Latin America – understanding political risk

Understanding political developments is key to successful investing in Latin America. With major elections next year in Brazil and Colombia, investors are analysing the governance situation for signs of who might triumph in the polls. But a rejection of establishment politicians for political outsiders has made the results very hard to predict.

The long-term political challenge in Latin America is fragmentation, highlights Dr. Monica de Bolle, Senior Fellow, Peterson Institute for International Economics. For decades, power has been split across multiple institutions, which is not conducive to strong leadership. This in turn leads the region to disappoint when it comes to economic growth.

Add to that the more recent phenomenon of polarization. Voters across the continent are dissatisfied with how their countries have been run and have left the middle ground to vote for candidates at different ends of the political spectrum. The severe impact of COVID-19 in Latin America has only made electorates more disgruntled.

“We are looking at a region that is facing a lot of challenges when it comes to removing the structural obstacles that have always been part and parcel of its history,” she said.

Investors might see a decrease in the wave of public disaffection that brought populist governments to power in Argentina and Brazil, said Kevin Ivers, Vice President of DCI Group. A few years ago there was a real desire for change, due to a lack of economic opportunities, disgust with corruption, and the failings of the established parties.

But the traumatic experience of the pandemic has changed public opinion: “We are seeing a lot of exhaustion with choices that were made before the pandemic. I think that people want to go back to a sense of comfort and familiarity,” he said.

The economic background to the political environment is a region hit hard by COVID-19, which resulted in a 7% contraction in the Latin American and Caribbean economy in 2020. Although the International Monetary Fund forecasts a 5.8% rebound this year¹.

“In the case of Latin America, we are seeing a widespread recovery, with significant rates of economic growth all over the region,” said Javier Guzman Calafell, Former Deputy Governor, Central Bank of Mexico.

“But there is also the expectation that next year, there is going to be a return to the relatively low rates of growth that many Latin American countries have seen over the years.”

There are also fears that rising prices could dampen the recovery, and there are even concerns that inflation could turn into stagflation.

Long-term inflation and stagflation are not base case scenarios, said Mr. Guzman, but the uncertain outlook means it is important to consider how the situation could change. He highlighted how supply-chain shocks have lasted longer than many expected, that there are labour shortages in a number of countries, as well as narrowing fiscal positions across Latin America.

From a valuation perspective, Latin America is not attractive considering the levels of political and economic risk present in the region, said Alberto J Boquin, Senior Research Analyst, Brandywine Global.

“The leaders coming into power in Latin America are inheriting much shakier balance sheets, and the urgency to implement institutional reform is even greater than it was when their predecessors were coming in,” he said.

Furthermore, he highlighted how the region’s voters and institutional investors are looking for different things from politicians. Their expectations used to be broadly aligned, with both looking for low inflation, job creation and bank stability. Nowadays, local populations want more spending, pension reform, and higher taxes on corporations.

Assessing the impact of political risk on sovereign debt is a process that requires qualitative judgements, said Shelly Shetty, Managing Director, Head of Latin American Sovereigns, Fitch Ratings. This includes factors such as whether a government has the will and the capacity to address the economic and fiscal challenges that it faces.

These governance indicators in Latin America are weaker than in other parts of the world, she said, and continuing to deteriorate – due to factors like poor growth prospects and distrust of institutions.

Latin America’s main political event over the next year will likely be the presidential election in Brazil, the region’s largest economy. Although there are still 12 months until the polls, it is likely to be a two-ticket race, said Dr. de Bolle, between incumbent President Jair Bolsonaro and Luiz Inácio Lula da Silva (commonly known as “Lula”). One positive surprise could be the emergence of a single candidate representing the center-right parties, but this may not happen until closer to the election.

Regardless who is elected in Brazil, they will need to satisfy a population that wants a reduction in poverty, more social programmes, and better social mobility, she said.

“They want to see the things that they haven’t seen for a long time, and that will require an expansive fiscal policy, and not the reforms that market participants have been talking about for a long time,” she said.

Going into 2022, investors will be carefully looking for news that could influence Latin America’s upcoming elections, and developments that could affect the ability of existing governments to deliver economic growth and institutional reform. The challenge, as always, will be to separate the noise from the events that have genuine political significance. It is the investors that can do this who will stand out from their peers in Latin America.