Given the tailwinds from high commodity prices, low exposure to major geopolitical events and improved fiscal accounts after the response to COVID-19, investors might have expected Latin American financial markets to fare better in 2022. But despite a solid fundamental outlook, headwinds have been present, too.
Global inflation has been red hot for much of the year, and across Latin America domestic headline and core inflation numbers have been elevated as well. The stronger US dollar has dampened foreign investment in the region, and internal political events have created some level of uncertainty.
What can we expect for the rest of 2022? It will depend a lot on the balance of headwinds and tailwinds as we move forward. It also requires a closer look at lessons learned from political events in the region, and an assessment of October’s coming presidential election in Brazil, the region’s largest economy.
Commodities Impact and Improving Fundamentals
The commodity run-up has clearly benefited Latin American fiscal and external accounts. After several years of languishing, aggravated by the demand drop-off from the COVID-19 pandemic, commodity prices today are 50% above their levels at the end of 2019.1 They’re also nearly 100% above their pandemic lows, a boon for Latin American economies that are net commodity exporters (Display).
Brazil, for example, is home to both the world’s largest iron-ore company and biggest meat-packing company. Chile’s CODELCO is the largest copper company in the world, while Argentina is an important producer and exporter of soybeans and wheat. The oil sectors in Mexico and Colombia are important to each country’s external and fiscal accounts.
Fiscal balances and debt sustainability have improved over the past two years in larger Latin American economies, as the withdrawal of pandemic stimulus, higher tax receipts from rebounding growth and high inflation reduced fiscal deficits. According to International Monetary Fund estimates, the average fiscal balance in the region as a percentage of gross domestic product (GDP) will return to its pre-pandemic level in 2023 after improving sharply in 2021 and 2022 (Display).
This improved fundamental outlook ran into stiff headwinds from the inflation shock and surging global interest rates. However, most of the region’s largest economies are well along in their monetary policy cycles, so relative to developed markets, monetary policy positioning is actually at multiyear highs in terms of both nominal and real interest rates.
Countries with high current account deficits, such as Chile and Colombia, are more exposed to a longer period of high global interest rates, creating tighter liquidity conditions, but we think the foreign-exchange reserve levels in these countries are ample. What’s more, these nations enjoy access to financing from foreign private and multilateral organizations, which reduces the risk that a sudden halt in external financing will evolve into a deeper economic crisis.
Concerns About Shifting Economic Policy May Be Overstated
In our view, much of the region’s subpar performance stems from expectations for deep changes in economic policymaking. After President Andrés Manuel López Obrador’s election in Mexico in 2018, leading Latin American countries saw a political shift that favored relative outsiders advocating for radical changes in the economic framework. In the past 14 national elections, 13 have seen incumbent parties either lose possession of the government’s top position or face reduced representation in the legislative branch. Nicaragua stands as the notable exception.
President López Obrador’s election in Mexico followed Alberto Fernández’s win in Argentina, Pedro Castillo’s in Peru, Gabriel Boric’s in Chile and Gustavo Petro’s in Colombia. In Brazil, the region’s largest economy, former president Lula da Silva is leading in the polls for the October elections. The change in economic direction poses challenges for the region, but we see at least three signs that could lessen the economic consequences:
1. No clear shift toward fiscal imbalance. Up to this point, political change has not implied a clear change of direction toward policies that would create fiscal imbalances. Mexico’s austerity policy prevailed even during the pandemic. Both Peru’s and Chile’s governments seem committed to delivering a zero primary (excluding interest) fiscal balance in 2022. They’ve also vowed to finance any increase in permanent spending with higher revenues through tax-code changes. Even Gustavo Petro, Colombia’s newly inaugurated president, is preparing to present tax reform as his initial action, hoping to reduce the fiscal deficit and fund higher social spending.
2. Modest support for winners limits deep reforms. None of the newly elected administrations enjoy high enough support among the population or the political clout to enact deep reform agendas. They’ve also embraced markets as the main way to allocate resources, promised to honor existing contracts and international treaties, and welcomed foreign investment, with respect for private property and acquired rights. We can expect a shift in focus from growth-promoting policies to policies favoring measures to alleviate poverty and redistribute income; the uncertain impact is a risk to the medium-term outlook.
3. Democratic institutions have largely prevailed. While protests and discontent have engulfed the region in the past few years, administrative changes have happened, for the most part, with fully functioning judicial and electoral institutions rising to the challenge. Electoral processes have so far assured free and fair elections, with the preferred outcome for most of the population and proper guarantees for minority opposition parties. However, Cuba, Nicaragua, Venezuela and El Salvador stand as exceptions to this general trend.
As the Election Approaches, Is Brazil Different?
When Jair Bolsonaro was elected as Brazil’s president in 2018, he adopted a liberal economic policy mix led by University of Chicago–trained economist Paulo Guedes. The approach hinged on shrinking the government by privatizing state-owned companies, eliminating public-sector employees to cut the wage bill, reforming the public-pension system, and partnering with the private sector to finance large infrastructure projects.
The commitment to fiscal discipline and a spending-cap rule limiting growth in public expenditures have helped anchor expectations and kept interest rates relatively stable, even through the pandemic. While Bolsonaro provided cash transfers and support to households during the crisis, inflation has now soared to double digits, and growth has stagnated. The president’s approval rating lingers around 35%, and many voters may be looking for change when they head to the polls in October.
The main challenger, former president Luiz Inácio Lula da Silva, represents change. He rejects the idea of small government, advocating for higher government spending and increased benefits. This populist approach increases the risk of fiscal deterioration and rising debt loads over the next administration’s term. And in contrast to Chile, Peru and Colombia, Brazil is unlikely to approve broad tax reform that boosts revenue enough to finance excesses, given the distribution of parties in the National Congress and opposition from state governors.
Ambitious Reform Efforts Could Lose Steam
Bolsonaro’s administration has undertaken an ambitious reform agenda in Brazil. Not all its initial objectives have been met, partly because of the pandemic and partly due to a lack of consensus within the government. But structural reforms are helping to lay the groundwork for higher potential growth in the future. Regardless of who wins, without a strong mandate it’s unlikely that radical reforms to improve the economy’s structure and efficiency will continue. The outlook may not worsen, but it also won’t markedly improve.
Claims of voter fraud and irregularities have become more prevalent in recent years across the Americas, including in the US. Bolsonaro has attacked the Brazilian election system in recent weeks, possibly setting the stage for claims of fraud if he loses in October. Judicial institutions have proven strong in Brazil, especially throughout the Lava Jato investigation in 2014, which was a stiff test for the country’s judiciary. But claims of an unfair election could stoke social unrest.
Looking at the Big Picture
Even as Latin America’s financial markets have underperformed those of other emerging-market regions, fundamental improvements have continued over the past six months, thanks to high exposure to commodities, improvements in fiscal and external accounts, and well-advanced monetary-policy tightening in most countries that has quelled inflationary pressures. All these developments should decrease macroeconomic vulnerabilities going forward.
However, given the political currents in the region, concerns surrounding the political outlook will likely remain at the forefront. While the first few signals from the new administrations are encouraging, we continue to monitor the risk of deteriorating fiscal-account outlooks and will keep a close eye on the prevailing level of respect for economic and democratic institutions.
Armando Armenta is a Senior Economist at AllianceBernstein (AB) and Katrina Butt is a Senior Latin America Economist at AB.
1. BCOM Index from December 30, 2019 to July 29, 2022 and March 31, 2020 to July 29, 2022
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.