Market Bulletin. Latin America: A turning of the tide. October 21, In brief. From revolution to evolution: A turn away from populism

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1 Market Bulletin October 21, 2016 Latin America: A turning of the tide In brief So far, 2016 has been a positive year for emerging market (EM) performance due to stabilization in key external variables, including the dollar, commodity prices and Chinese growth. This improved external backdrop has allowed EM growth and earnings expectations to improve, especially in the commodity-heavy region of Latin America. Returns for Latin America assets this year have far outpaced those of EM as a whole, highlighting important idiosyncratic trends in the region. Many of the trends in Latin America stand in stark contrast to what we are seeing across the rest of EM as well as the DM world, such as a shift in government programs toward business-friendly policies, a return to fiscal discipline and the end of stagflation. Gabriela Santos Global Market Strategist The region is also dealing with the common global challenge of lower trend growth, driven by an aging population and low productivity. However, we see early signs that reforms are being implemented in order to improve many countries long-term growth potential. These nascent but encouraging changes bring with them opportunities for investors. As always, the challenge will be in the implementation of key reforms. Abigail Dwyer Market Analyst From revolution to evolution: A turn away from populism Across Latin America, there has been a recent turn toward open markets and business-friendly policies. This stands in contrast to movements seen across Europe and the U.S., where the establishment has been challenged and globalization charged as a cause of lackluster growth.

2 For the better part of the last decade, Latin American countries embraced center-left, even populist, governments. These governments widely rejected many policies of the 1990s, including a commitment to fiscal discipline, to fighting inflation and to open markets. Instead, their focus was on growing the middle class and reducing poverty. In order to do so, many countries used a series of subsidies and redistribution programs financed by the government, and simultaneously shunned open, globalized markets as a cause of social inequality. The true cost of this shift was masked by the commodity price boom and accompanying abundant capital inflows. This fueled economic growth and allowed wages to increase and the middle class to grow. However, the landscape changed dramatically when China s growth slowed, commodity prices fell precipitously and investors retreated from EM assets. This change in landscape took a dramatic toll on the economic growth of commodity exporting countries (Exhibit 1), particularly in Latin America. Recently, frustrated voters who had previously credited the improvement in living standards to the governing parties have become increasingly discontent. The dramatic slowdown in growth after the commodity price collapse caused unemployment to swell alongside inflation. This caused the previous decade s rapid improvement in income inequality to stall (Exhibit 2). In some countries, political corruption also helped fuel resentment and a desire for change. It became apparent that the populist policies of the past, while aiding the middle class during the commodity boom, were ultimately unsustainable. Over the past year, a seismic political shift has occurred in several key Latin American countries. Voters have empowered new governments that focus on more heterodox economic policy, bringing with them the return of fiscal discipline, the beginning of Commodity-oriented EMs have suffered the most EXHIBIT 1: YEAR-OVER-YEAR % CHANGE IN GDP EM COUNTRIES, MID-WEIGHTED 12% Estimates 1 8% 6% 4% 2% -2% Manufacturing -4% Commodity -6% '00 '02 '04 '06 '08 '10 '12 '14 '16 Source: IMF, J.P. Morgan Global Economic Research, national statistics agencies, J.P. Morgan Asset Management; data are as of October 21, GDP aggregates are calculated using the mid-weighted average, which is the mean of GDP-weighted average and simple average. GDP estimates start in 3Q 2016 and are from J.P. Morgan Global Economic Research. For illustrative purposes only. Inequality measures have largely flattened out in Latin America EXHIBIT 2: GINI INDEX 0 = PERFECT INCOME EQUALITY, 100 = PERFECT INCOME INEQUALITY Colombia 46 Brazil Latin America 44 Peru 42 Argentina Source: World Bank, J.P. Morgan Asset Management; data are as of October 21, For illustrative purposes only. the end of stagflation and the search for new and sustainable drivers of economic growth. Although domestic and foreign confidence levels have surged following a reduction of political uncertainty, the challenge remains in maintaining enough political momentum to pass tough reforms. 2 LATIN AMERICA: A TURNING OF THE TIDES

