The Big Idea
Lessons learned in Latin America in 2023
Siobhan Morden | December 15, 2023
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.
My two investment themes heading into this year were to look for upside on select assets trading at recovery value and for lower beta carry alternatives. The ideal asset selection among high yield issuers meant avoiding the worst performer, Ecuador, and favoring the best, El Salvador. My top picks also included The Bahamas and Argentina, which also were top emerging markets performers. Core exposure to illiquid ‘BB’ credits has also worked well with Costa Rica again ahead of the pack. The one disappointment was Guatemala, a reminder that politics matter even for those ‘BB’ credits with stellar repayment metrics.
Choose wisely and prioritize fundamentals
There is a tendency to oversimplify with an investment strategy that relies mostly on valuations or technicals. For the distressed or stressed credits, those rules involve either buying at recovery value levels or buying after consecutive years of underperformance. The fundamentals always typically dominate. This is why I avoided Ecuador in 2023 and plan to do the same in 2024. The high beta status allows for trading opportunities with a short-term strategic long position from November 2022 through January 2023. However, the precarious liquidity risks and track record of unwillingness to pay makes it hard to invest over the medium or long term. There was serious damage to investor sentiment after all of the many setbacks of the Lasso administration and a wider consensus that Ecuador is ungovernable with no recognition or commitment to fix a structural fiscal deficit and the low growth trap.
Argentina still offers opportunity
It is the memory of extreme crisis that reduces repeat failure. Argentina remains my top pick from 2023 and into 2024. The next few months represent the litmus test on execution of shock therapy. This is what ultimately will determine the probability of default—managing near-term liquidity risks—and recovery value—following through on medium-term economic stabilization. Argentina bond prices have been edging higher on optimism about the high-quality technocrat team, the policy pragmatism and the political capital of the Milei administration. There is no other country that is attempting Argentina’s scale of shock therapy, with a proposed 5%-of-GDP fiscal consolidation. There is still room for optimism and for further recovery of bond prices back to a higher range of recovery value (40-50).
The lessons learned from policy failure is why Argentina will avoid another crisis and why I remain constructive. There is commitment across the political establishment to avoid the heterodoxy of central bank deficit monetization with fiscal adjustment the only alternative under limited financing alternatives. The social pressures may stress test this policy orthodoxy. But ultimately the recipe remains the same under any scenario. There is no quick fix to the large macro imbalances, but the forced fiscal adjustment should reduce these imbalances and improve debt repayment capacity.
Understanding why many missed the El Salvador trade
El Salvador was the uncontested winner in Latin America for its 110% total returns year-to-date through December 13. These smaller countries are often overlooked. They have small market capitalization, and many investors find coverage hard in a large emerging markets credit universe. However, it is exactly these frontier credits that offer a competitive advantage for their idiosyncratic risk. I did not share the market skepticism that default was imminent and inevitable when bond prices were trading in the 30s. The bond buybacks in September and December 2022 were a game changer on reaffirming the country’s commitment to pay while also providing liquidity relief on the Eurobond amortization calendar through 2025. My initial price target of 50 was met with investor skepticism but then positive developments forced upward revisions to now current prices of 70 to 80. El Salvador still offers high carry returns with positive optionality of an IMF program next year and supportive technicals on continuing core underinvestment across the emerging markets investor community (Exhibit 1).
Exhibit 1: The winners/losers PX_MID
Let Costa Rica keep running
Costa Rica is also an interesting outlier as the only credit with three years of consecutive positive total returns and the only credit since Brazil in 2000 that benefited from a 2-notch rating upgrade from ‘B’ to ‘BB-‘ in the same calendar year (Exhibit 2). Costa Rica is also the only credit in Latin America with a plan and a trajectory towards an investment grade rating. The alpha returns now may be over at a mature phase of outperformance; however, I still expect a gradual compression of credit spreads and a slow divergence away from the illiquid ‘BB’ credits. The supply and demand technicals could also improve with broader recognition and exposure for the larger market capitalization and positive rating action into the ‘BB’ category. Costa Rica should benefit from a larger investor base as it crosses from frontier to mainstream and wider recognition among the emerging market investor community.
Exhibit 2: LatAm EMUSTRUU BB % total returns
Disappointment in Guatemala
Guatemala was my single disappointment, barely eking out positive returns. The election cycle quickly shifted from almost a non-event to now a potential institutional crisis as corrupt factions threaten the political transition. The bottom line is politics matter with election cycles still relevant for even solid ‘BB’ credits like Guatemala. This doesn’t quite alter my view for the upcoming elections in Panama and the Dominican Republic for their track records of policy moderation across the political establishment. It does however dampen any trajectory for an investment grade rating for Guatemala. The ESG criteria matter, and the latest announcement from the US State Department with 300 individual sanctions that includes two-thirds of the congress creates much higher policy risks even after the political transition. That should imply a higher political and policy risk premium on credit spreads that restrains the relief rally. It’s also hard to shift overly bearish on still the investment grade repayment metrics of low 30% of GDP debt, high 20% of GDP foreign exchange reserves and the small fiscal deficit of 2% of GDP. The fundamentals remain resilient but not completely immune to political risks.