2013 Retrospective: Rebalancing The Dominant Theme

BMI View: The six key themes we highlighted for Latin America in 2013 have played out relatively well. In particular, our expectation that slowing growth in China and lower commodity prices would hit regional metals exporting economies hard has been a major theme in macroeconomic analysis this year with consensus growth expectations converging with our own in several cases, as well as being an important driver of financial market performance this year.

The key themes we identified for Latin America in 2013 have broadly played out ( see 'Our Key Themes For 2013', December 12 2012). In particular, our views that industrial metals exporters would be hit hard by slowing growth in China and lower commodity prices, policy rates would remain low throughout much of the region, reform efforts would make Mexico an investor favourite, and new leadership in Venezuela would not see political risk abate have all withstood the test of time. Our expectation that Argentina would face a perfect storm of economic conditions requires slightly more nuance, as despite avoiding a one-off devaluation of the currency, the rate of depreciation has exceeded our initial expectations, while legal wrangling has forestalled a technical default for now.

One area where we were caught out is the Brazilian economy. Throughout this year it became increasingly clear that structural constraints in the infrastructure sector, as well as continual changes to the government's concessions policies, were still delaying tendering processes and causing projects be waylaid in the implementation phase, meaning that the backlog of construction projects failed to feed through to the boom in fixed investment we expected for a second year in a row.

Consensus Clearly Moving In Our Direction
2013 Real GDP Growth Forecasts For Chile (LHS) & Peru (RHS), %

2013 Retrospective: Rebalancing The Dominant Theme

BMI View: The six key themes we highlighted for Latin America in 2013 have played out relatively well. In particular, our expectation that slowing growth in China and lower commodity prices would hit regional metals exporting economies hard has been a major theme in macroeconomic analysis this year with consensus growth expectations converging with our own in several cases, as well as being an important driver of financial market performance this year.

The key themes we identified for Latin America in 2013 have broadly played out ( see 'Our Key Themes For 2013', December 12 2012). In particular, our views that industrial metals exporters would be hit hard by slowing growth in China and lower commodity prices, policy rates would remain low throughout much of the region, reform efforts would make Mexico an investor favourite, and new leadership in Venezuela would not see political risk abate have all withstood the test of time. Our expectation that Argentina would face a perfect storm of economic conditions requires slightly more nuance, as despite avoiding a one-off devaluation of the currency, the rate of depreciation has exceeded our initial expectations, while legal wrangling has forestalled a technical default for now.

One area where we were caught out is the Brazilian economy. Throughout this year it became increasingly clear that structural constraints in the infrastructure sector, as well as continual changes to the government's concessions policies, were still delaying tendering processes and causing projects be waylaid in the implementation phase, meaning that the backlog of construction projects failed to feed through to the boom in fixed investment we expected for a second year in a row.

Breaking Down Our Track Record

1) Ill Prepared For Major Rebalancing (Hit)

Our view that industrial metals exporting economies in Latin America would be hit hard by slowing growth in China and weaker metals prices played out well in 2013. Chile, Peru, and to a lesser extent Brazil have been hit hard as weaker exports have fed through to widening current account shortfalls, and in some cases have helped to make net exports a more significant drag on growth in 2013. Fixed investment and private consumption growth have slowed as well, impacted by both reduced capital expenditure programmes by major mining firms, as well as exchange rate weakness, as commodity currencies passed their peak ( see 'Commodity Currencies Likely Peaked As Rebalancing Takes Hold', October 1). Although our Commodities team forecasts lower average copper, iron ore, and gold prices next year, we believe that the bulk of the downside for metals exporting economies has played out, forecasting real GDP growth to remain near current levels in 2014, at 4.9% in Peru and 4.2% in Chile, as compared to our forecasts of 4.8% and 4.3% respectively in 2013.

Consensus Clearly Moving In Our Direction
2013 Real GDP Growth Forecasts For Chile (LHS) & Peru (RHS), %

In addition to playing out on the macroeconomic front, this theme was a major driver of financial markets this year. Not only have Peru's IGBVL, Brazil's Bovespa, and to a lesser extent Chile's IPSA underperformed other equity benchmarks in the region less exposed to Chinese industrial metals demand, like Colombia's IGBC and Mexico's IPC, but they have seen Latin American stocks underperform their emerging market peers this year.

2) Policy Rates To Remain Low (Hit)

Monetary stimulus was a key theme in Latin America this year, as central banks began to shift their focus from fighting inflation to stimulating growth, despite significant exchange rate weakness. In Mexico, the magnitude of the cutting cycle was more substantial than we initially expected given a weak recovery in the manufacturing sector and significant delays in infrastructure projects following a change in government in January.