3 Swimming against the tide: Examples of political change in Latin America The most significant example of political change in Latin America has been the election of Argentine President Mauricio Macri, a center-right candidate who was elected in November Mr. Macri ran on the platform of reversing his predecessor Cristina Kirchner s economic policies, which had resulted in stagnant growth, double-digit inflation and a nation economically and financially cut off from the world. Mr. Macri s policies are a return to more orthodox economic policy, including the lifting of capital and currency controls and the reduction of export tariffs that had discouraged trade. He has also successfully concluded a deal with holders of defaulted Argentine debt, removed several subsidies and encouraged both private investment and a return to independence in key industries and institutions. While Mr. Macri has made significant strides in his short time in office, these great shifts in policy have been accompanied by short-term pain during the adjustment period. For example, lifting currency controls and reducing unaffordable energy subsidies have placed further upward pressure on already high inflation. The challenge is now remaining committed to long-term reforms aimed at improving Argentina s global competitiveness and economic imbalances, while also facing declining popularity amongst voters. In Brazil, reducing imbalances in the economy have also been challenging. President Michel Temer s newly appointed government is working to undo the policies of his impeached predecessor, Dilma Rousseff. This effort includes fiscal reforms aimed at controlling the deficit and the nation s increasing debt levels, the removal of several unsustainable subsidies and the encouragement of private investment to boost the country s competitiveness. The way forward will not be easy; unemployment remains elevated at 11.8%, inflation has only recently fallen to single digits and the population remains skeptical of a corruptionplagued congress. However, recent municipal elections in Brazil in early October saw the former ruling party, the Worker s Party, lose significant strength and government-allied parties gain some ground. This is a sign that voters largely seem to be in favor of the government s new direction. Peru, while in less dire straits than other Latin American countries, has also recently elected a more market-friendly president. President Pedro Pablo Kuczynski ran on the promise to make Peru s economy more competitive by reducing the country s reliance on mining and focusing more on tourism and agriculture. His aim, like the leaders of the neighboring countries, is to achieve sustained improvement in the lives of citizens by improving access to essentials, such as health care and education, and to increase the competitiveness of corporations by embracing globalization and more cost-efficient ways to run businesses. Promises make debt and debt makes promises: The return of fiscal discipline Many of the governments in Latin America have turned their focus toward fiscal discipline. This trend stands in sharp contrast to the rest of the world, where the conversation has quickly shifted toward fiscal stimulus as a way to spur growth. In Latin America, the conversation is one of reversing unsustainable debt trends. When populist governments took power in the early 2000s, they largely shunned the fiscal discipline of their predecessors. Following election, many of these governments implemented costly subsidies in an attempt to grow the middle class. In Brazil, for example, the government supervised prices such as gasoline, provided subsidies for electricity and implemented tax cuts on auto and furniture purchases. In addition, many governments provided J.P. MORGAN ASSET MANAGEMENT 3

4 generous pension benefits and raised government salaries, thus increasing mandatory costs. As many of these programs became law, the rigidity of government expenditures made reversing the trend extremely difficult. It was not until the collapse of commodity prices that these countries were forced to face reality; their revenues were not permanent, but their expenses were. Across the region, as fiscal results deteriorated and debt levels rose (Exhibits 3 and 4), governments were faced with higher interest costs and debt downgrade warnings from rating agencies. In Brazil, the mismatch between revenues and expenditures and rising interest costs resulted in a fiscal deficit of over 1 of GDP, with gross debt levels climbing to over 7 of GDP. As a result of these dynamics, the country was downgraded below investment grade by all the major rating agencies by early Public sector finances have deteriorated due to ballooning expenses and falling revenues EXHIBIT 3: PUBLIC SECTOR BALANCE AS A % OF GDP 6% 4% 2% -2% -4% -6% Peru -8% Colombia Mexico -1 Argentina Brazil -12% '00 '02 '04 '06 '08 '10 '12 '14 Source: IMF, J.P. Morgan Asset Management; data are as of October 21, For illustrative purposes only. The gap in revenues and expenses was not isolated to industrial metals exporters, but ultimately spread to countries like Colombia and Mexico, post the 2014 collapse in oil prices. Both of these countries are currently on downgrade watch by several agencies, Government debt has risen due to previous policies EXHIBIT 4: GROSS DEBT AS A % OF GDP % 42% 66% 78% 48% 44% 42% 56% Source: IMF, J.P. Morgan Asset Management; data are as of October 21, *2016 are IMF estimates. For illustrative purposes only. and should they not materially alter their fiscal positions, they too may be downgraded below investment grade * 44% Argentina Brazil Colombia Mexico Peru 26% The improvement in fiscal results will most assuredly not happen overnight, but current governments are being graded by investors and rating agencies alike on their ability to continue to make difficult and often unpopular spending decisions. While these decisions will likely cause short-term pain, they will help both consumers and corporations as they benefit from lower interest costs. Faulty premises, faulty policies: The battle with high inflation While the rest of the world has dealt with the threat of deflation and low rates since the financial crisis, Latin America has largely been dealing with stagflation and high interest rates. The loose fiscal policies of previous governments in the region contributed to a significant inflation problem for many countries, one that did not improve despite anemic economic growth and high interest rates. This was because monetary restraint became less effective when combined with direct and quasi fiscal stimulus. In addition, governments were simultaneously implementing policies that caused 4 LATIN AMERICA: A TURNING OF THE TIDES

