Why markets in the Andes have been climbing

The past decade has been tough for Latin American equities, which have lagged both developed and emerging markets (EM). This year, however, the trend has reversed. Latin American equities, as measured by the MSCI EM Latin American Index, are among the best-performing global markets year-to-date, as at 21 June 2022. 

Within the region, it is two of the three Andean markets that have led. Chile has generated a robust, double-digit gain in US dollar terms and is also the best-performing market in the MSCI Emerging Markets Index. Fellow Andean markets Colombia and, to a lesser extent, Peru, have generated a more modest gains, but are still ahead of broader EM. In Colombia this is despite a sell-off this week, following Sunday’s presidential election result.

After such a strong start to the year, what’s next for these markets?

High commodity prices are a clear support, but this year’s gains mask much more going on. Indeed, it was only a year ago when we wrote about the rising policy uncertainty that was casting a shadow over the region. Is this risk receding?

How commodity prices have been supportive

In the wake of Russia’s invasion of Ukraine, commodity prices in general spiked, as the chart below illustrates. All three Andean economies are net exporters of commodities, and higher prices have been beneficial. 

In Colombia, higher crude oil prices are supportive. Despite a more than 20% fall in total production since 2015, oil still accounts for 57% of total exports. The main impact is via a terms of trade boost – oil and mining combined only account for around 5% of GDP.

For Chile and Peru, copper prices are key. Combined, the two markets account for over 55% of total global exports. Although copper is actually down on a year-to-date basis, owing to deterioration in the macroeconomic outlook in China, this hides the fact that the commodity was already trading at elevated levels at the start of the year.

A smaller factor in terms of GDP, but of significance for the equity market, is lithium. Chile is the second largest global producer of lithium, and has the largest global reserves. Lithium is essential to the energy transition, and its price has soared on strong demand from battery manufacturers, particularly in the electric vehicle sector.  

What is the macroeconomic outlook?

After a strong rebound last year, GDP growth in all three Andean markets is generally forecast to continue to normalise this year. Strong commodity prices are supportive of the external sectors of the economies. However, the sharp bounce in the domestic economy post Covid-lockdowns is easing, fiscal support is fading, and accelerating inflation and monetary policy tightening are beginning to dampen activity.  

Chile’s economy may slow to around 1.5%, from 11.7% in 2021, with growth increasingly reliant on the export economy. Weaker activity is anticipated in the second half of the year as pent-up demand post the lifting of Covid restrictions falls, and the impact of three pension fund withdrawals over recent years, which boosted consumption, peters out.

In Peru, economic growth is expected at close to 3% for 2022, from 13.3% last year. Activity has been buoyed by strong private consumption as the economy has recovered from the impact of the pandemic. This is set to wane as the year progresses, and the impact of rising inflation drags on real incomes. 

Colombia has perhaps the strongest growth prospect for this year. This is partly attributable to the fact that the economic recovery took hold later than in Andean peers, but also due to ongoing momentum in domestic demand, which was picking up from a low level pre-pandemic. Full-year growth may be as high as 6%, from 10.3% in 2021, the highest in Latin America and among the highest globally. Nonetheless, after a strong first half, momentum is expected to moderate later in the year. The outcome of last weekend’s presidential election, discussed below, could change this profile to a certain extent.

Inflation is at multi-decade highs

As with much of the rest of the world, inflation in Latin America has been on the rise. Annual headline consumer price inflation, shown below, is higher than that seen during the global financial crisis in all three economies; one has to go back to the 1990s to see price increases above current levels.  

The very sharp rise in food prices contributed to social unrest in Peru earlier this year. Food and non-alcoholic beverages represent over 25% of the consumer price inflation basket in Peru, the highest share in the Andean region. The equivalent figures for Chile and Colombia are 20% and 15% respectively.

All three central banks began to tighten policy rates from pandemic lows last year. Chile’s central bank has hiked by a total of 850bps to 9.0%, following a 75bps rate rise in June. Peru’s central bank has increased its key rate by 525bps to 5.5%. In Colombia, the central bank began to tighten policy later in 2021, in part a reflection of the slower recovery from the pandemic. It has increased rates by 425bps to 5.5%. Further rate rises are likely in all three markets this year.

From a balance sheet perspective, the fiscal accounts are in deficit across all three economies, but forecast to improve, aided by the withdrawal of pandemic support, and higher export revenues.

Peru has provided a short-term support package, including fuel subsidies this year, but the impact is small. Colombia has a more persistent and sizeable fiscal deficit. While some consolidation is expected for this year, several Covid-related support has been extended for 2022. The modest tax reform agreed last year generated material social unrest and there is ongoing public demand for higher social spending. Growing mandatory expenditures on pensions are reminiscent of Brazil’s pension system before it was reformed in 2019. As a means to ease inflation, local gasoline prices are currently heavily subsidised. Reducing the deficit more meaningfully will be a challenge for the next administration.  

Net government debt-to-GDP is most elevated in Colombia at close to 57% for 2021, and emphasises the need for longer term reform. Chile may see some deterioration in the government debt-to-GDP this year, but from a lower level of 31% in 2021. Peru had a government debt-to-GDP ratio of 34% in 2021 and this should remain stable this year.

