The outlook for major Latin American markets continues to deteriorate, despite the favourable commodity cycle and relatively higher rates to support local currencies. Local politics and unfavourable pandemic outcomes are still our main reasons for concern, but external factors – strong dollar and higher U.S. yield – also create additional headwinds. One would expect the region to capture part of the reflation trade excitement, but this is not happening. At first, we thought Brazil was the weakest link, given the country's inability to deliver minimal improvements to the fiscal outlook and incessant negative political headlines that kept investors away and maybe soured sentiment for the region. But now, the outlook for Colombia and Peru is also deteriorating rapidly. Here we review some of recent developments and high-level themes across these markets.
Brazil is still a mixed bag in terms of factors driving asset prices, with this mix still skewed negatively. The pandemic continues to rage across the county. The government's health authority, Anvisa, decided to reject the Russian Sputnik vaccine based on uncertain methodology and safety concerns. The decision was highly controversial and represented a setback for the expected vaccination efforts. Still, the pace of vaccinations is improving, with about 15% of the population now having received a jab. There's also some upside risk that a domestic vaccine will be approved in the near term, but it's hard to say. On the political front, the current source of headline noise will come from the government facing an investigation commission about mismanagement of the pandemic.
The fiscal outlook remains the cornerstone for Brazil's asset price performance. We had some mildly positive news on the front with the end of the gridlock in congress. President Bolsonaro signed the budget, which is good, but it was a missed opportunity to deliver an upside surprise. Part of the spending proposal will stay outside the budget rule, so the spending trajectory is still very expansionary and will continue weighing on markets.
The currency is getting some support from widening interest rate differentials after the central bank decided to frontload the tightening cycle. The BCB surprised markets with a 75 bp hike (vs. 50 bp expected) in the March meeting and will surely deliver the second dose of the same magnitude in today's meeting. We think there is a lot more tightening in the pipeline, though this is already reflected in the futures curve. The recent appreciation of the real, if sustained, could shorten the cycle to some extent, but it's still too soon to tell. Either way, we think the BCB is acting appropriately by confronting the government expenditures and rising headline inflation figures, even if they ultimately prove transitory.
The Colombian government's attempt to stabilize the budget was thwarted by political pressure and street protests. At the core of the story lies a controversial tax plan intended to fund the pandemic stimulus expenditure by raising 1.4% of GDP in extra income. This would ensure the budget remains on a sustainable path and hopefully avoid a downgrade. This increases the risk of downgrades to sub-investment grade, as per S&P's recent warning. Colombia CDS prices continue to trend higher, now over 135 bp. This is at the top of the recent range and still well below Brazil's (195 bp) and South Africa's (220 bp). The peso depreciated 2.5% against the dollar yesterday.
Finance Minister Carrasquilla resigned in the wake of street protests and was replaced by Commerce Minister Manuel Restrepo, a less polarizing figure. The government is now revising the plan, and we think the odds of a resolution are considerably higher after the cabinet reshuffle. Still, any agreement that emerges from the next round of negotiations will likely mean a water-downed version of the original proposal, changing some of the most unpopular measures, such as extending the VAT to a more extensive set of goods. This raises the risk of downgrades to sub-investment grade, as per S&P’s recent warning. Moreover, more street protests could follow, further weighing on confidence.
Peru's near-term performance hinges on the outcome of the Presidential elections. The latest polls still show the left-leaning opposition candidate, Pedro Castillo, ahead of the presidential race. The gap has narrowed slightly, with Keiko polling at 34% (+3 ppts) and Castillo at 43% (-1 ppt). Notably, Keiko's rejection rate fell to 50% from 55%. Castillo had stepped away from the campaign trail due to health concerns but has returned now. Castillo tried to ease worries about the nationalization of mining assets or an attempt to change the constitution without a referendum. He also said he would respect central bank independence if elected. Still, markets are on edge, and rightfully so, in our view. Markets will remain at the mercy of polls until the runoff vote on June 6.