In Eco-political analysis

In the age of political polling, never as today have leaders in major Latin American economies suffered such massive voter disdain. At 37% the divisive U.S. President Trump enjoys more support than the Presidents of Brazil (Temer – 3%), Mexico (Pena Nieto – 19%), Colombia (Santos – 23%), Chile (Bachelet – 32%), Peru (PPK – 27%) and Venezuela (Maduro – 22%). Each administration led by these six Latin American presidents has been accused of corruption—and sometimes worse deeds. A fiercely robust social media-channeled press unleashed a constant barrage of critical coverage over the last few years as commodity supported tax revenues plummeted, revealing mismanagement and fraud. Latin America’s political class, with few exceptions, is unprepared for this new era of 24/7 scrutiny. And yet, all this political noise has surprisingly little impact on Latin American economies.

2 Key Fundamentals Driving LatAm’s Future

The region’s prospects remain disproportionately driven by two external factors:

  1. The pricing of commodities that dominate exports
  2. The U.S. Federal Reserve interest rate

Latin America’s economic vulnerability stems from the fact that its citizens and companies opt to keep roughly half of their savings (approximately $4 trillion USD) outside of the region. That lack of faith in its own institutions leaves Latin America chronically short of capital and obliged to borrow in dollars to finance its government spending and corporate expansion. The cost of servicing dollarized debt is influenced by local country risk but also by the U.S. Fed rate. The ease or difficulty with which these economies service their debt and buoy their currency is largely shaped by commodity prices. The correlation between South American currencies and the top three commodity exports of each country ranges from 90-97%. As such, 2015-2016 were costly years for the region. Over a trillion dollars of GDP evaporated when oil and mineral prices collapsed, or roughly 20% of the region’s spending power.

net energy imports

However, the tide began to shift in a positive direction in late 2016 and the region’s currencies on average have appreciated more than 5% in 2017.


Encouraging Signs

2018 will continue the positive momentum begun in 2017, for reasons that have little to do with politics. During the difficult last few years, the Latin American corporate sector has done an admirable job at tightening its belt and paying down heavy debt levels. Regional bourses responded favorably, rising over 20% in 2017 through the first ten months. International portfolio monies returned to Mexico, Brazil, Colombia and Chile and boosted the very narrow Argentina equities market by more than 60%. National productive sectors, punished by strong currencies pre-2014, were relieved to see their national currencies weaken, effectively pushing out foreign competition and opening up domestic sales opportunities again. The strongest of these domestic producers are now rediscovering the thrill and challenge of exporting. Such swings in the economy are painful but have a positive impact on terms of trade and by extension the currency.

For some countries, rising mineral prices, combined with a more welcoming posture towards international mining has just recently reignited interest from mining investors. Peru alone anticipates nearly $50 billion in new mining project commitments over the next 10 years.

us growth will peak in 2018

The New Normal

But do not mistake a recovering Latin America with a return to the robust growth years of the commodity super-cycle (2003-2013). With few exceptions, the new normal for the region is 1.5-3% annual growth. Firstly, oil prices are not bouncing back anytime soon. American producers, small, nimble, well-financed and plentiful seem committed to filling any foreseeable supply gaps. American interest rates have already begun to rise and will continue to do so as the US finally begins to feel the inflationary effects of more than a decade of loose monetary policy. Nearing full employment with a shrinking labor pool and anti-immigrant policies means that US wages must rise.


3 Key Growth Factors

Despite these challenges, there are several trends that should help Latin America on the road to recovery:

#1 A Strong Dollar: The U.S. dollar should remain relatively strong, thanks to a rising Fed rate and cheap oil. A strong dollar is beneficial to Mexico, Central America and the Caribbean whose product and service exports (including tourism) thrive with a strong dollar. Less favored is South America. Their commodity export economies do better in a cheap dollar / high energy price world. Today’s global economic condition suppresses consumer spending in big energy exporters like Colombia, Ecuador, Venezuela, and Bolivia.

#2 Chinese Engagement: Today, China is the largest bi-lateral lender in the region, the 2nd largest trading partner and the 3rd largest source of new FDI. China’s thirst for commodities remains strong but lower prices compel the Chinese to sign long-term supply contracts versus purchasing assets. But the China-LatAm play has moved beyond commodities. China’s thriving private sector wants to market its hundreds of global-ready consumer brands in the auto, and consumer electronics sectors to middle income markets like Brazil, Mexico, Panama, and Peru. China is now a major player in global infrastructure as it winds down its overspending at home and shifts its focus off-shore, to its near and far east neighbors but also to Latin America. Last but not least, Chinese tourists are gradually discovering the Caribbean. Chinese hoteliers and other tourism operators are keen to buy or build tourism infrastructure across the Caribbean.

#3 Demographics: Latin America is the world’s fastest-aging region as households have shifted in record speed (30 years versus 60 years in the US) from four kids – one income to two kids – two incomes per household. The demographic dividend helped supercharge consumption in Latin America starting in 2000. Optimal demographics (shrinking number of kids and elderly) will last another 10-20 years in Latin America (less time in relatively old Argentina, Uruguay and Cuba, but longer in the youthful Central America), helping sustain decent GDP growth.

