Latin America focus: can politics boost the growth outlook in 2018?
When Chile went to the polls on 17 December it marked the start of a 12-month period which will also see elections take place in Colombia, Mexico and Brazil. As long-term fundamental investors, we do not invest based on elections. But these polls provide a kaleidoscope through which one can look at future policy direction in these countries, and in turn the prospects for growth and investment.
The investment case for the region as a whole is supported by a growing middle class, relatively low labour costs and rich natural resources. Although there are a number of common growth drivers, economic cycles within the region are different. As a result, correlation between equity investment returns in Latin countries is relatively low, providing a diversification benefit.
Latin America has seen a major turnaround in its fortunes in the last two years. With the pace of global liquidity tightening more gradual than previously expected, a reversal in US dollar strength has supported a recovery in many currencies in the region.
There have been signs of improved macroeconomic management across the continent and a fade in populist policies. A stabilisation and subsequent improvement in commodity prices has also been supportive. These factors have underpinned a cyclical recovery in a number of Latin American economies; in particular Brazil which exited deep recession in 2017.
Here, we look country-by-country at the state of the continent politically.
Chile: new president to boost growth but stockmarket expensive
Chile’s economy slowed under the leadership of outgoing President Michelle Bachelet. Strong opposition to her left-wing New Majority (NM) coalition’s reform programme has been a factor in the decline in business confidence and private investment over the past three years. A fall in copper prices and a corruption scandal have also weighed on growth. The recent election of Sebastián Piñera as president has the potential to change this.
In our view, the business community needs certainty over the investment environment, be it the regulatory environment, fiscal policy, labour reform or pensions. Although Piñera will not control congress, better-than-expected performance from centre-right parties in congressional elections means he should be able to deliver investment certainty. Piñera also plans to invest US$20bn over eight years into public-private infrastructure projects. Together with a modest recovery in commodity prices, low inflation and low interest rates, these factors could provide a positive outlook for growth in 2018.
Despite a sell-off following uncertain first round results, the Chilean equity market increased significantly in 2017. This was largely predicated on a Piñera victory and expectations of better policies under the next administration. Macroeconomic data, meanwhile, has continued to show a mild pick-up in the economy, helped by domestic consumption, mining and trade. However, despite the sell-off, at an aggregate forward price-to-earning ratio (PER) of 17.5x, Chile remains the most expensive market in Latin America.
Colombia: relative calm with orthodox policies expected to continue
Compared with many other Latin countries, the political outlook in Colombia appears more subdued. The country is currently led by Juan Manuel Santos of the centre-right Social Party of National Unity (Party of the U). In his second term Santos successfully reached a peace agreement with the Armed Revolutionary Forces of Colombia (Farc). However, an external shock from the sharp decline in oil prices negatively impacted the fiscal and external accounts, and economic growth has slowed.
A presidential election is scheduled for May 2018 but a major change in policy is not expected, with a president from the right of the political divide likely to remain in power; either a candidate from the Party of the U or Ivan Duque, the candidate for the conservative Democratic Centre Party. The main policy differences are likely to revolve around how to manage the ongoing peace process and how to reduce the large fiscal deficit. The selection of Duque as candidate for the Democratic Centre Party may be positive given his more moderate stance with regards to the peace process. The most likely challenge to this base case could come from former Bogotá Mayor, Gustavo Petro, who has recently seen a pick-up in support. He is an anti-establishment candidate and his more left-wing policies could negatively impact corporate appetite for investment.
We expect Colombia’s economy to experience a mild re-acceleration in 2018. Macroeconomic management has been comparatively orthodox and we anticipate the new government to prioritise stability over growth. In the near-term there are few drivers of a sustainable pick-up in growth, aside from corporate tax cuts. On an aggregate basis the market trades on close to 13.4x forward PER with earnings per share growth of 21.2%.
Mexico: Nafta and political uncertainty may keep peso volatile
President Peña Nieto, of the centrist Institutional Revolutionary Party (PRI), has faced a number of challenges during his six-year leadership. Subdued GDP growth combined with a series of domestic scandals has led support for the president and the PRI to dwindle. This weakness was compounded by President Peña Nieto’s handling of relations with the US following the election of Donald Trump. Domestic security concerns have also weighed on the president’s approval rate as the murder rate has increased.
