The ups and downs of markets in the Andes
We dig deeper into the Andean markets of Chile, Colombia and Peru to see how the opportunity set, valuations, and growth outlook have evolved.
Latin America has been one bright spot in what has been a somewhat lacklustre year so far for emerging markets. The MSCI Latin America Index has returned 10% in US dollar terms year-to-date, as of 22 May, broadly in line with the MSCI World, which has gained just over 10%. Broader emerging markets, as measured by the MSCI Emerging Markets Index have returned less than 4%.
Much of Latin America’s strength comes from Mexico, with the MSCI Mexico Index up 21% year-to-date as at 22 May. Almost half of this gain can be attributed to peso strength – the currency has appreciated by 9% relative to the US dollar. However, macroeconomic resilience in key trade partner the US, and optimism towards nearshoring have also been important drivers.
Elsewhere in Latin America, political concerns linger and have contributed to market volatility. This month we look at the Andean region, which has been at the centre of this trend for a number of years. The rally in commodity prices in 2022 was supportive but this has faded for now, amid slowing global growth. Meanwhile, the policy outlook remains unclear. These markets are different in terms of investor opportunity but are united by elevated uncertainty.
The slowing macroeconomic picture
Growth across the Andean region has been slowing post the recovery from the pandemic. The spike in commodity prices in early 2022, triggered by Russia’s invasion of Ukraine, proved supportive but is fading amid the slowing global growth outlook. Inflation picked up sharply and led central banks in the region to hike policy rates to levels not seen since the 1990s. Inflation is now beginning to ease, as the chart below shows, with the decline in energy prices and easing food price inflation, supportive. This is in line with the global trend, ex China. This summary masks some nuance in the macroeconomic outlook for each of the Andean economies though.
Peru may see the most resilient growth this year, with the World Bank projecting an expansion of 2.4%, slowing from the 2.7% recorded in 2022, led lower by consumption. In response to the pandemic, congress passed legislation to allow early pension withdrawals. This boosted consumption but the impact has eased. Political uncertainty, which we will come onto in more detail, stemming from the impeachment of President Castillo and subsequent attempts to impeach his successor, Dina Boluarte, has weighed on consumer and business confidence. The impeachment of Castillo led to large-scale protests, though these have calmed somewhat recently. Government spending has decreased, and the fiscal deficit is coming down. Meanwhile, inflation has started to moderate, easing to 8% in April. Food inflation was 12.1% y/y in April. Although it is lower than in in other Andean markets, it has not fallen meaningfully yet, and food’s share of the inflation basket is higher than in Chile and Colombia. The current account deficit has widened, owing to a fall in exports, though imports are likely to decline too as consumer demand moderates.
In Colombia GDP growth is forecast to be 1.1%, down from 7.5% last year. With wide fiscal and current account deficits, it is the most vulnerable economy in the region, and imbalances are emphasised by the high rate of inflation at 12.8% year-on-year (y/y). The pandemic interrupted fiscal consolidation efforts and contributed to Colombia’s loss of its investment grade status with global bond ratings agencies. The government has proposed tax increases but at the same time has increased spending, suggesting that the fiscal deficit is unlikely to narrow meaningfully. The current account deficit remains wide at 6.2% of GDP in Q4 2022.
Chile is the only Andean economy expected to contract this year. GDP is forecast to fall by -0.7% as the impact of stimulus withdrawal comes through. Economic activity received a boost over recent years as a series of early pension fund withdrawals were approved by congress, to help citizens manage with the pressures of the pandemic. This pillar of support for consumption has now ended. With inflation elevated, the central bank hiked rates, while the government has reigned in spending to bring the fiscal account back into surplus. Against this backdrop activity is slowing. With consumer demand easing, imports have come down, aiding some narrowing in the current account deficit, which has in turn provided some support to the currency.
Politics continues to cast a shadow on Andean markets
We have underlined the policy risks facing the Andean markets on several occasions in recent years. Political turbulence, be it triggered by protests against incumbent leaders, changes in government, presidential impeachments, or more radical policy making, has remained high. Such uncertainty is not healthy for financial markets. Indeed, up until a recent election in Paraguay (which does not have representation in major global equity indices), an anti-incumbent wave had seen incumbents, or their favoured candidate, lose 15 consecutive regional elections. Peru has been led by five presidents in three years, two of whom were impeached.