5 inflation to spiral and become very sticky. In Brazil, mandatory minimum wage increases, indexed to inflation, were established. (The formula for which was the prior year s inflation, plus the level of GDP growth two years back, should it be positive.) Inevitably, wage costs continued to increase despite the steadily deteriorating economy. Since 1995, the minimum wage has grown 688% in nominal terms; over the same period, inflation has grown 145%. 1 On top of that, the mandatory increases fed through to Social Security benefits, wage bonuses for formal sector workers and elderly and disabled benefits, as they are all tied to the minimum wage. This, combined with lax fiscal policy, has resulted in Brazil experiencing double-digit inflation while suffering through the worst recession in its history. Similar to Brazil, Colombia also implemented policies related to wage indexation. These policies cause shortterm shocks to the economy, such as currency depreciation or food price inflation, to turn into longterm issues. This is because, as wages get readjusted upward due to the initial inflationary shock, services prices are pressured and inflation expectations are deanchored, resulting in a vicious cycle. Inflation in Latin America far outpaces other EM regions EXHIBIT 5: YEAR-OVER-YEAR % GROWTH IN HEADLINE CPI LATIN AMERICA* & EM ASIA AGGREGATES 1 9% Latin America 8% EM Asia 7% 6% 5% 4% 3% 2% 1% '01 '03 '05 '07 '09 '11 '13 '15 Source: J.P. Morgan Economic Research, J.P. Morgan Asset Management; data are as of October 21, *Latin America index excludes Argentina, Ecuador and Venezuela. In addition to the longer term structural problems, inflation in Latin America has spiked over the past couple of years (Exhibit 5) due to shorter-term effects, such as steep currency depreciation and the reversal of unsustainable subsidies. As these effects fade during the rest of 2016 and into 2017, inflation should continue to decrease. This fall in inflation should eventually lead to rate cuts or at least the end of rate hike cycles, finally providing a pillar of support for growth in the region. The future looks bright: A shift in economic model It will be no small feat for Latin America s newly elected governments to return the region to long-term economic growth. They must simultaneously battle debt and inflation while also rethinking economic models. In this regard, they are also confronting the global challenges of an aging population and low productivity. For much of Latin America, outside of the commodity boom years, productivity has been low or nonexistent. Therefore, these new government leaders must also focus on investing in infrastructure, boosting competitiveness and enhancing labor flexibility. Going forward, Latin American economies will not be able to rely on the consumption-based models of the past. Instead, they will need business investment to become an increasingly bigger driver of growth. Compared to consumption, investment spending has historically been a small part of Latin American economies (Exhibit 7). This is the opposite problem facing many Asian economies, such as China, which previously relied heavily on investment and now must shift to a consumption-focused model. The lack of investment spending in Latin America stems, in part, from the difficulty of doing business in many countries (Exhibit 6). In Brazil, this issue is known as the Brazil cost : the cost of labor is high, 1 Brazil 101: The 2015 Country Handbook. J.P. Morgan. September J.P. MORGAN ASSET MANAGEMENT 5

6 average education levels are low, taxes are elevated and complicated to file, bureaucracy is high, infrastructure is poor and regulations may be unpredictable. These issues require micro reforms, which are necessary in order to improve the region s long-term economic potential. There are early signs that many governments in the region are prioritizing better cooperation with the private sector in order to boost investment spending and competitiveness. Latin America could improve its competitiveness by encouraging investment and micro reforms EXHIBIT 6: SELECTED COMPETITIVENESS INDICATORS: 2015 Indicator Brazil Lat. Am. OECD High Income Ease of doing business (rank, 1-189) Days to register a new business Days to deal with construction permits Days to resolve a dispute Recovery rate from insolvent firm (cents) Number of hours spent preparing taxes 2, Total tax rate (% profit) Source: World Bank "Doing Business in 2016" survey, J.P. Morgan Asset Management; data are as of October 21, Investment is a chronically small part of Latin American economies EXHIBIT 7: TOTAL INVESTMENT AS A % OF GDP 48% 43% 38% 33% 28% 23% China India Mexico Peru Colombia 18% Brazil 13% Argentina 8% Source: IMF, J.P. Morgan Asset Management; data are as of October 21, For illustrative purposes only. Investment implications The paradigm shift taking place in Latin America provides much better prospects for future growth, as necessary structural reforms are being implemented by market-friendly governments. Year-to-date, Latin American equities have been global outperformers as multiples expanded on improving expectations. While a repeat of such outperformance seems unlikely next year, the run up in valuations in many countries may be justified given the improving outlook. Going forward, earnings growth will need to materialize to propel future returns. While challenges remain in the commitment to and implementation of reform agendas, investors should be cautiously optimistic that countries in the region, such as Brazil, Argentina and Peru, are making significant progress. High rates of inflation have finally started to recede, allowing central banks in the region to either end rate hike cycles or begin new rate cut cycles. This, combined with fiscal reforms, should help to reduce the risk premium for many countries in the region. While credit spreads have tightened considerably over the course of 2016, they are still above their long-term averages and should continue to move down as these countries move forward with implementing reforms. The challenge for investors remains in distinguishing between countries that do make improvements in their fiscal results versus those that lag behind and see their premiums move up once again. As is common with both political and fiscal reforms, the main investment risk lies in implementation; the reforms needed will take grit not only from the government, but also from the citizens of the region as they bear the brunt of these changes over the medium term. For investors, selectivity will be key; identifying countries that continue to make progress versus countries where political uncertainty remains a challenge could have significant implications for longterm returns. 6 LATIN AMERICA: A TURNING OF THE TIDES

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