FBZ - Explaining Latin America's Winning Season
2023-06-24 00:20:00 ET
Summary
- Latin American local currency debt faced challenges in 2022 including rising U.S. interest rates, reduced demand for commodities, political instability and persistent regional inflation.
- Surprisingly, the asset class has shown remarkable resilience so far this year, delivering an return of nearly 20%, as measured by the JP Morgan GBIEMGD Index, and outperforming other EM regions.
- In January, Latin American local debt benefited from China’s economic recovery, improved growth projections in developed markets, and reduced uncertainty surrounding the Federal Reserve.
By Billy Lang
We’ve seen a sweet spot in local rates and FX markets.
Latin American local currency debt faced challenges in 2022 including rising U.S. interest rates, reduced demand for commodities, political instability and persistent regional inflation.
Surprisingly, the asset class has shown remarkable resilience so far this year, delivering a return of nearly 20%, as measured by the J.P. Morgan GBIEMGD Index, and outperforming other EM regions.
So, what factors have contributed to this performance?
In January, Latin American local debt benefited from China’s economic recovery, improved growth projections in developed markets, and reduced uncertainty surrounding the Federal Reserve.
Even during March’s market stresses, the Latin American index remained largely unaffected. As expectations for Fed rate hikes decreased, gains in Latin American duration were supported by the historically high beta to U.S. yields. A high risk premium incentivized investors to stick with FX carry trades as the year progressed.
In addition, stronger currencies generated a positive self-reinforcing loop, helping to anchor inflation expectations, and this new stability prompted shifts in strategic allocation, as global investors underweighted Asia and favored Latin America.
Actions by Latin American monetary authorities were also crucial. Early and prolonged interest rate hikes earned policymakers credibility in fighting inflation, while coordination of monetary and fiscal policies contributed to the disinflation process.
Disinflation is now present in Brazil, Chile and Mexico, while core inflation has stabilized in Peru and Colombia. Latin American local yield curves have also seen significant declines. Currently, the front end of the curves has priced in many cuts, while at the back end, Brazil and Colombia still offer favorable term premiums.
Investor positioning has played a role, too. Initially, there were concerns about left-of-center governments with ambitious reform agendas. However, robust checks and balances within local democratic structures weakened governmental positioning on reform, leading local Investors to cover short positions.
The interplay of these factors has played a crucial role in supporting the asset class this year. We remain optimistic as to absolute and relative value versus developed markets.
That said, the risk premium has compressed. Although investor attention is now likely to turn to the start of an easing cycle, actual rate cuts may not happen as early as expected as central banks aim to keep high policy rates for longer to ensure disinflation.
Stability as to politics and currencies will be essential; however, we believe the critical determinant for further price gains lies in the potential return of off-benchmark foreign investors into the asset class.
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Explaining Latin America's Winning Season