The volatile political backdrop brings a lack of clarity to the policy outlook, complicating long term planning and forecasting. In Colombia, congress recently blocked reforms proposed by President Petro, and this led to broad-scale cabinet changes.
A glance at the approval, or disapproval, ratings of leaders of the Andean countries illustrates public discontent in Chile and Peru in particular and raises the prospect of further policy change at future elections. With the gap between political parties having widened in recent years, this amplifies the scale of policy change if the anti-incumbent trend persists.
Chile: from lithium intervention to policy optimism
In Chile, President Boric’s announcement of a plan to bring the lithium industry under state control is negative for the country's reputation for business friendliness, and regulatory risk has increased. The public-private partnership plan is not an expropriation, as the companies do not have ownership or a concession on the resource, but it would involve changing the role of the state from that of a receiver of a lease payment to that of a majority shareholder. The details of how such a joint venture would work are still to be defined, and the creation of a new lithium state-owned enterprise is subject to congressional approval. So, the future shape of the lithium industry in Chile remains unclear. As Chile has the largest proven lithium reserves in the world, the move raises questions around the supply outlook. Majority state ownership will require its participation in long term investment and cash flow decisions, which could be complicated by political cycles and fiscal demands.
While the policy outlook does remain uncertain, May constitutional assembly elections in Chile reflected dissatisfaction with the incumbent government and were echoed by falls in the president’s approval rating. Chile is in the process of writing a new constitution, which the assembly is tasked with composing over the next three months. With over two-thirds of votes going to conservative parties, expectations are that more market-unfriendly articles may be blocked. The first draft new constitution, which was rejected by the public last year, was written by a left-wing dominated convention.
What do valuations look like?
Valuations for all three Andean markets are below their historical average on a z-score basis. This incorporates trailing price-earnings, 12-month forward price-earnings, price-book, and dividend yield. Chile stands out and is the cheapest market in the emerging markets universe.
In fact, on a forward price-earnings basis, the MSCI Chile trades close to a record low valuation. Increased policy risk is a factor here.
Latin American currencies in general have performed well year-to-date versus the US dollar. Among the Andean markets, the Chilean peso and Colombian peso lead, up around 7%, while the Peruvian sol (+3%) have also advanced, as at 22 May 2023. Even so, the Colombian peso remains well below its long-term average on a real exchange rate basis. The Chilean peso and Peruvian sol are cheap but to a lesser extent.
The contrasting market opportunities
One important point when reviewing the Andean markets is the contrasting stock market opportunity set. These are smaller equity markets, both in terms of market capitalisation and number of stocks, when compared with other regional and global emerging markets such as Brazil, India and China. Perhaps unsurprisingly, with the exception of Colombia, these markets all have a higher weighting towards materials or energy relative to wider emerging markets. Financials exposure is also higher, notably so in Colombia and Peru. There are other opportunities though, most evidently in Chile, though other sector representation can be found off-benchmark in these markets.
Our view on the Andean markets
The outlook for commodity prices and the path for policy will remain key areas to monitor for the Andean region. The long-term outlook for commodity prices is in our view positive, underpinned by the energy transition. This is covered in more detail in this paper, Re-appraising the case for Latin American equities. In the near term, policy uncertainty looks set to persist, and market volatility may remain a risk, though this is in some cases compensated for by attractive valuations. State intervention in the lithium sector in Chile raises a number of concerns, though there is incrementally positive news from Chile with regards the new constitution.
Among the Andean markets, we favour Peru and Chile. In Peru, political risk is likely to remain elevated. There may be further attempts to impeach the current president and there has been a proposal to bring forward the next presidential election to 2023. For now, congress looks likely to block significant reform proposals. The political wrangling is unlikely to change the bright long term economic outlook.
In Chile, macroeconomic challenges remain but we expect to see some signs of an economic recovery towards the end of the year. Moreover, there are signs that uncertainty stemming from the renewal of the constitution is fading and valuations are attractive.
In Colombia, we hold a negative view. The economy has twin fiscal and current account deficits, political risk remains elevated and policy is insufficient to alleviate macroeconomic imbalances.