Argentine president Mauricio Macri’s passed his crucial mid-term test with flying colours. He gained some seats but, more importantly, momentum in his reform programme was maintained with the population’s clear validation of his attempt to move the economy onto more orthodox footing.
Reinforcing last year’s good political vibes, Chile’s presidential election continued the market-friendly theme with the election of president Sebastián Piñera in mid-December.
Taken together, can we expect these to be a positive signal for this year’s important electoral tests in Colombia, Mexico and Brazil?
Each country will be more driven by domestic issues than influenced by any regional movement back towards centre-right market-friendly governments.
Colombia is first up, with the first round in May and a potential run-off in June, and it is still far from clear who will be on the ballot. The traditional, dominant political parties have lost their sway over the Colombian electorate and faith in all parties is reportedly low.
The peace process has also polarized support and there is a strong possibility that an independent candidate could emerge. The good news is that, so far, it is unlikely that a viable candidate will emerge with the potential to take Colombia away from its consensual and orthodox economic approach (the country suffered a morale-sapping downgrade in December 2017).
The same cannot be said for the Mexican election scheduled for July. Like Colombia, the outlook is uncertain, but in Mexico there is the potential for a left-wing candidate to win and spook the markets.
Andrés Manuel López Obrador (popularly known as AMLO) is one of the leading candidates and his commitments include repealing the country’s energy reforms. In practice AMLO may prove to be less of a threat to investors than he appears (as with president Lula da Silva in Brazil after his win in 2002), but even if his radicalism is scaled back, progress on reforms would likely stall and it might lead to a breakdown in efforts to agree a new Nafta trade deal.
And then at the end of the year comes the big one. What direction will Brazil turn? One option may be legally closed off this month, when the candidate that is leading the early polls – former president Lula – could be ruled out from running if his conviction for corruption is upheld. Even if he is allowed to proceed with his presidential bid, it is impossible to predict how the country, tired of corruption and economic recession, will react.
So some emerging market (EM) investors would be forgiven for anxiously reviewing their Latin America exposure as we enter 2018. But if they do, they should do so using the following perspective – investing in Latin America today is a much more solid and stable proposition for three main reasons
First, while there has been a strong increase in debt issued in the region it does not appear to be unsustainable. Capital Economics points out that EM debt issuance has almost trebled, from $15 trillion in 2007 to $43.7 trillion in 2017. However, this time the debt has been in the corporate sector and sovereign balance sheets (let’s ignore Venezuela) are in a strong position. Systems can clearly absorb corporate defaults if the sovereign remains unaffected.
Also most of this build-up has been a China story, accounting for almost 80% of the increase in EM debt. And while Latin America remains vulnerable to economic problems in China, it does mean the debt issue one-step removed. Credit bubbles in the region – such as that in Brazil – are now unwinding and the dangers of systemic issues are receding.
The danger from the dollarization of this debt is also a traditional concern. Again, this is now more a corporate issue than sovereign and most of these corporates have dollar earnings to enable FX volatility to be managed. Also, EM GDP has nearly doubled in dollar terms in the past decade, which also makes servicing debt and rolling debt over an easier proposition – even during times of stress.
The other habitual fear among EM investors is that changing differentials between US and local interest rates could lead to sharp sell-offs and a rush for the exit on a one-sided trade. Even just the fear of this caused the “Taper Tantrum”.
But again this staple of EM investment theory does not bear scrutiny. The majority of EM debt is now denominated in local currencies and so even a quick rise in US interest rates is unlikely to lead to a spike in EM debt servicing costs. Also, the strong development of these local markets in the past ten years, and the emergence of large local institutional investors, has created a buyer for foreign investors if they chose to withdraw. These buyers lessen the likelihood of market-driven accidents; of exit strategies turning into stampedes.
2018 is going to provide many tests of nerve for investors in Latin America, with political noise affecting three of its biggest markets. But the region is a fundamentally different place than it was a decade ago and these stress tests won’t lead to any systemic danger.