Latin American economies on the defensive

A fresh wave of disruptive volatility in the emerging-market asset class has resurfaced. The financially integrated Latin American economies have been caught in tandem by this renewed bearish market tone, yet the overall impact differs from country to country based upon unique macroeconomic circumstances and market liquidity conditions. Scotiabank notes that four major external factors are at the heart of the sell-off momentum present in developing-market securities and currencies:

1. the anticipated increase in interest rates as a result of monetary policy normalization by both the US (Fed) and UK (BoE); 
2. increasing evidence of economic growth deceleration in China and associated overbought conditions in selected asset markets;
3. continuous fragility in most commodity prices due to supply/demand imbalances in the current business cycle; and last but not least, 
4. the relentless appreciating bias embedded in the US dollar (USD) against major peer currencies. 

The Latin American currency environment retains a bearish market tone, with flows and technical indicators pointing to further near-term weakness. However, signs of overshooting may emerge by the end of the third quarter leading to a timid stabilization phase by the end of the year. Brazil and Colombia have been the worst performers over the past 12 months, with their currencies depreciating by 35% against the USD. The drivers of such negative performance are quite distinct. 

The Colombian peso (COP), which traded as low as 2,971 per USD on August 7th (21% depreciation in three months) was primarily hit by a second oil price shock, which led to a 29% decline in crude oil prices since June 10th. Persistent weakness in oil prices, compounded by an unsustainable current account deficit (edging 6% of GDP) will continue to weigh on the COP before testing and establishing a new trading range at weaker levels. Non-deliverable forward (NDF) markets imply further weakness for COP in the near term. 

As for Brazil, the real (BRL) has maintained a steady depreciating phase triggered by severe macroeconomic imbalances (both fiscal and external) which ended in a prolonged high-inflation recessionary context. In fact, the fiscal gap reached 8.1% of GDP over the past 12 months with the market-watched IPCA inflation rate touching 9.6% in July. In late July, the Brazilian real (BRL) broke through technical support levels and weakened to 3.57 per USD (August 6th). NDF contracts imply a modest weakening of the BRL (in nominal terms) by the end of the year, hinting that the Brazilian currency may be testing "oversold" waters. Contrary to public belief, the wild cards for Brazilian market performance in the months ahead are not solely to be found in domestic factors. Scotiabank forecasts that the renewed US dollarization of investment portfolios (the tradeweighted USD index increased by over 20% over the past 12 months) and the inevitable deceleration of Chinese economic growth (not US monetary policy shifts) will be the key drivers of Brazilian exchange rate trends over the next 12 months. The risk of multiple downgrades of Brazilian sovereign credit ratings remains latent; indeed, all credit rating agencies maintain a "negative" outlook on the country's sovereign credit ratings.

Mexico deserves a special analytical chapter given its triple identity (North American, Latin America, and Emerging Market). The market differentiation between Brazil (the world's seventh largest economy) and Mexico (the most attractive investment-grade debt asset in North America) is eloquent. Despite the bearish trend present in "all" emerging-market asset classes, the relative outperformance of Mexico vis-à-vis Brazil is a result of both cyclical and structural factors. The spread between Brazil and Mexico (as implied in credit default swaps) has widened from 0 bps to 185 bps over the past three years. Mexico is an integral part of the North American economic and financial market landscape. The Mexican economy will strongly benefit from the improving economic and employment outlook in the US, particularly in two sectors with positive effects on the MXN (motor vehicles/auto parts and remittances). In addition, Mexico continues to offer an attractive carry -trade investment option trading at a yield spread of 385 bps vs US treasury debt and 460 bps over Canadian government bonds. The monetary outlook in Mexico will most likely be aligned to the policy normalization phase to be adopted by the US Federal Reserve, strongly aided by major advances in combatting inflation (headline rate at 2.7%, below target, in July 2015). 

In brief, the Mexican peso (MXN), which traded as weak as 16.5 in intra-day trading on July 30th, will not be immune to the bearish directional phase embedded in emerging markets at present. Nevertheless, we believe that Mexican assets will become relative outperformers within Latin America and the core group of financially integrated emerging markets. Given the sizable foreign holdings (primarily from US-based investors) of Mexican treasury bill and government bonds, the shape of the US treasury (UST) yield curve and the Fed's management of its bond portfolio will be critical determinants of capital flows dynamics and potential repatriation flows in the months ahead. In conclusion, Scotiabank notes, "we project that the MXN will trade between 16 and 16.50 in the near term in anticipation of shifts in US monetary policy conditions."