The Big Idea
World Outlook 2022: Latin America | Another year in transition
Siobhan Morden | November 19, 2021
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.
Latin America should continue to transition next year in the aftermath of Covid as many countries enter either a more difficult phase of their International Monetary Fund program or an election cycle. Despite economic recovery, there is recession fatigue after surviving prolonged pandemic shock. This makes it socially and politically difficult to adopt the fiscal restraint needed to tackle higher debt burdens. A trend of rating downgrades has also made debt sustainability difficult. However, it is also difficult to be bearish when most of the ‘B’ sovereign credits are trading at or near double-digit yields and discount a significant probability of default. We head into next year with attractive valuations that argue for less defensive positions.
The restructured high yielders in Latin America and other ‘B’ sovereign credits are close to year-to-date worst levels. The unwind of global liquidity argues for prioritizing carry to protect against the risk of higher US Treasury rates, but it demands careful asset selection (Exhibit 1). Stay focused on the high yielders. The top picks are the Bahamas, the Province of Buenos Aires and Ecuador for either high carry or the potential in their low cash prices—potential anchored by promising IMF programs and by fundamentals out of sync with current valuations.
Exhibit 1: Risk from rising US Treasury yields in EM
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Event risk is still fluid
Fluid event risk makes it difficult to commit to a 12-month investment horizon for the high yielders. El Salvador was Amherst Pierpont’s high conviction overweight heading into 2021 and was the top emerging market performer into the first half of 2021; however, the Bukele risk premium forced us to shift to underweight when the country lost the anchor of an IMF program. El Salvador is now finishing this year as the worst performer (Exhibit 2). We are starting next year with a “nervous neutral” for El Salvador based on uncertain liquidity and solvency risks but with more reasonable valuations than earlier this year. We shifted from underweight to neutral when bond prices dipped below $70 in late September. Holding El Salvador will require close scrutiny of rollover risk ahead of the bulky $800 million Eurobond amortization in January 2023, which will depend on whether the country can muddle through without an IMF program. The risks are binary. Credit risk also remains fluid in Ecuador on their path for economic reform. Argentina represents a longer-term view as the country makes a decisive shift towards regime and policy change with prices at historic lows.
Exhibit 2: Just a few outperformers in EM in 2021
IMF execution risks still dominate
Political risks dominate the region with either latent social pressures post-Covid or emerging election cycles in Chile, Costa Rica, Colombia and Brazil. This may undermine IMF relations or discourage fiscal discipline. The IMF serves as an anchor by not only providing near-term liquidity and broader access to external capital but also by providing a medium-term policy framework for debt sustainability. The markets have unwound the probability of an IMF program in El Salvador with an autocratic political agenda that undermines a rational economic program. Costa Rica, as the first country post-Covid to negotiate an IMF program, now faces higher execution risks while entering an election cycle. Argentina also now enters difficult negotiations to finalize a program early next year and avoid default on heavy IMF loan repayments. Ecuador stands apart from the others and should benefit from political capital in the early stage of an orthodox Lasso administration and from political acumen required to socialize an ambitious reform agenda.
Attractive valuations at distressed levels
EMBIG spreads are midway between a tight 325 bp to 375 bp multi-year trading range. Carry looks like an insufficient buffer against the risk of higher US Treasury rates, driven by rising inflationary concerns and by early stages of a liquidity unwind. EMBIG total returns at -1.6% year-to-date through mid-November have fallen short of positive territory while spreads at 350 bp remain relatively unchanged the end of 2020. This argues for an investment strategy biased towards either higher yielding or higher beta opportunities. The current valuations for high yielders appear attractive and discount high risk scenarios. Argentina sovereign bond prices in the $30s are back at the historic low for recovery value. The majority of the other high yielders are also at or above distressed levels of double-digit yields. This increases the risk asymmetry towards positive credit developments with more attractive risk-and-reward scenarios and unstable equilibriums that also increases volatility and market beta.
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The cases for Provence of Buenos Ares, the Bahamas and Ecuador
ARGENTINA | MODERATE POLICY SHIFT. Argentina’s recent midterm elections represent an important turning point in voter sentiment. The public rejected Kirchnerismo at a mature phase of policy failure. The Fernandez administration is now much weaker and will have to negotiate with the opposition for the full two years remaining in its term. This ruling party defeat is good news for bondholders and explains the bounce in bond prices after elections.