A Crucial Catch-Up That Needs to Happen

However, LatAm growth cannot catch up with middle income countries in Asia unless the region improves its ability to innovate and/or assimilate new productivity-boosting technologies. When it comes to productivity gains, Latin America has lagged the rest of the world over the last fifteen-plus years.

Books have been written on the subject of Latin American competitiveness but in the end, they boil down to one factor, a lack of confidence in the legal system. Without it, risk capital will not bet on new innovations and instead, Latin America’s inventors take their ideas to California. Without the ability to defend intellectual property, many of the world’s patent holders have been loath to license their technologies to Latin American customers for fear of piracy. Unable to invent or even buy technology at the pace of competitors in Eastern Europe and Asia, Latin America’s productive sectors have fallen behind. Only those Latin American sectors capable of attracting foreign investors, who have the means to protect their technology, have kept up with the global pace of change.

Thanks to cloud computing, there is now some hope that Latin America will finally convert its own creative inventiveness into productivity gains. Storing intellectual property in the cloud enables technology to be shared without risking the theft of its IP core. Cloud based technology diffusion has proven particularly successful in Latin America. Uber includes two Latin American cities in its global top ten markets. Netflix downloads have overwhelmed 3G networks across the region. Latin America is Airbnb’s fastest growing region with 250,000 listed homes and bookings growing at c. 150% per year. Latin America’s installed base of more than 266 million smartphones ensures rapid and deep penetration of new apps. Venture capitalists have taken note and now have the confidence to invest in home grown Latin American innovation. VC capital deployment in LatAm is now doubling every three years, albeit from a modest base. Much of that capital is pouring into disruptive technologies that will challenge many of Latin America’s labor intensive inefficient service sectors such as transportation, education, retail, banking and healthcare.

The First Full Growth in 5 Years

2018 will mark the first year of across-the-board positive growth for Latin America since 2013 (Venezuela is a likely exception). Investor confidence began rising in 2016, temporarily hiccuped when Trump began campaigning but continued upward by the end of Q1 2017.

LatAm corporates again have clean balance sheets that enable them to borrow, invest and expand. The same goes for global mining companies eyeing LatAm’s plentiful assets. US multinationals are ready and willing to deploy their hoarded cash in emerging markets. Though they prioritize Asia, experienced direct investors recognize the undervalued profile of LatAm assets today. In a recent LAVCA survey, LPs expanding their VC investments in LatAm next year (2018) outpaces those reducing their positions by a ratio of 8:1. Money began to return to LatAm equity markets in 2017. Appreciation of those assets will continue in 2018. Taken together, if all goes well, LatAm growth could surprise on the upside.

So What Could Go Wrong?

What are the black swans looming over this rosy projection? There are a few.

#1 NAFTA Negotiations: These may still go off the rails. The Americans want to re-write local and regional content laws in the automotive sector, whose supply chain linkages cross NAFTA borders like migrating birds. Both Mexico and Canada’s ability to attract investment would be jeopardized by a suspended NAFTA. Both countries’ currencies have been hit by the divisive 4th round of NAFTA talks that began in early October, 2017. But the US is also vulnerable and the Mexican delegation knows it. Should NAFTA be suspended, then the trilateral agreement devolves back to three separate bi-lateral relations under WTO rules. In such a scenario, Mexico retains MFN (most favored nation) access to the US market, limiting any U.S. tariffs to 3.5%. But as an emerging market, the less competitive Mexico can apply significantly higher tariffs to U.S. goods exported there. Overall, the average WTO tariff on U.S. goods imported into Mexico would be 7.1%, but certain product categories would face much higher rates, such as 15% on wheat, 25% on beef, 75% on chicken and potatoes, as well as a range of 15-20% on clothing, soap, handbags and fireworks.

That is the “nuclear” option being used by Mexican negotiators to galvanize bi-partisan US Senatorial and corporate opposition to changing controversial NAFTA rules. On November 16th, 70 Republican congressional representatives declared their opposition to the US NAFTA delegation’s pursuit of higher regional and U.S. minimum content laws in the auto sector. Further complicating negotiations is the likelihood that both the Trump administration and congressional leaders will try to package negotiating positions on NAFTA with that of the other great Washington debate under way – the reform of the US tax code.

#2 2018 elections in Colombia, Mexico and Brazil: Some fears still linger that a populist candidate will unhinge investor confidence (AMLO in Mexico, Jair Messias Bolsonaro in Brazil, Petro in Colombia). Their campaigns began with some controversial statements designed to garner attention in a crowded race but none of these candidates with govern with a majority in the Senate or Congress. None of them wants to fundamentally change the path of the private sector led economies (versus a Chavez in Venezuela). The risk lies more in 4-6 years of non-action on much needed reforms and institutional strengthening more than any ideologically led policy leap. Latin America cannot afford to muddle along and keep losing ground to Asia. Latin American constitutional government structures and robust press helps prevent a return to dangerous populism of the past (Venezuela and Cuba exempted). For most of the region, the risk posed by populist governments is the specter of even greater levels of corruption, nepotism and ineptitude.


Longer-Term Limitations

In short, the risks facing Latin America are of a medium-long term, not short term, nature. Investors can expect adequate growth (2.5% average) for the next five years. The problem lies in making a longer term bet on Latin America. Until legal accountability becomes a reality for the powerful in government and business, Latin America’s wealth creation potential will never be realized.

Recommended Posts