Latin American countries have been convulsed by political and economic tumult in recent months. On Sunday, Brazilian voters will go to the polls in the second-round runoff of a presidential election that has been dominated by three issues: economic weakness, corruption scandals and rising levels of violence.
Meanwhile, in Mexico, the future of the capital’s new airport hangs in the balance this weekend as voters decide in a non-binding referendum whether to proceed with the country’s biggest infrastructure project.
Ahead of the two key votes, we assess the landscape for credit investors in Latin America.
Latin American credit has outperformed all other emerging-market (EM) regions – in terms of total return – for the past three years (see Figure 1).
So far, however, 2018 has been a challenging year for EMs. Countries such as Argentina and Turkey have faced currency crises, while US dollar strength and trade-war tensions have weighed on other EM countries. Against this backdrop, Latin America has underperformed its peers by total return so far this year. This can largely be explained by its spread duration – that is, its sensitivity to changes in credit spreads – which is higher relative to other regions. However, on a spread basis, Latin American credit has outperformed its EM peers over the same period.
Figure 1. Latin American credit has outperformed other EM regions (by total return) since 2015
Latin America’s largest country and economy votes in the presidential election runoff – between former army captain Jair Bolsonarro and Fernando Haddad from the leftist Workers’ party (PT) – this Sunday.
A slew of adverse events have rocked Brazil in recent years: commodity-price weakness and concerns about a Chinese slowdown in 2015-16 compounded fiscal problems to cause the worst recession in the country’s history; a deep and broad corruption scandal, known as Lava Jato or ‘car wash’, implicated all big political parties; and levels of violence jumped, with nearly 64,000 murders recorded last year1. And although the economy has normalised (in 2017, real GDP grew by 1% year-on-year), the unprecedented 10-day trucking strike over fuel prices in May and weaker business and consumer confidence in the run-up to the much polarised presidential election has weighed on economic momentum.
What’s more, the weakened Brazilian real is starting to impact the central bank’s monetary policy. Last month, the Brazilian central bank acknowledged the possibility of a future rate hike: it noted that there is a higher risk that inflation could overshoot its 2019 target of 4.25%2.
The outcome of this weekend’s presidential election will therefore dictate the central bank’s near-term monetary policy. The market-preferred candidate is Bolsonaro as he represents the best chance of preventing the PT from reclaiming power. In addition, Bolsonaro’s economic advisor, Paulo Guedes, is an orthodox University of Chicago-trained economist and should provide investors with enough confidence in his aim of passing much-needed reforms through Congress, such as overhauling the country’s pension system and implementing spending and tax cuts.
Voter anger over corruption has also shaped recent elections in other Latin American countries. Left-wing populist Andrés Manuel López Obrador won the Mexican presidential race in July. And with just over a month to go until he takes office on 1 December, the president-elect has called a referendum-like consulta on the future of Mexico City’s partially built airport.
Investors will pay close attention to the nationwide vote, which takes place from 25-28 October. The vote will ask voters whether they want to proceed with the $13bn project or go for a cheaper alternative. Cancelling the airport expansion would come at a high economic cost: it would adversely impact sentiment and increase funding costs for Mexican corporates.
Investors have given López Obrador the benefit of the doubt since his presidential win in July, but the non-binding referendum is the first real test for the president-elect: it will serve as a preview as to what the market can expect from the incoming administration, including its future relationship with state-owned oil company Pemex, and the outcome will determine the attractiveness of Mexico as a recipient of foreign capital.
In markets, though, volatility breeds opportunity – and we still see plenty of opportunities in the current environment.
Today, bottom-up factors remain supportive for certain Latin American issuers. For example, pulp and high-quality iron-ore exporters are supported by margin expansion in an environment where local-currency costs are improving and demand remains strong. Similarly, oil exporters are also robust, thanks to a strong global economy, OPEC’s production cuts, and conservative management teams that have experienced oil-price falls below $30 a barrel.
Moreover, at the aggregate level, we believe the technicals influencing EM debt remain underappreciated by the market. In the nine months to September, EM debt issuance has fallen by $60bn year-on-year – that’s a decline of 23% (see Figure 2). Similarly, issuance in Latin America fell by 28% over the same period, and this lack of supply supports the performance of outstanding debt. However, this could change: if positive results emerge from both Mexico and Brazil over the weekend, issuance in the region should increase.
Figure 2. EM debt issuance has declined in 2018
We believe that current holding Vale, a Brazilian miner, is a credit issuer that is well placed to perform well in the current environment – despite the political risks (see our recent Spectrum Beyond borders: breaking down silos in global credit for further information).
The company focuses on producing high-quality iron ore, which enables more efficient and cleaner steel production. Recently, there has been a structural shift in demand towards high-quality iron ore, in part reflecting changes in Chinese environmental policy which has incentivised more efficient steel production. Moreover, the Brazilian real has depreciated by more than 10% so far this year, while prices for high-quality iron-ore have risen. This means that the weaker local currency has reduced the relative cost base and the strong demand for iron ore traded in US dollars has boosted its credit profile through margin expansion.
Having assessed its environmental, social and governance metrics, we welcome the progress that the company has made since a dam burst at its Samarco mine in 2015. Meanwhile, its migration to the Novo Mercado, together with the conversion of its class A preferred shares into common shares, has highlighted Vale’s commitment to higher corporate governance standards and strengthened our positive view on the company.