Latin America | Refreshing 2021 views
admin | December 11, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Assessing high beta credits is always a fluid process. Weak fundamentals almost ensure that. And now a wave of global liquidity has set up strong demand for high yield heading into next year. In LatAm ‘B’ credits, there are still solvency problems and potentially liquidity problems that explain the lack of normalization back to pre-Covid yields. Argentina and Ecuador hinge on solvency, Costa Rica and El Salvador on liquidity. Investors have to choose their risks carefully.
Argentina and Ecuador are not carry-trades because of near-zero coupons and consequently should not correlate with external risk. The total returns instead depend on idiosyncratic risk and options around debt solvency. The carry trade for Costa Rica and El Salvador depend on access to liquidity, preferably under programs from the International Monetary Fund that require improved solvency and improve potential price appreciation for Eurobonds. The IMF role is critical for all these countries as lender of last resort. However, execution risk is high. The targets are ambitious, and governability is weak. Investors should be slightly more bearish on Argentina and slightly less bearish on Costa Rica. There is still high event risk for Ecuador into year-end around the country’s reform agenda and IMF relations and uncertainty into elections. For Costa Rica, it is still a question of watching auctions for rollover risk in local markets. El Salvador does not disappoint as the top performer last month and into this month.
Argentina is the least favorite. The possibility of an orthodox policy shift has declined, and liquidity indicators still look weak. Foreign exchange reserves are still at precarious levels, and the difference between the blue-chip foreign exchange rate and the official rate reinforces the balance of payment stress. The formula for future debt repayment requires slow foreign exchange reserve accumulation. The IMF in itself is no fix but only a political compromise. The Kirchnerista ideology reinforces the balance of payment crisis and refuses to deliver lower spending, higher interest rates and foreign exchange flexibility. The piecemeal pragmatism under Guzman wastes time necessary to accumulate foreign exchange reserves. Gross foreign exchange reserves are $38 billion against DSA metrics of $50 billion at the end of 2020 and $64 billion once amortizations commence in 2024. How does Argentina accumulate foreign exchange reserves with inward isolation and policies that encourage US dollar demand? Eurobonds offer no carry, and investors are not paid to wait with upside bond prices only correlated with higher foreign exchange reserves. Argentina needs either a positive to shock to investor sentiment with the right policy mix or a positive external shock on commodity prices. Neither seem imminent and, as such, reaffirms a bearish credit view of underperformance.
Ecuador is worth a neutral weighting. Current yields coincide with political and policy risks after upcoming elections. However, the balance of risk and reward is eroding under still high electoral uncertainty. It is important to remember that there is still high uncertainty of election outcome and high execution risk of economic reform program. On attempting to back out what is implied in current ECUA’2040 yields, the political and policy risks are tilting optimistic. The near 10% yields on 40s implies either higher than 60% chance of CREO centrist Lasso win or less than 8% yields against 14% yields under Correista Arauz. The outcome is also becoming more binary as the opposition exposes Arauz’s radical views of de-dollarization and Chavez-type policies, so maybe 15% yields are more appropriate. This would shift odds closer to 70% for Lasso at implied 8% yields.
The current yields imply optimism about election outcomes and policy management while polls suggest a two-way race and tight runoff round. The budget stress could also influence the polls. The front-loaded IMF program should reduce budget stress and the risk of populist backlash. The next test is the reform bill with recent delays worrisome. After elections, there is high execution risk but reason for optimism under a centrist candidate, especially if Lasso gains strength for a first-round win. The liquidity relief provides breathing room from bondholders, so there is no logic for another restructuring after elections. There is no better alternative to an IMF program. To defend dollarization, Ecuador need economic reform and fiscal discipline. The Moreno administration is an example of forced pragmatism under dollarization. This should also hold true under a Lasso administration but admittedly much higher risks under an Arauz administration.
The normalized Costa Rica yields do not compensate for high rollover risk and unresolved solvency risks for a country that recognizes the debt trap but cannot agree on an IMF program. The base case view is shifting to one without an IMF program and high dependence on local investors. However, there is a chance that Costa Rica may be able to muddle through based on recent treasury auctions and central bank foreign exchange intervention. The rollover risk shifts to the local markets and its willingness to fund into insolvency. The saturation risks are not obvious after consistent funding of higher structural fiscal deficits for a decade. More important is the willingness to fund extraordinarily large gross financing needs of 15% of GDP next year. The critical questions are whether investors continue to fund the treasury if there is risk of distressed debt liability operations or no IMF program? How much can the central bank assist? There is high budgetary rigidity, large gross financing needs and typically only consensus for adjustment under duress. There has been sufficient demand at the recent auctions while active foreign exchange intervention from the central bank reduces financial market stress. The muddling through carry trade is feasible if domestic demand remains resilient. This encourages a less pessimistic view for Costa Rica, maybe closer to neutral weighting, but still concerns about rollover risk and mark-to-market risk for Eurobonds.
El Salvador offers potential for lower volatility and higher carry. Rollover risk looks manageable near term, and the positive shock of an IMF program after elections could lift prices. The rollover concerns look overstated. El Salvado still has access to domestic demand while also benefiting from budget flexibility from low structural spending and a full recovery in tax collections (even VAT). Like other dollarized countries, the inability to access funds translates into lower spending like this past October and forces austerity. After elections, look for stronger governability—95% approval ratings for President Bukele as well as a mature recovery and the rollover of multilateral loans should reduce social backlash and provide budget flexibility. There are no viable options other than negotiating an IMF program. Local funds look shallow, and the budget is underfunded for 2021. The heterodox alternatives risk economic backlash. The consistent informal talks with the IMF suggest a formal process next year. El Salvador has been a top pick starting in mid-November and continues to outperform into this month.