Latin America Central Bank Policy Rates, %
End-2012 Current
Colombia 4.25 3.25
Chile 5.00 4.50
Peru 4.25 4.00
Mexico 4.50 3.50
Brazil 7.25 10.00
Source: BMI, Respective Central Banks

In Chile, our view for 50bps of cuts in 2013 was spot on, following 25bps reductions in October and November to 4.50%. After a pause in December, we forecast the Banco Central de Chile to resume easing in Q114 to 4.00% by end-2014 on the back of slowing economic activity and declining consumer confidence, in line with our view for further exchange rate weakness in the coming months ( see 'Monetary Easing To Continue In 2014', November 26). In neighbouring Peru, the economy's significant slowdown in the year-to-date prompted the central bank to unexpectedly cut the policy rate by 25bps to 4.00% in November - we adjusted our forecast for a hold through year-end as inflation remained near the upper band of the bank's 2.0% ± 1.0% tolerance band.

Brazil was the major exception here. While we expected a modest rate hike in 2013, the central bank's reluctance to hike interest rates from a record-low 7.25% in the face of rising headline inflation in early 2013 saw it lose control of inflation expectations. Indeed, we suggested that such an outcome was possible in March, as a failure to hike rates and rein in inflation expectations in the near term could force the bank into a more aggressive tightening cycle later in the year ( see 'BCB To Frontload Tightening Cycle', March 20). This has played out in a big way, as the Banco Central do Brasil has hiked the Selic target rate by 275bps to 10.00% this year.

FX Weakness Another Dominant Theme: While we expected that monetary easing would go hand-in-hand with exchange rate weakness in many major regional economies, we did not anticipate the scope of the sell-off seen this year, as the prospect of imminent tapering of the US Federal Reserve's quantitative easing programme saw massive capital flight from Latin American FX, as well as other emerging market assets ( see chart). Moreover, with less capital to go around in the next few years, we expect investors will increasingly discriminate on the basis of macroeconomic fundamentals, preferring those Latin American economies with stronger domestic consumer stories and ties to the US over those economies highly dependent on demand for industrial metals ( see 'Commodity Currencies Likely Peaked As Rebalancing Takes Hold', October 1). As such, we expect that those commodity currencies that have seen significant appreciation in real terms in recent years are likely to see further downside.

Latin FX Hit Hard By Tapering Fears
JP Morgan Latin America FX Index & Inverted Generic US Government 10-Year Bond Yield

3) Construction Backlog To Provide Boost To Economic Growth In Brazil (Miss)

While the fundamental factors underpinning our view for a pick-up in construction activity and fixed investment in 2013 remain, namely significant spending related to the PAC II growth acceleration programme and infrastructure development in advance of the 2014 FIFA World Cup and 2016 Olympic Games, the government failed to capitalise on them once again this year. After contracting in year-on-year terms in 2012, fixed investment looks set to post positive growth this year, although it is unlikely to provide a significant boost to economic activity as we expected.

Another Disappointing Year
Brazil - BMI Real Construction Industry Growth Forecasts, %

While 67.2% of the money for the PAC II programme has been allocated as of August 2013, projects have been waylaid in the implementation stage, emphasising the structural constraints facing Brazil's economy. Moreover, continual changes to the terms of the country's concessions infrastructure programmes have resulted in delays in bringing transport projects to tender and done little to improve investor sentiment. As such, we believe local firms, or those with significant experience operating in Brazil, will be the most likely beneficiaries of concessions going forward. These factors have seen our Infrastructure team revise its forecasts for real construction industry growth in the next few years, from 5.8% at this time last year to 2.8% at present ( see 'Growth Revised Down As Government Gets In The Way Of Potential', July 26).

4) Reform Effort To Make Mexico An Investor Favourite (Hit)

Mexico's reform drive was the focus of major investor interest this year, although it did not help the economy to avoid weak growth in the manufacturing and infrastructure sectors, the poor performance of which we expect to drive a slowdown in real GDP growth from 3.8% in 2012 to 1.6% in 2013 ( see 'Growth To Accelerate In 2014', November 5). Nevertheless, a pro-reform multi-party cooperation pact, known as the 'Pact for Mexico', enabled President Enrique Peña Nieto's administration to push through education, telecommunications, fiscal, and banking reforms, while energy sector reform is set to be voted on before year-end. The administration's ability to push through reforms has exceeded our initial expectations, with the 'Pact for Mexico' able to withstand criticism from opposition groups and stay focused on its reform agenda. Investor reactions to these reforms have been broadly positive, with the initially disappointing exclusion of a valued added tax on food and medicine in the fiscal reform largely seen as a concession to the political left, enabling for a stronger negotiating position on energy sector reform. However, significant protests over education reform highlight the challenges the government will face in implementing these measures.