Presidential elections are scheduled for July 2018. Left-wing candidate Andrés Manuel López Obrador, known locally as ‘AMLO’, currently leads opinion polls albeit it is very early in the race. It is his third tilt at the presidency and this time around he appears to have a better team in place. Unlike in the past he is now seeking to engage with business and the investment community and as a result has gained support from some corners. Despite this, AMLO’s track record as a left-wing politician has started to weigh on market sentiment somewhat. There is concern that under an AMLO presidency, the pace of energy sector reform would slow for example. This risk is somewhat contained in our view, given that a referendum on energy reform reversal would require support in in both houses; something that AMLO would not have.
The ruling PRI is expected to confirm José Antonio Meade as its candidate for the presidency; he resigned from his position as finance minister in November and announced his presidential bid. Meade has experience in government under the leadership of the National Action Party (PAN) as well as the PRI and is regarded as a more technocratic politician. Along with the fact that Meade is not actually a member of the PRI, this may play to his favour given the global wave of protests against traditional politicians in recent elections. The largest opposition party, the PAN, remains divided. Some members support Meade while others are split between Ricardo Anaya, expected to represent the PAN, and independent and former PAN-member Margarita Zavala.
The impact of President Trump’s campaign pledges saw the Mexican peso lose value against the US dollar post the US election. In turn, this contributed to a rise in inflationary pressure in Mexico which has been exacerbated by the government’s removal of petrol subsidies. As a result the central bank has been forced to increase interest rates to stabilise the peso. Meanwhile, the government is focused on reducing the deficit after the decline in oil prices and years of fiscal stimulus led the deficit to increase.
Although Mexico’s economy is experiencing both fiscal and monetary policy tightening, domestic growth remains firm, underpinned by strong consumption. There is potential that growth can improve in the second half of 2018, supported by expectations for an easing in monetary policy, reconstruction efforts in Mexico City following a major earthquake in September, and the fiscal spending associated with the presidential campaigns in the first half of the year. However, this outlook is overshadowed by uncertainty over negotiations to modernise the North American Free Trade Agreement (Nafta). These are unlikely to be concluded in advance of the Mexican elections and the overhang from this uncertainty could therefore endure.
We believe that the termination of Nafta would have a long-term negative impact on foreign direct investment, unless the government is able to internalise its investor protection clauses and enact them in law. An AMLO election victory meanwhile could also serve to diminish appetite for investment in Mexico. There is a risk of increased protectionism at a time when these changes to the law would be essential. After recovering from lows at the start of 2017, volatility in the peso has picked up again, owing to the potential ramifications of these factors. Valuations, meanwhile, remain elevated with the market trading on an aggregate forward PER of 15.9x, while earnings per share growth expectations have decreased to 3.8%.
Brazil: economic recovery broadening out but politics uncertain
Brazil’s economy exited from a deep recession in 2017. Politics has been an important factor in the recovery. Current President Temer took the helm following the impeachment of Dilma Rousseff in August 2016. Under Rousseff’s leadership the budget deficit had increased significantly, hampered in part by heavy falls in commodity prices. A major corruption scandal at state-controlled oil company Petrobras also served to undermine her government.
President Temer has implemented an economic reform programme, including measures to control the economy’s main weakness: the fiscal deficit. After passing legislation to limit future increases in budget spending, he has also been successful in garnering support for a labour reform bill. However, corruption allegations have twice forced congress to vote on whether to send the president to the Supreme Court for trial. Although he received sufficient votes and faced no further action on both occasions, there are signs that support may be waning. Temer has stated long ago that he will not run for re-election but declining support has clouded the outlook for further reforms before October’s election, notably with regards to the key pension reform.
The economy has taken major steps in its recovery, supported by these improved policies. The current account deficit is now closed and the government is passing measures to address concerns regarding medium-term fiscal sustainability. Public policy is essentially halfway through the key adjustment required to put public finances on a more stable footing. These reforms are vital in order to secure business and investor confidence which can support the long-term outlook for growth in Brazil. So far, these efforts have supported a decrease in inflation and enabled the central bank to cut its headline policy rate materially, laying the conditions for a virtuous circle to take hold.
