Latin America Outlook 2023: Down, not out

Nur Cristiani, Head of Latin America Investment Strategy

Franco Uccelli, Senior Emerging Markets Economist

Xavier Vegas, Head of Global Credit Strategy

Federico Cuevas, Global Investment Strategist

 

Originally Published December 14, 2022 updated on April 23, 2023

Revisiting Latin America’s Outlook for 2023 - Update after the first quarter of 2023

A full quarter of the year has gone by since we first published our economic outlook for Latin America for 2023. As such, the time seems now right to reassess our initial macro forecasts and adjust them as called for by ever-changing, idiosyncratic, regional, and global factors, including the likely economic consequences of China’s reopening and the financial implications of recent banking crises on both sides of the Atlantic, that may have impacted them for better or for worse. In this note, we do just that, focusing on four key dynamic indicators—growth, inflation, interest rates, and currencies—that best capture the current state and near-term prospects of the Latin America economy amid today’s volatile and uncertain times.

Key takeaways

• Latin America’s near-term growth outlook has not changed much, but there are fine country-specific nuances that set them apart
• Inflation is already moderating, but it may prove to be stickier than previously expected
• While interest rate cuts are in the horizon, they will probably stay high longer than anticipated
• Recent appreciation of regional currencies may soon run out of runway, forcing a reversal of fortune

Growth outlook has stayed virtually unchanged, but the regional average masks significant variations across countries. A confluence of both positive factors, such as the favorable impact of the China reopening, and negative factors, such as the recent financial stress in the US and Europe, have largely offset one another and caused Latin America’s regional growth outlook for 2023 to remain virtually unchanged over the past three months. However, the country mix has experienced some meaningful revisions. Whereas Argentina, which continues to struggle with an epic drought, triple-digit inflation, a collapsing currency, political infighting, and its inability to contain fiscal deficits, is now expected to contract much more than first projected, Chile, where the government has moved toward moderation and political risks have receded, is now poised to shrink less than initially feared. At the other end of the economic growth spectrum, while Brazil, which has proven much more resilient than expected, and Colombia, where early-year activity has surprised to the upside, are set to expand more than anticipated, Peru, where activity was severely hit by social unrest early in the year, is likely to grow a tad less than originally estimated. Apart from Mexico, no other LA6¹ country is likely to reach its medium-term growth potential this year, and only Chile and Peru will probably do so next year, but just barely.

 

¹LA6 is a grouping of the six largest Latin American economies and includes Brazil, Mexico, Argentina, Colombia, Chile, and Peru, in size order.

Inflation will continue to progressively ease, but not as fast as first expected. As Latin American economic growth decelerates considerably this year, with tight monetary conditions and softer global growth constraining domestic activity, regional inflation has pivoted to a declining trend. However, the speed of the downward shift may not be as intense as first thought, as resilient core inflation prints and relatively elevated inflation expectations will likely lead to a relatively gradual, rather than sharp, decrease in inflation. The outcome of this scenario will probably be higher-than-first-expected inflation readings in Argentina, Brazil, Colombia, and Peru for 2023, with our earlier forecast for Chile holding steady, and consumer prices in Mexico rising a tad slower than we estimated three months ago. Although regional disinflation will progressively gain momentum, annual prints will probably not return to target ranges until the latter part of 2024, in the case of Brazil, Chile, and Mexico, or even beyond next year, in the case of Colombia and Peru. Argentina, where price increases have reached untenable levels, is the only LA6 country without a proper inflation targeting scheme, and there is no sign that one will be adopted anytime soon.

Despite some expected cuts, interest rates will probably stay high longer than anticipated. Thanks to an early and aggressive response to rising consumer prices the world over, the LA6 countries have been relatively successful containing inflationary pressures. As inflation continues to moderate going forward, interest rates will likely be lowered into yearend, but probably not as fast as desired given stickier than expected inflation. While a decline in commodity prices eased pressure on monetary policy in the first two-and-a-half months of the year, commodity prices have steadily climbed since mid-March, and they (particularly oil prices) may continue their recent ascent in the near term. This could, at least in part, keep inflation, and hence interest rates, somewhat elevated this year, in most cases reaching levels higher than those we estimated three months ago.

