By Jorge Amato
Head - Latin America Investment Strategy
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Underlying fundamentals in Latam remain on a positive trend
Latin American markets have suffered a large correction over the last 2 weeks. The retracement has been even sharper over this past week. A closer look at broader markets, however, suggests that this sell off is not exclusive to Latam markets. While there are country specifics that merit a closer look, the fact is that broader markets have moved in risk off fashion since 18 April.
Since mid-April, capital has flowed out of non-USD markets and into short term USD fixed income securities which now yield a more attractive return. It is likely that the sharp rise in 10yr yields from 2.85 towards and – briefly - past 3% heightened investor anxiety and acted as the initial trigger.
Investors have been heavily positioned in emerging markets for quite some time and expectations for performance were high following a very strong 2017 (Barclays’ Latam Local Currency Bond Index up nearly 17% unhedged last year). Upcoming elections in Mexico and Brazil bring further uncertainty to investor sentiment. In the case of Argentina, the unexpected announcement of a tax on local bonds fuelled portfolio outflows, put pressure on the currency and tested a surprisingly unprepared Central Bank. Even after the sell-off, Latam equities and local markets are still outperforming broad global indices. Commodities sustained the risk off move quite well, even as the USD appreciated as a result. Strong global and regional growth is still our base case. Balanced portfolios should remain overweight the region.
Risk-off flows are most notably observed through currency movements. Currency depreciation is a consequence and not a cause of the outflows. As investors pull funds from domestic markets they sell local currency and buy USD, causing the local currency to depreciate and the USD to appreciate.
In Argentina local markets have been uneasy since late December. Throughout last year the administration had signalled to international investors that they would contain peso depreciation pressures. In this context, nominal interests above 20% made for an attractive carry trade, as long as the peso remained relatively stable. This changed in December when the Ministry of Finance and the Central Bank (BCRA) announced a change in the inflation targets, implying a shift in strategy towards the peso and the outflows began. This caused the first leg of depreciation (17%) that lasted into mid-March. At that time the market interpreted that the BCRA would again move to curb peso weakness in a range around 20.00-20.25 which held until last week when a new 5% tax levied on foreign holders’ income on Lebacs (Central Bank bills) would come into place.
The outflows triggered by the new tax combined with broad market weakness pushed the peso to 22.37 where it closed yesterday despite the BCRA efforts (interventions of more than $5bn and 600 basis points (bp) rate hikes).
Paradoxically, we don’t see a fundamental deterioration that suggests this pace of panic and depreciation is sustainable. While several important structural macroeconomic challenges remain, the Central Bank’s balance sheet is relatively well positioned, the local banking system is well capitalized and the economy is expected to pick up pace in the 2H18.
As a more aggressive response to recent events the government held a press conference on 4 May to reassure investors that the economic plan remains in place and that the fiscal adjustment will continue to accelerate. Meanwhile, the BCRA raised rates another 675bp to 40% on their short term benchmark rate. They also announced measures to reduce the limits of USD local banks have to hold to 10% from 30%, thereby increasing potential USD supply to the market. This interest rate shock therapy is likely to provide much needed stability to the currency in our view and could increase peso demand.
Argentina is not part of our benchmarked portfolios but we have been suggesting investors with high risk tolerance add unhedged local currency bond exposure in their opportunistic, more speculative, portion of their portfolios. This recommendation worked out well through late 2017 but has since turned sour given several policy and communication missteps. At this stage it is too late to unwind, in particular after the recent announcements which we believe will have the desired effect of calming down investor expectations.