The political outlook in Brazil is less certain. Although the potential field of candidates is not yet confirmed, opinion polls show a lead for Lula. However, his participation remains unclear after being found guilty of corruption last year. He has appealed the conviction but unless this is successful he may be barred from standing. Behind Lula in opinion polls are candidates from the right, in Jair Bolsonaro and the left, through Marina da Silva. More centrist candidates include Brazilian Social Democracy Party (PSDB) leader Geraldo Alckmin and current Minister of Finance Henrique Meirelles. They currently poll relatively lower in surveys, in part due to the fact that only Alckmin has confirmed his intention to run, and that was only recently. With nine months to go, a lot could change. However, in our view it is crucial that whoever is elected embraces reforms aimed at reducing the fiscal deficit.
Political uncertainty remains and market volatility is likely to increase as we move closer to elections. However, the economy has troughed and recovery is broadening out across other sectors. Continued low inflation and the central bank’s easing cycle have fuelled a rebound in consumer and business confidence. As a result, GDP growth expectations have seen upward revisions and other macroeconomic data have improved. Our economists expect the economy to expand 2.5% in 2018, up from an anticipated 0.6% in 2017. The pace of recovery from here could revolve around the outlook for future reform and whether a path to fiscal stability can be established. The market trades on a forward PER of 12.5x with earnings per share growth of 14.5%.
Argentina: economic recovery to continue
In Argentina, which is not currently included in the MSCI Latin America Index, there has been a major policy change in the last two years. After eight years of unorthodox policy under Cristina Fernandez de Kirchner, President Mauricio Macri was elected to power in 2015 with a reform agenda aimed at stabilising the economy, tackling high inflation and boosting economic growth.
Midterm elections were held in October with his centre-right Cambiemos coalition exceeding expectations. Although Cambiemos lacks a majority in parliament, the opposition remains fractured, which in our view has improved the ability of the government to legislate reform. Tax reform was approved in late December and we expect labour reform to follow in the first half of 2018. There is also the potential for capital market reform.
Inflation remains elevated, in part a result of regulated price increases. We expect further regulated price increases in April but thereafter inflation should begin to fade and there is some potential for the central bank to ease interest rates from elevated levels in the second half of 2018.
Economic recovery in Argentina is forecast to persist. In addition to the reform agenda, a pick-up in growth in Brazil, its key trading partner, is also likely to be supportive. MSCI opted not to reclassify Argentina to its emerging markets index in June. We continue to see firm demand for primary offerings in Argentina. However, the country remains on the list for review. Should policy continue to improve, there is a strong prospect for a reclassification announcement in June 2018.
Peru: potential for economy to accelerate
There is potential for an acceleration in Peru’s economy in 2018. This should be supported by the large reconstruction budget, better coordination between the executive and congress, and stronger commodity prices, notably copper. Longer term, the prospect for the launch of new infrastructure and mining projects may support expansion.
However, politics has led to a rise in uncertainty. President Pedro Pablo Kuczynski faced an impeachment vote in December due to corruption allegations linked to Brazilian engineering company Odebrecht; the company is at the centre of a major corruption scandal that has had repercussions across the region. Although Kuczynski survived the vote, his subsequent pardoning of former President Alberto Fujimori has been followed by the resignation of several congressmen in his Peruvians for Change Party, as well as two cabinet ministers.
Since his election in 2016, President Kuczynski has struggled to deliver the expected positive reform agenda. This is partly due to some obstruction from the main opposition party. A focus on reconstruction efforts following major floods and the fallout from the Odebrecht scandal, which has led to delays in project approvals, has also hampered progress.
Valuations are reasonable, with the market trading on around 13.5x forward PER with 16.1% earnings growth, and GDP growth is expected to increase from a projected 2.8% in 2017 to 3.7% in 2018.
Look through the short-term noise
From an investment perspective, the presence of strong institutions and a government with market-friendly policies is an important factor. A change in policy can be a catalyst and there is much evidence of this in Latin America. A lack of certainty has been a major issue for private investors in Chile over the past two years, for example.
Brazil has seen a huge inflow of foreign direct investment, and an improvement in confidence, since the impeachment of Dilma Rousseff in 2016. A similar trend has taken place in Argentina in the two years since the election of President Macri. Monitoring and understanding the changing policy outlook and its economic implications is therefore fundamental for Latin American investment.
The outlook for Latin America is positive for 2018, in particular given the ongoing recovery for the largest economy, Brazil. We have identified a number of opportunities within most of these markets and we also maintain a favourable view on Argentina where we invest on an off-benchmark basis. The coming year may see an increase in political risk as we move towards these polls. Looking through the short-term noise that these events may bring is in our view key to capturing investment performance.
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