Currencies are poised to depreciate into yearend, though in most cases not as much as once thought. Despite the fact that all LA6 currencies, with the notable exception of the Argentine peso, have appreciated in nominal terms against the U.S. dollar so far this year, they are likely to change course and depreciate against the greenback in the remainder of the year as domestic monetary policies become more accommodative amid a moderation in inflation and political uncertainty remains elevated in the region. However, the degree of nominal depreciation of Latin American currencies this year may not be as acute as once thought, as, much like Latin American central banks, the Federal Reserve may also lower interest rates in the US late in the year if a recession breaks out as expected, limiting the narrowing of the interest rate differentials between the US and individual LatAm countries.

Conclusion

While Latin America’s growth outlook for 2023 may not have changed all that much from three months ago, a close look at the region reveals that there are important differences in the growth prospects of the region’s largest countries. Some of them are expected to contract more than before (Argentina), but others less (Chile). Meanwhile, some countries are poised to grow more than previously expected (Brazil, Colombia, and Mexico), but other less (Peru). The same can be said about inflation, which despite being projected to be somewhat higher than we thought before, some countries, like Mexico, are poised to deliver better results than we previously assumed. Stickier inflation will force central banks to keep interest rates relatively high for longer, but with some rate cuts likely on the way, Latin American currencies will probably have to give some of their recent gains back, though some (Colombia and Chile) more than others (Brazil and Peru). Overall, the Latin American economic outlook remains challenging, but not hopeless, as there are signs of resilience that should safeguard the region from the worst of the global slowdown that seems to be taking form.

Latin America Outlook 2023 as of December 14, 2022

We expect 2023 to be a year of consolidation, with the most anticipated recession in history hitting the US by the second half of the year. However, even as the global growth outlook deteriorates, not all regions will fall equally

From a macro perspective, LatAm growth surprised to the upside in 2022, despite high inflation and central banks in tightening mode for most of the year. Pretty much across asset classes, LatAm outperformed other regions, both in EM and DM. While the macro outlook should deteriorate, the region can continue to be a (relative) bright spot for investors, as we noted in our global 2023 outlook.

On one end, growth is expected to slow significantly. This would be welcome news from an inflationary standpoint, yet inflation will remain above most Central Banks´ comfort zones, until well into 2024. Furthermore, there is risk of fiscal deterioration driven by political and social pressures as growth fails recover to pre-pandemic levels and social inequality becomes even deeper.

Despite the bleak outlook depicted above, LatAm stands out from across EM as major Central Banks in the region should start to ease monetary policy and thus softening the blow to growth stemming from a global slowdown. Furthermore, supportive commodity prices could also offset some of the impact, as China´s economy reopens post COVID lockdowns. Structural shifts such as nearshoring should also support FDI and hence help keep current accounts in check.

With a focus on the six largest LatAm countries (LA6)—Brazil, Mexico, Argentina, Colombia, Chile, and Peru— in this document we leverage our Global Outlook 2023: See the potential and take stock of the region’s economic and political prospects for 2023, as well as of investment opportunities that it may offer in some key asset classes.

Our highest conviction recommendations remain traditional fixed income and capitalizing on dislocations from a valuation angle through gaining exposure to US small & mid caps and defensive sectors such as healthcare, with alternatives adding diversification benefits to portfolios. The US remains our preferred region given its more defensive profile, yet as the cycle progresses, EM will pick up relevance and LatAm should be key part of those conversations.

Given relatively high real rates, FX in the region should be (relatively) better positioned to outperform in an environment of weaker USD. On the credit side, LatAm corporates are better suited to manage a global recession than most US HY issuers, yet we continue to favor DM IG given depressed valuations for the latter. Finally, on the equity side, the advent of the USD peak could drive flows into EM as growth differentials widen. Given current valuation multiples and relative macro fundamentals, we believe Brazil and Mexico could capitalize on the move.

Key takeaways

• LatAm economic growth is poised to slow considerably, dragging inflation down in 2023 despite it remaining above official targets until 2024.
• Interest rates are apt to peak in early 2023, yet stay in low double digits through the end of the year.
• Fiscal deterioration is in the cards for 2023 amid lower economic growth, increased social spending, political pressure, and higher borrowing costs.
• Nearshoring and commodity exposure, coupled with attractive valuations across asset classes, should remain supportive of LatAm financial assets.

Macro

After experiencing a deep contraction in 2020 prompted by the pandemic and ensuing economic crisis, Latin America recovered in 2021 and early 2022 underpinned by a more supportive external backdrop. But global winds are now shifting, and they seem to be shifting fast. Amid persistent inflation, tightening global financial conditions, and rising financing costs, the world economy is quickly weakening, commodity prices are softening, and capital flows to emerging markets are slowing. The combination of these factors will make for a challenging 2023 for LatAm, with growth expected to decelerate substantially and print well below potential.

