Images of green oxygen cylinders symbolize the collapse of the healthcare system in the Brazilian city of Manaus, in the northern state of Amazonas. In this city of two million inhabitants, patients with Covid-19 are dying due to a shortage of medical equipment. The management of the pandemic in Latin America highlights the differences in policy, with important consequences for economic recovery.
The economic impact of the slow start of vaccination campaigns, coupled with the risk of inflation, generates risks for investors in the region. In addition, Latin America is the focus of attention from the rest of the world as it tries to deal with a new variant of Covid-19.
As a whole, Latin America has suffered the highest number of Covid-19 cases in the world in proportion to its population, with a high death rate. One in ten deaths linked to Covid-19 in the world is Brazilian. The country recorded the second highest number of deaths from the coronavirus after the United States, with 224,504 deaths recorded on February 1 and the third highest number of infections, with 9.2 million cases. Mexico is the third country in the world in terms of deaths linked to covid-19, with 158,536 deaths and just under two million confirmed infections.
In Brazil, the immunization program was launched in a tense political climate. It was a state governor, rather than the federal government, who was at the origin of a partnership with the Chinese Sinovac. As a result, S? O Paulo State began immunizations on January 17, ahead of the distribution of the Oxford / AstraZeneca doses nationwide. In a message to President Jair Bolsonaro, the first vaccines were described by the governor of S? O Paulo Jo? O Doria, as “the triumph of science and life against deniers”. The president, who called the Covid-19 a “little flu”, said he would not be vaccinated.
As of this writing, Brazil has vaccinated 1% of its population while Mexico has vaccinated 0.5%.
In Mexico, President Andrès Manuel López Obrador (“AMLO”) announced last week that he had tested positive for the virus. On December 24, Mexico became the first country in Latin America to launch a vaccination program. The country buys the AstraZeneca and CanSino vaccines, as well as 24 million doses of the Sputnik V treatment developed by the Russians.
Different budget choices
In terms of economic normalization, high-frequency indicators show that Brazil and Mexico have regained 80-85% of their pre-pandemic activity levels.
At first glance, economic activity does not seem to vary much. However, the respective budgetary choices of Brazil and Mexico left the two economies with different reserves in terms of financial strike force.
The Brazilian government’s stimulus plan, the scale of which was in line with that of many developed economies, cushioned a contraction of -4.7% of GDP in 2020, which seems healthy compared to some of its neighbors (cf. . board). The country has thus chosen to devote up to 9.3% of its GDP to support measures, including monthly cash distributions to its poorest populations. This allowed Mr. Bolsonaro to consolidate his political position during the year 2020.
However, the government is now overstepping its budget limits and public debt has increased to over 100% of GDP. In December 2020, inflation exceeded the target of 3.75% set by the Brazilian central bank for 2021. In a recent statement, the latter hinted that it could raise policy rates from the current level of 2.0%, which could jeopardize the economic growth of 3.2% that we expect for this year.
In contrast, Mexico spent relatively little on budget support. As a result, its economy suffered more in 2020, contracting by -8.5%, while the country’s budget deficit was less than 3.5% of GDP. Public debt expressed as a proportion of GDP is expected to reach 54% in 2021. In addition, inflation is within the central bank’s target range, which leaves room for maneuver to lower key rates by 25 basis points to 4%.
Mexico is likely to have the option to spend more on its recovery in 2021, depending on political will. However, AMLO has always opposed an increase in public debt, rejecting calls from the IMF and the World Bank.
Other economies in the region, such as Argentina, find themselves in a situation that is struggling to convince investors. Argentina’s near-term growth prospects remain poor, with the pandemic exacerbating an already complex environment marked by high inflation and great political uncertainty. As a result, consumption, investment and exports remain weak.
Government control of capital limits access to the dollar. This continues to widen the gap between official exchange rates and the parallel market. Investors are still waiting for a credible policy aimed at generating fiscal stability as a precondition for economic growth. The International Monetary Fund will exert additional pressure for tax reform, although these efforts may meet with some resistance in a volatile political environment, especially in terms of spending cuts. Inflation is expected to be around 36% on average in 2020.
Selective approach to emerging assets
These differences in economic health mean that we remain very selective in asset allocation. As part of our global positioning, we overweight emerging market assets. However, this is largely due to our overweighting of Asian investments, especially Chinese.
Latin American stock markets are dominated by financials, commodities and energy, and account for over 60% of the MSCI Brazil index. They are trading at relatively cheap twelve-month valuations, or 12.5 times earnings per share, which is in line with their ten-year average.
However, while this represents a substantial discount to the rest of the world, in the near term the outlook is uncertain for LatAm stocks. Later in the year, once the economic recovery takes hold, the cyclical rotation will particularly benefit companies active in commodities such as Brazilian and Mexican oil, Brazilian soybeans and Chilean copper.
In the very short term, the global silver market hit its highest level in 8 years this week, acting as a catalyst for Mexican stock indices. Mexico is the world’s largest producer of silver, with some 12% of the MSCI Mexico index made up of mining companies.
The bond market demands an equally cautious investment approach. In 2020, the region’s sovereign debt underperformed emerging markets in Asia, the Middle East and Eastern Europe. Therefore, some names in the high yield credit segment help to generate more value because, unlike government bonds, the region offered the highest credit yields. This gap reflects fears of social instability in the run-up to the next elections. Corporate credit, a segment where many issuers benefit from solid fundamentals, continues to offer attractive carry opportunities in a context of low sovereign debt yields. Moreover, a tightening of spreads relative to sovereign bonds is unlikely.
Throughout 2019 and 2020, we have remained cautious vis-à-vis the Brazilian real, due to the country’s high debt levels. We favored other currencies, such as the Mexican peso and the Chilean peso. Today, we believe the Brazilian real will only partially benefit from the rally in emerging markets against the US dollar. Indeed, foreign exchange markets have started to factor in higher interest rates and we remain cautious about the uncertainties surrounding fiscal policy and vaccine distribution.
On the other hand, while Mexico’s fundamentals are generally strong with positive real rates, we have recently become more cautious; the peso is overvalued and could suffer from uncertainties ahead of the midterm elections scheduled for this year. Any cut in interest rates would also compromise carry returns for investors.
Upcoming political tests
As the region battles the latest wave of Covid-19 contamination, investors are also focusing on a whole series of political tests in 2021. This week, Brazilian parliamentarians elected a new speaker of the Chamber of Deputies and a new one. President of the Senate, by endorsing the choice of Mr. Bolsonaro for these two roles. This result consolidates the president’s tenure and could pave the way for more public spending related to Covid-19. It also allows him to pursue the structural reforms he promised during his campaign. Mr Bolsonaro will not face a general election until October 2, 2022, and the victory of his candidates now wards off any threat of impeachment.
In July, Mexico’s midterm elections will constitute a referendum on AMLO’s presidency, giving it the chance to consolidate political control. The next legislative elections in Argentina will take place in October.