On the external accounts side, Chile saw notable deterioration in its current account to a deficit of 6.4% of 2021 GDP. This was attributable to a sharp increase in demand for goods and services in its pandemic recovery, and higher oil prices. That said, higher exports of copper, and an easing in domestic demand, should see this fall.

Peru’s current account is also in deficit, at a smaller 2.8% of 2021 GDP. This is largely due to higher fuel import costs.

Colombia has a deficit of 5.7% 2021 GDP, attributable to high import demand. Some improvement is forecast for this year but domestic subsidies mean that further upside to oil prices is likely to provide little benefit.  

Are currencies still cheap?

Andean currencies are all below their longer term averages. The degree of cheapness differs and reflects varying levels of uncertainty around policy risks to the outlook in each market.

Colombia and Chile remain as cheap as they have been for the past six months while Peru’s sol is less attractive relatively.

How has the policy outlook progressed?

When we wrote about the Andean markets in May 2021, uncertainty was extremely high. Chile was voting to elect the members of the body charged with writing the new constitution, Colombia had experienced major anti-government protests, while political unknown Pedro Castillo had come from nowhere to lead a first round presidential election in Peru. Uncertainty has remained elevated for much of the last 12 months, with some variation among markets.

Pedro Castillo won the second round election and took office in July of last year. Since then Castillo has presided over multiple cabinet reshuffles, and appointed four different prime ministers. He has also faced two impeachment attempts, amid a deteriorating relationship with congress. Peru has underperformed Chile and Colombia this year. Even so, policy has not taken a radical turn, constrained by a divided and right leaning Congress.

Congress remains divided, and has so far acted as a barrier to potential market unfriendly policies. Domestic pressures, as a result of high energy and food prices, triggered road blockades, strikes and social unrest in April. Some fiscal support was delivered through fuel subsidies but the fiscal impact is modest. President Castillo has renewed his proposal for a new constitution, but this seems unlikely to progress in congress.

In Chile, after a more left-wing constitutional convention was elected, the articles of the draft new constitution have been more far-reaching. So far, it appears that the direct market impact will be limited. Over the longer term though, fiscal liabilities are likely to rise and some of the proposed changes to the institutional framework are a concern; in particular the possible substitution of the senate with a chamber of regions with limited powers. A confirmatory vote is due in early September and while opinion polls point to it being rejected, the share of undecided voters is high.

Presidential elections, held in December, saw left-wing candidate Gabriel Boric come to power. He pledged to increase social spending, funded by higher taxes, but has so far been pragmatic, including appointing the previous central bank governor as finance minister. We await more details on tax proposals but his coalition lacks control in congress, which may act as a brake on more radical policies; as could the significant decrease in Boric’s public approval rating.  

We’ll come on to valuations, but the chart below illustrates the impact of political uncertainty. The 12-month forward price-earnings ratio has decreased significantly since the left-wing constitutional convention was elected. The date of the election is highlighted in red. Uncertainty over the outlook and future earnings has seen the ratio fall steeply since, despite ongoing copper price strength.

In Colombia, former mayor of Bogotá, Gustavo Petro, was elected as Colombia’s first left wing President last weekend. Petro has promised to increase social spending and his election could see greater fiscal support come through. Petro’s ambitious plan to increase fiscal revenues by taxing corporations and the wealthy is likely to be diluted and the current projections by the finance ministry to significantly reduce the fiscal deficit in the following years seems very unlikely. This could  potentially exacerbate existing macroeconomic weakness, given the large twin deficits. A divided congress may filter out some of his most radical proposals.

What do valuations look like?

The earnings outlook has picked up across all of the three regional markets, and has been supportive of market performance.

Average valuations are behind their historical average for all three markets. Chile is the cheapest market, followed by Peru, as the chart illustrates.

On a 12-month forward price-earnings basis, Chile is the cheapest market in the EM index. Colombia and Peru are below their historical average but to a lesser degree. On a price-book and dividend yield basis, Chile and Peru both score as cheap, while Colombia neutrally valued.

What to make of all this?

There are a range of crosswinds to consider along the Andes. Yes, high commodities prices are positive, but tighter monetary and fiscal policy will weigh on economic activity; a dynamic seen across much of the rest of the world. And then there is still uncertain policy environment…

The issues remain very country specific, even if high food and energy prices may be exacerbating existing issues relating to inequality. Striking a balance between macroeconomic orthodoxy and addressing public concerns will be a challenge for whoever is in office in these markets. So policy uncertainty seems set to remain in the near term across all three markets, but may well offer further opportunities for active managers. What is key is that institutional strength continues to act as something of an anchor for conventional macroeconomic policy over the longer term.

Against this backdrop, the outlook for Colombia looks even less compelling than a year ago. Political risk has ticked higher, and may increase in the short term, which is a particular concern given the large twin deficits. Valuations relative to other Latin American markets are also less attractive. In Peru, valuations are more interesting when compared to Colombia. But policy remains a concern and the institutional framework is not as robust as in Chile.

Despite the strong year-to-date performance, Chile offers the cheapest valuations of all three Andean markets. However, the policy risks discussed above will not be vanquished by either an approval or rejection of the new constitution in September’s confirmatory vote. So while we’re more sanguine towards Chile than the other Andean markets, we continue to tread carefully.