’s conclusions, our broad outlook for Latin America, and where we see opportunity.
Q: How are Latin American economies faring as we come out of the pandemic?
Dhawan: Aided by sizeable monetary and fiscal stimulus, economies recovered rapidly in 2021, in many cases restoring GDP to near pre-pandemic levels. Supportive global conditions in the form of low interest rates, reduced dependence on external financing, and rising demand for commodities – particularly oil, copper, and coffee – should provide a brisk tailwind for most of the region this year. Yet it may not be enough to overcome the drag from chronically low productivity growth, elevated inflation, heavy deficits, and a likely reversion to low trend growth rates. As such, we believe the region in aggregate will likely remain vulnerable to any new shocks.
Q: How will inflationary pressures in LatAm affect policymaker responses on local rates and ultimately currencies?
Dhawan: Central banks’ inflation-targeting efforts have generally remained robust. Nonetheless, inflation is likely to prove stickier in some countries due to post-pandemic political constraints.
In Brazil and Colombia, high debt levels and large fiscal financing needs may constrain central banks from tightening monetary policy enough to choke inflation ahead of crucial presidential elections.
Meanwhile in Chile and Peru, parliaments have turbocharged domestic demand by tapping into private pension system savings. Heightened spending will likely require tighter monetary policy to contain inflation. But pandemic-related political constraints may prevent central banks from moving fast enough to meet the challenge.
Finally, Mexico is an example of a country suffering inflation pressure despite maintaining an otherwise conservative fiscal policy. Sectoral interventions and large minimum wage increases may only serve to exacerbate supply constraints, in our view.
The burden on tighter monetary policy to compensate for these risks may provide a strong catalyst for exchange rate appreciation, even as it threatens economic growth and central bank independence. We view Argentina – with its persistently loose fiscal policy, central bank money printing and ever-rising inflation – as a cautionary tale that is not likely to be repeated by other countries in the region.
Q: Will the populist wave recede in LatAm or is it here to stay?
Frieda: We doubt the wave of populism in Latin America will recede soon. Typically, countries revert from political extremes back to centrism only after populism stalls. Moreover, political fragmentation – as distinct from populism – appears endemic, hindering the ability of governments to garner consensus on much-needed structural reforms.
At our Secular Forum, Arminio Fraga and Alfonso Prat-Gay observed that Latin America remains vulnerable to populist leaders preaching easy solutions to complex problems. The region lacks mainstream political leaders who communicate empathetically with voters, a skill typically in abundance with populist leaders.
Latin America’s role models, namely Chile and Peru, are suffering their own strains of populism, raising the risk of a return to discredited heterodox policies. The International Monetary Fund (IMF) appears to have adopted a greater tolerance for pre-emptive sovereign debt restructuring and capital controls. Accordingly, we have incorporated into our investment frameworks the risk of “black holes” (hard-debt defaults) and other tail scenarios that may drain liquidity from the system.
We believe a number of near-term signposts bear close watching:
- Chile’s impending constitutional reform process will likely determine governability for the region’s historical model pupil.
- Brazil’s 2022 election may be the region’s most consequential test of whether politics can revert to the mean without first lurching to crisis. A third-party centrist candidate could potentially right Brazil’s fragile debt dynamics, while a continuation of the status quo or indeed a return to the left would risk a local crisis of confidence and capital flight.
- The success of Ecuador’s IMF stabilization program.
- The resilience of Peru’s system of checks and balances.
- The Argentine government’s policy changes, particularly in public spending, after the Peronist party lost its Senate majority for the first time since the return of democracy in the 1980s.
Q: What does a slower, larger China mean for LatAm?
Frieda: China’s trend growth appears set to slow as its government moves to rein-in the debt-driven property market, become self-sufficient in key commodities, and more equitably spread the benefits of economic growth among society. This inward transition will likely fall heaviest on those countries most dependent on China’s seemingly insatiable demand for commodities over the past 20 years – the non-energy commodity exporters, particularly those that specialize in key industrial metals used in construction, such as iron ore.
Q: How will the world’s transition to green technologies affect LatAm?
Frieda: The world’s nascent transition to green technologies may be a game changer for some countries, offsetting the drag from China’s slowing property and infrastructure spending. Renewable energy, electric vehicles, hydrogen, and carbon capture are all more metals-intensive than their fossil fuel-based equivalents. Accordingly, we expect global demand will rise for major metals, including copper, nickel, cobalt and lithium, lifting the economies of those exporters (see chart below).
Q: How can LatAm emerge stronger from the pandemic period and where are we seeing the most value?
Dhawan: We look at investments in countries that are set to benefit from a number of positive conditions over the next 12 to 18 months.
First, in the majority of cases, institutional resilience has remained intact. This applies not only to central banks but also to judicial systems. Ultimately, we believe such resilience is key to macro stabilization. Without it, the traditional Latin curse of stagflation can return, as we have seen in Argentina.
Second, external conditions look reasonably supportive for Latin America. Despite pandemic-related inflation pressures lasting for longer than expected, we believe these pressures will ebb over 2022 and, thus, that the Fed and other developed market (DM) central banks will normalize policy relatively slowly.
Third, we believe commodity prices will remain firm – particularly those for energy and copper, major LatAm exports – and provide an economic tailwind. Energy supply constraints in developed economies, coupled with our expectations for rising copper demand from green technologies, should support commodities.
Finally, in most cases, democracy still functions and can restore orthodox centrist governments, particularly in response to market pressure for reforms. This is not to downplay the challenge of governability in the face of political fragmentation, but to the extent that reformist leaders return to power, markets will likely tend to give some benefit of the doubt to their policy promises. Credible plans tend to create space for governments to balance often painful reforms with the minimum growth objectives necessary to keep voters on board.
Q: Given this outlook, how is PIMCO looking at investing in LatAm? And how are investors based in LatAm responding to the changing local environment?
Dhawan: We approach Latin America as a broad opportunity set and not as a passive beta investment. Politically stable countries with relatively benign inflation and credible central banks are increasingly attractive as yields have risen and currencies have remained undervalued. We see select frontier-market opportunities, such as the Dominican Republic, that should be less correlated to EM beta.
Q: How should investors approach investing in LatAm assets?
Clancy: Given the potential risks in Latin America, and EM more broadly, active management is expected to be critical. A focus on risk management, and both top down and bottom up analysis is essential. We see opportunities in Latin America, particularly in the private market, for eligible investors who do not have liquidity constraints. These opportunities include private lending, infrastructure, and corporate credit.
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