Distressed bonds prices in the $30s should be close to a bottom (Exhibit 3). The market and IMF negotiations are pushing a gradual and decisive shift toward policy moderation. It still looks like a tense few months of IMF negotiations. There is no other alternative to an IMF agreement as a stabilizing anchor amidst a current crisis of confidence, an intense cash flow deficit and a zero stock of US dollar assets. The initial comments from President Fernandez are encouraging after he requested cooperation from the opposition. And the behind-closed-door IMF negotiations suggest some adjustment to the 2022 budget.
Exhibit 3: More market stress, more optionality for policy change
This is no quick fix for Argentina but rather the beginning of a slow turn towards policy moderation. It has been a lost two years since the original DSA analysis of March 2020. Gradualism is no longer sufficient to repay the restructured debt, and distressed bond prices are still discounting a high probability of default. This should cap the upside of any relief rally after negotiating an IMF program. The moderate policy shift should allow for marginal gains; however, there is no quick fix to macro-imbalances. There has been considerable damage since the political Kirchnerista transition. There is higher structural fiscal deficit from higher subsidies, persistent high structural inflation and an indebted central bank.
This reaffirms our recommendation for the Province of Buenos Aires. The province benefits from high current yield and similar positive optionality as a spread product to the sovereign. The BUENOS’37A should capture the slow turn towards policy moderation with prices at historic lows but yet higher coupons relative to the sovereign—a current yield of 8.8% that shifts to 11.8% in March 2023 (Exhibit 4). This is a longer-term investment strategy with historic price lows and higher conviction for policy reversal under marginalization of Kirchnerismo. The gradual policy shift should focus an investment strategy on higher coupons and less leverage of the quasi-sovereigns and corporate credits.
Exhibit 4: Buenos 37A cash flow and high current yield
ECUADOR | REFORM SUCCESS. We remain bullish on the political acumen of the Lasso administration despite the skepticism implied by low bond prices. Ecuador’s reform momentum benefits from early negotiations with coalition parties, a progressive reform agenda, an aggressive political strategy willing to use snap elections, and less social tensions. Ecuador bond prices remain at the low end of the 6-month trading range even after initial progress in containing social unrest and building political support.
There is a wide range of scenarios involving policy and political risks and outcomes on bond yields. Our assessment of fair value is biased towards lower yields of 8.9% for ECUA’30 and 9.26% for ECUA’40. Those valuations assume a high probability of tax reform and a stronger Lasso administration under the threat of snap elections. It’s not easy to reach consensus on controversial reforms; however, the progress on tax reform could push bond yields back to the lower end of trading range—toward 8.25% on 5% ECUA’30 and 9% on ECUA’40 (Exhibit 5). The breakthrough 8% yields for the 5% ECUA’30 will require back-to-back progress, with the next challenge being labor and investment reform over the next few months. Technicals should still support high yields, although those yields perhaps underestimate a successful reform agenda. Initial progress should invite sponsorship from conservative real money investors. Our preference has been the 5% ECUA’30 that should benefit not only from the bullish curve steepening but also from higher current yield over a lengthy multi-phase economic reform process.
Exhibit 5: 5% ECUA’30 outperforms on tax reform optimism
THE BAHAMAS: HIGH CARRY, MUDDLE THROUGH. Uruguay inflation linkers were our top pick heading into this year for their high carry. UI bonds did not disappoint. They delivered not only high 7% inflation income but also a reduction in real yields for an impressive 13% foreign-exchange adjusted total returns through November 15 on the UI’2028s (15.9% unadjusted). The Bahamas is our top carry trade for this year. The near double-digit yields are unique after years of abundant global liquidity has compressed yields across most emerging markets sovereigns. The high 7.9% to 9.4% yields and a bearish flat curve still reflect latent concerns after misunderstood comments on debt liability management last September. There has since been repayment reaffirmation after a month of high coupons in October, a reduction in the fiscal deficit target for FY2021-2022 and a new financing program that prioritizes financing from locals and multilaterals.
There has been a concerted to effort to communicate with investors and reaffirm commitment to pay. Eurobond coupons are at a manageable 2% of GDP and all debt coupons only 15% of budget. Why would any country with unblemished track record of repayment pre-emptively default on coupon payments? Why would a country with an important offshore banking sector break financial contracts? It also seems pre-mature for bond prices to shift toward a higher implied probability of default 25 months ahead of the next amortization payment. The liquidity and rollover risks should also improve on the shift towards domestic and multilateral funds while also reducing the supply risk overhang in Eurobond markets. We reaffirm our overweight (off index) recommendation to target either high carry or near full recovery after the pronounced 12.2% September EMUSTRUU underperformance.
Exhibit 6: A high yield premium despite repayment reaffirmation