The Big Idea

Out-of-consensus views on Latin America for 2025

Siobhan Morden | November 22, 2024

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. This material does not constitute research.

Emerging markets spreads stand at multiyear lows, similar to stretched valuations across other risk assets. It is a difficult juncture for an asset class sensitive to external risks and vulnerable to US Treasury risk. There is also little clarity on US policy during the transition to a new administration in Washington. This requires a somewhat cautious asset selection. Emerging markets credit remains sensitive to overall market direction, valuations are tight and lower potential returns increase the possibility of error. There are few if any outliers that could deliver the same impressive returns seen this year, and it is hard to identify double-digit potential return alternatives. But some names stand out: Argentina, Colombia, El Salvador and the Bahamas and Costa Rica.

Exhibit 1: LatAm outperformers YTD 2024 (EMUSTRUU % total returns)

Source: Bloomberg, YTD as of 11/18/2024

Exhibit 2: LatAm EMUSTRUU BB % total returns – who are the laggards/leaders next year?

Source: Bloomberg, YTD as of 11/18/2024

This sets the stage for a more dynamic approach on high beta assets and a more defensive approach to selecting credits at a mature phase of asset price normalization. Argentina remains my top pick under the transformation of the Milei administration even though potential returns should be lower and volatility higher during the next phase of economic stabilization. The laggard performance of Colombia in 2024 as the cheapest ‘BB’ credit could make it a leader in 2025, especially closer to the election cycle. More defensive options include the higher beta and illiquidity of credits like the Bahamas and El Salvador while Costa Rica stands apart for its trajectory towards an investment grade rating. Ecuador could surprise to the upside as still a distressed credit; however, risks remain binary and require a more tactical trading strategy closer to the election cycle next year with more poll transparency. The positive surprises next year across the region should all focus on fiscal adjustment –whether Panama delivers sufficient adjustment to maintain its investment grade rating, or the Dominican Republic breaks the inertia for consolidation under the fiscal rule.

Exhibit 3: The near normalization of B/CCC rated credits (yield/duration)

Source: Bloomberg, YTD as of 11/18/2024

Exhibit 4: The outperformance of high yielders

Source: Bloomberg, YTD as of 11/18/2024

Less stressed credit: Argentina

Among the highest yielding credits, my favorite remains Argentina. It is hard to have conviction ahead of the election outcome next February in Ecuador, with weak fiscal finances and asset prices vulnerable to binary policy risks. The investment strategy for Ecuador remains tactical. However, Argentina’s impressive transformation under the Milei administration allows for further curve normalization. The fiscal anchor is unique and impressive as maybe the only country in the region with a fiscal surplus. The foreign exchange rigidity is not ideal with low foreign exchange reserves. However, the temporary US dollar windfall from the tax amnesty should provide some breathing room while the fiscal surplus should also restrain external pressures. Governability is equally important to sustain the political commitment to multiyear structural adjustment. There is also a unique priority payment to bondholders with US dollar funds allocated abroad ahead of scheduled payments and track record of payment through the worst of the liquidity stress. The next phase of asset normalization should be slower albeit on still unresolved macro imbalances with a low stock of foreign exchange reserves and rigid foreign exchange rate. The investment strategy should prioritize upfront payments for higher current yield of those tenors with sinking-fund payments.

High yield laggard: Colombia

The laggards one year can convert into the leaders the next year. Colombia is the potential candidate at the bottom of the pack on regional returns this year and with room for optimism next year on political and economic transitions. Recent commitment to the fiscal rule should reaffirm the checks-and-balances and institutional strength that should keep Colombia within the ‘BB’ category. The confirmation of compliance with the 2024 fiscal rule early next year would improve prospects for compliance with spending restraint into 2025. The commitment to spending cutbacks shows the importance of adhering to the medium-term fiscal program. The technicals are quite favorable, too, with current valuations out of line with the country’s resilient ‘BB+’ composite credit ratings and trading at only a small spread premium to ‘B’ credits after the impressive rally across ‘B’ through ‘CCC’ ratings. This may argue for less US Treasury contagion, with valuations anchored by stronger relative value. The excessive policy risk premium should also decline more quickly with the approach of the election cycle later next year and with potential to trade closer to ‘BB’ peers like Panama and the Dominican Republic. Colombia trades at a significant 75 bp to 130 bp pickup on the longer tenors. This seems excessive assuming compliance with fiscal rule and minimal damage to the legislative agenda while rating agencies slow play the negative rating action from the current composite ‘BB+’ levels.

High carry and low beta combo: El Salvador and the Bahamas

These credits have normalized from double digit yields earlier this year. It’s a mature phase of credit spread normalization with 8% yields aligned to ‘B’ credits. The next phase is much harder, with movement toward a ‘BB’ rating depending on a credible record of fiscal discipline and slow reduction of the debt burden. However, there are unique technical benefits. The supply-and-demand dynamics are quite strong, with a declining stock of Eurobonds after successful debt liability and low-to-maybe-no Eurobond issuance next year. This illiquidity should lower the market beta to US Treasury contagion while still offering relatively high carry returns. The Bahamas benefits from a track record of effective fiscal management while El Salvador may soon finalize an International Monetary Fund program under the commitment of a fiscal anchor. The confirmation of an IMF program should validate single ‘B’ ratings across the agencies, especially in the context of lower execution risks from strong political capital of the Bukele administration. It should be a slower phase of spread compression depending on progress towards the fiscal target needed to reduce high debt ratios. However, the still high carry and low beta combination offers potential for diversification from an uncertain external backdrop.

Investment grade candidate: Costa Rica

There has been much debate about the frontrunner for an investment grade rating in Central America and the Caribbean after successive regional rating upgrades. This is a fun topic for a region that benefits from fiscal discipline and low spending, high foreign direct investment, strong growth and upside from near shoring investment and growth. Costa Rica now may edge out the Dominican Republic after their setback on tax reform. If both countries now have to rely on the fiscal rule for lowering debt ratios, Costa Rica already has an established track record. This commitment to fiscal restraint has allowed for high primary fiscal surpluses and knock-on impact of higher FDI inflows and stronger economic growth. The challenge next year will be how to manage a strong foreign exchange rate with downside risks to tax collection and economic growth and a burden on the central bank to either cut rates or accumulate more foreign exchange reserves. It’s a balancing act on managing US dollar inflows and sustaining the favorable inflation and growth tradeoff. What’s next to push credit ratings higher? Are there other qualitative factors beyond the fiscal/debt targets? Interestingly, the Fitch sovereign rating model already assigns an investment grade rating to Costa Rica with qualitative deductions that adjusts the rating to ‘BB.’ One of the deductions is for restricted access to financing. The recent efforts for regulatory flexibility on external debt issuance could provide a surprise credit rating boost. Costa Rica remains our favorite credit in the region to express a core medium-term investment strategy on potential for higher credit ratings while also offering diversification and lower beta through the uncertainty of US financial contagion.

Siobhan Morden
siobhan.morden@santander.us
1 (212) 692-2539

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