Growth is set to decelerate to a crawl

Although recent developments in LatAm have been greatly impacted by two global shocks, the pandemic and the war in Ukraine, a third development, the tightening of financial conditions, is now increasingly shaping the region’s near-term outlook. Following a sharp 6.6% contraction in 2020 as the world suffered from the worst effects of the pandemic, LatAm’s economy rebounded strongly in 2021, boosted by the global recovery and a surge in commodity prices, and grew 6.6%.

By early 2022, expansionary policies, supply-chain bottlenecks, and the war in Ukraine caused inflation to spike, forcing central banks to contain them by aggressively hiking interest rates. As global monetary and financial conditions tighten and global activity cools, LatAm growth is expected to slow to 3.5% in 2022 and to a meager 0.7% in 2023, below the region’s estimated growth potential of 1.7%.

Inflation will be halved, but from a high base

The swift response of LatAm central banks, which began to hike domestic interest rates much earlier than other regions, to surging inflation has helped most of them to contain rising price pressures and to keep long-term inflation expectations relatively well anchored. Except for Argentina, where consumer prices continue to rapidly increase, it is estimated that inflation has already peaked in the rest of the LA6 countries and will gradually recede going forward.

Our latest forecast calls for LatAm inflation to close 2023 at 4.1%, roughly half the 8.1% projected for 2022, as economic growth decelerates, commodity prices soften, global food and energy prices moderate, and statistical effects turn supportive. While lowering inflation to more manageable levels would undoubtedly be a momentous achievement—after all, falling inflation should boost consumption and hence growth—in no case is an LA6 country expected to meet its official inflation target at least until 2024. Accordingly, the key challenge for regional monetary authorities will be to withstand political pressure to ease monetary conditions—i.e., lower interest rates—much too soon, particularly as a decline in inflation that is substantial, but not sufficient, may encourage central banks to pause their tightening efforts.

Interest rates are likely to peak in early 2023, but remain relatively high

Shortly after inflation started to rear its ugly head in 2021, and earlier than in other regions, LatAm central banks began to hike interest rates to contain undue consumer price pressures. Although the agility and intensity with which monetary conditions were tightened has helped to contain inflation, the struggle in the region is by no means over. Only two of the LA6 countries, Mexico and Peru, have managed to maintain inflation in the high single digits at its peak, with three others, Brazil, Colombia, and Chile, keeping it from breaking the 15% mark, and Argentina, the exception on many fronts, likely to see it climb to triple digits by early 2023.

Against a backdrop of stubbornly high and more persistent than anticipated inflation, the hiking cycle, which has taken average nominal interest rates to nearly 12% in LatAm, more than 400bp higher than in EMEA EM and more than 800bp higher than in EM Asia, is likely to peak in 1Q23, and decrease only slowly to close next year just north of 10%. Only two LA6 countries, Chile and Peru, are apt to cut rates materially (~400bp each) in 2023, with the other four keeping then in double digits through the end of next year.

Key fiscal deficits are poised to widen, as financial costs stay elevated

The LatAm regional fiscal deficit widened significantly to 9.1% of GDP in 2020 as governments sought to shield their economies from the severe impact of the pandemic and the crisis it produced. Although meaningful consolidation took place as growth rebounded sharply in 2021, with the deficit coming in at 4.2% of GDP, further progress at closing the fiscal gap was rather marginal in 2022, and the deficit is estimated to have only declined to 4.1% of GDP.

As growth decelerates markedly adversely impacting fiscal revenues and the various leftist governments seek to deliver on their promises to increase social spending, the regional LatAm deficit is projected to widen to 5.9% of GDP in 2023, with Brazil and Colombia, both of which are aiming to implement tax reforms, expected to print the largest shortfalls. Given elevated financing costs from high interest rates, means putting public debt on a firm downward path in the near term will be no easy feat.