Major Reforms Passed During Mexican President Enrique Peña Nieto's Tenure
Reform Date Approved By Legislature Summary
Banking Nov-13 Seeks to stimulate loan growth by facilitating the recovery of collateral on non-performing loans and streamlining the bankruptcy process. The reform also expands the role of the banking regulator in order to spur competition between commercial lenders, and increase the role of development banks.
Fiscal Oct-13 Expands tax base by increasing the top income tax rate from 30% to 35%. It also increases the VAT in border states from 11% to 16%, imposes a 7.5% royalty on mining firms and hikes taxes on sugary drinks and junk food, among other measures.
Education Sep-13 Imposes evaluation-based firing, hiring and promotion. Creates a national organisation that supervises education, effectively reducing the role of unions in processes such as hiring and allocation of funds.
Telecoms May-13 Aims to end the power of dominant companies in Mexico's telecommunications industry. The bill will target fixed-line phone, internet, mobile and TV providers with over 50% market share, by introducing further competition and forcing operators with significant market power (SMP) to sell off assets.
Source: BMI, Local Press

In addition to keeping investors focused on Mexico's long-term growth potential, we believe that it could see a change in tone in some other Latin American economies in the coming years, as governments across the political spectrum acknowledge the necessity of making structural improvements to attract investment.

5) A Perfect Storm In Argentina (Mostly Hit)

Argentina faced a near perfect storm of economic conditions in 2013, but shrewd policymaking and some legal wrangling have enabled the economy to emerge mostly unscathed. Indeed, in order to avoid a one-off devaluation of the currency, our view at the start of this year, the government dramatically increased the rate at which the crawling peg depreciates ( see 'ARS: Faster Depreciation Likelier Than One-Off Adjustment', September 4). This means that even our initial average and end-2013 exchange rate forecasts, which factored in a one-off adjustment, remained broadly on track for this year. We expect substantial managed depreciation to continue through 2014, although with foreign reserves dwindling, we acknowledge the risk of a transition to a dual exchange rate system or even a currency crisis over the next 12 months, as the monetary authorities' room for manoeuvre is limited ( see 'ARS: Growing Risk Of A Duel Rate Next Year', November 26).

Weakening Must Continue Over The Medium Term
Argentina - Official & Implied Exchange Rates, ARS/US$ & M2/Reserves Ratio

In addition, while the Argentine government has not been forced into a technical default as of yet, the prospect of one cannot be ruled out at this stage, although the Argentine government is unlikely to be faced with such a decision until mid-to-late 2014, or even 2015. A stay granted of the US Second Circuit Court of Appeals' ruling, which stated that the Argentine government will have to pay either all bondholders or none, gives the government a respite until the US Supreme Court decides whether it will take Argentina's case. If the court does not take the case, we believe the government is likely to change the bonds to Argentine law, triggering a technical default, unless ongoing negotiations with creditors bear fruit.

Nevertheless, with the ruling Frente Para La Victoria (FPV)'s highly interventionist policy mix having contributed to the party suffering a significant setback in the October 2014 midterm election, in line with our long-held view, we believe that a period of policy moderation is ahead. Most significantly, the FPV's failure to gain a two thirds legislative majority means that the party will likely not have enough votes to amend the constitution to allow President Cristina Fernández Kirchner to run again in 2015. Still, we caution that significant economic hurdles await future governments.

6) New Leadership In Venezuela: Political Risk Going Nowhere For Now (Hit)

Despite a relatively peaceful transition from former president Hugo Chávez to his successor President Nicolás Maduro, political risk has remained elevated as Maduro has struggled to consolidate his power since being elected in April. Moreover, with consumer price inflation soaring, shortages of basic goods worsening, and Maduro's approval ratings on the ropes, we believe that political risk will remain elevated.

Struggle To Consolidate Power Keeps Political Risk Elevated
Venezuela - President Nicolas Maduro's Approval Ratings, %

The December 8 municipal elections will provide important insights into popular sentiment, the viability of the opposition's political strategy, and the direction of policymaking in the months ahead ( see 'High-Stakes Municipal Elections Likely To Spur Instability', December 2). Given recent polls and grim economic realities, we believe that the opposition will post a strong showing, potentially setting the stage for more aggressive suppression by the Maduro government.

Investors Increasingly Price In Political Risk
Venezuela - US$ 2027 Government Bond Yield, %

In addition, given Maduro's increasingly aggressive rhetoric towards private enterprise and his recently-awarded decree powers, we cannot rule out a change in government policy towards future interest payments on existing debt ( see 'Credit Deterioration Has Largely Run Its Course', November 20). Unless a change in policy occurs, Venezuela's government bonds are likely to reflect an increasing realisation that a credit event is beginning to look more plausible .

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