Current account deficits should narrow slightly, in part owing to nearshoring

While lower commodity prices and softer global growth will negatively impact LatAm’s exports, weaker demand for imports amid lower domestic growth should help the region print a slight overall improvement in its external balances. LatAm’s current account deficit (CAD) is estimated to have risen from 1.6% of GDP in 2021 to 2.2% in 2022, but a sizable reduction in the shortfalls of both Chile and Peru should compensate for an increase in Mexico’s deficit to keep the regional tally unchanged at 2.2% in 2023. No LA6 country is expected to register a current account surplus next year. Among the LA6, the smallest CAD will be recorded by Argentina, at 0.6% of GDP, and the largest by Colombia, at 5.0% of GDP.

One of the global trends that could help LatAm improve its external balances going forward by increasing the region’s exports and integrating it further into U.S. and global supply chains is nearshoring. Defined as the practice of transferring a business operation to a country that is less expensive and geographically closer, nearshoring to LatAm has increased significantly over recent years, as geopolitical tensions and growing costs associated with manufacturing in distant countries like China have made the region increasingly attractive not only to U.S. companies, but also to European firms. According to recent estimates by the Inter-American Development Bank (IDB), nearshoring could increase LatAm’s total exports by $78 billion per year ($64 billion in goods plus $14 billion in services) in the near and medium term. While Mexico would see the biggest gains by far, all LatAm countries are expected to benefit from nearshoring. This, however, is much more of a long-term trend which should develop in the next decade or more.

Political pink tide to take center stage

The October 2022 election of Lula as Brazil’s next president put an end to a busy electoral cycle in Latin America that started in early 2021 amid pandemic-induced economic strains. By January 1, 2023, when Lula is set to be sworn in, the six largest and most financially-integrated LatAm economies (LA6)—Brazil, Mexico, Argentina, Chile, Colombia, and Peru, in that order—which together account for nearly 80% of regional GDP, will be led by left-leaning governments. By most accounts, the leftward shift, which has been dubbed the rebirth of a political pink tide in the region, has not been the result of an ideological realignment in favor of statist policies, but rather the product of voter discontent with the handling of the pandemic and ensuing economic crisis by incumbent right-wing governments. Put different, the success of the left in recent elections has been largely the result of a rise in anti-incumbency sentiment in LatAm and not clear support for leftist policies.

Recent elections have made evident that the pandemic has generally deepened, rather than reduced, political tensions and divisions in LatAm, increasing uncertainty and raising concerns about future economic policy direction. Meanwhile, from a market standpoint, the biggest risk associated with the ongoing regional swing to the left of the political spectrum is that it could prompt changes to the laws, regulations, or contracts governing investments in a way that adversely impact their financial returns.

The only LA6 country scheduled to hold a presidential election in 2023 is Argentina, but not until late in the year, with a controversial libertarian economist boasting a strong showing in recent polls and, in some cases, even outpacing his mainstream rivals. The next major general election will be in Mexico, but not until mid-2024.

Country risks in focus

Although a worsening external environment will undoubtedly cloud LatAm’s regional outlook in the near-term, each country’s prospects and risks will also be driven by idiosyncratic factors. In Argentina, for example, strengthening macro stability, containing elevated inflation, reducing policy uncertainty, and complying with the country’s IMF program will be key challenges. Meanwhile, in Brazil, tight financial conditions are likely to weigh on already soft growth at a time when a weak fiscal stance is expected to be relaxed even further as the new government prioritizes social spending. In Chile, growth is projected to moderate significantly from a low base as the authorities recalibrate monetary and fiscal policies and the possibility of social discontent remains a concerning risk, leading the economy to contract the most in 2023 among all LA6 countries.

Apart from high levels of political risk and policy uncertainty, Colombia’s twin fiscal and current account deficit remains a key source of concern, with growth projected to cool meaningfully as interest rates are kept high to contain the second highest inflation (after Argentina) in the LA6 space. While Mexico’s fiscal policy, a vital source of concern for many other countries in the region, is widely expected to remain prudent, the economy is poised to slow in tandem with the US, the destination of nearly 80% of its exports. Finally, though Peru’s fiscal and external buffers remain relatively large compared to most others in the region, its balance of risks is skewed to the downside owing to soaring political uncertainty.

Credit

Corporations in LatAm are better suited to manage global recession than most US HY issuers as they have lower leverage, hold strong cash buffers which limits their need for market access and are accustomed to cutting capital expenditures in a haste.

However, having behaved as if they were issuers of reserve currencies during the pandemic, the Sovereigns are now in a tough situation. Fiscal risk remains relatively unanchored at a time when inflation is peaking, and monetary policy must remain tight to offset fiscal policy. In a flashback to the 1980s the region is regressing to unorthodox fiscal policy which runs the risk of turning into fiscal dominance of monetary policy, further exacerbating currency depreciation and inflation dynamics.

Given this setup, we like corporate bonds of exporters with balance sheets and cash flow generators geared to benefit from a weaker currency within LatAm corporates. We do see a sustainable environment where the currencies will depreciate in spits and spats providing inherent operating leverage to exporters as the fixed costs and variable costs in local currency gets diluted and their topline holds with its hard currency basis.

Commodities are essentially back in vogue as years of underinvestment have led to basically matched supply and demand and marginal growth drives real price appreciation. This serves to support the “exporter’s” thesis as well as the local currency depreciation dynamics.

On a relative valuation, LatAm Corporates and Sovereigns remain expensive to Developed Market Investment Grade bonds particularly on the advent of a potential recession. Our bias is to continue to move up in quality preparing for next year.

FX
Recent LatAm FX performance has been mixed

Since LatAm currencies typically strengthen when the US cuts rates and weaken when the US hikes them, and the Fed has been in hiking mode since last March, several key LatAm currencies—including those of Argentina, Colombia, and Chile—have depreciated against the USD so far in 2022. A notable exception to this trend has been Brazil, which started hiking rates much earlier and more aggressively than the US, widening rate differentials in its favor.

LatAm currencies are apt to weaken in 2023

As most LatAm countries reach peak rates by early 2023 and shift to an easing mode to stimulate their cooling economies amid a global slowdown, and the US keeps interest rates relatively high well into next year, LatAm currencies are likely to gradually weaken by end-2023. In fact, there is not a single LatAm currency among the largest economies that is expected to appreciate against the USD in 2023.

That said, the degree of depreciation of LatAm currencies will likely be highly uneven, with the currencies of Argentina and Colombia bearing the brunt of the regional decline, while others, like the currencies of Mexico, Peru, Chile, and Brazil, projected to depreciate only slightly.

A quick word on the recent USD strength

Long-term trends in FX are heavily influenced by interest rate differentials. With U.S. rates exceeding those of other key DM countries, the USD has outperformed its DM peers in 2022.

This trend may change in 2023, however, as the Fed pivots from its current ultra-hawkish policy stance. This would limit, though not prevent, the depreciation of LatAm currencies, some of which seem better suited than other currencies in EM to weather a difficult global environment.

Equity
2022 Lookback

Despite global headwinds and political noise, LatAm equities significantly outperformed the rest of the world and EM in 2022, as of the time of writing. In fact, out of the main regions within EM, LatAm was the only one to post a positive return. Country-by-country, Chile and Peru made it into the top 5 performing countries in spots 2 and 3 and 5 respectively, while Brazil stood in the 6th place and Mexico in the 11th spot.

LatAm’s outperformance comes despite headwinds from higher US rates, a strong USD, idiosyncratic political risks, and persistent high inflation, among other factors. We attribute the region’s equity resilience to a high exposure to commodities, which are still the best performing asset class YTD, as well as cheap valuations and strong growth tailwinds supporting robust companies’ earnings growth. Growth prospects for Mexico and Brazil were consistently revised up this year, despite lingering fears of a Central Bank – driven recession.

2023 Key Drivers and What to Expect

Next year’s political calendar for the region will be significantly lighter than what it was in 2022, with the presidential election in Argentina taking the spotlight 4Q23. This means that main drivers for LatAm equities into the new year should be restricted to (1) foreign investor flow (i.e., global risk appetite), (2) idiosyncratic growth dynamics flowing through to earnings growth estimates, (3) lower rates as tailwinds for valuations that are too cheap to ignore.

Dynamics within the region will vary widely. Valuations across the region are unsustainably low, yet for Chile, Colombia, and Peru, given their markets’ low liquidity, we struggle to find catalysts to reverse the valuation discount. On the other hand, outlook for Brazilian equities seems like a coin toss at this stage. On one end, the BCB is expected to cut rates as soon as mid-year 2023, without impacting the BRL given high real rates. Domestic activity has been well supported and should remain so into 2023. However, fears about fiscal recklessness from the incoming government presided by Lula will cast a shadow keeping valuations below their historical average, especially for SOEs. On the other extreme, valuations in Mexico are also broadly attractive yet growth could be challenged by a recession in the US (our base case scenario). However, we see greater room for re-rating as international appetite reverts to EM as USD weakens and growth differentials across EMs vs. DMs narrow.