LatAm’s populist shake-up

Brazil, Mexico and Colombia all go to the ballot box this year amid the risk that recent efforts to improve the macro environment in those countries through a combination of economic reforms and a more steadfast commitment to fiscal responsibility may come unstuck if, as some polls suggest, more populist candidates are elected.

So far, investors seem unfazed about that potential outcome. Latin American sovereigns issued a record US$22.4bn of hard currency bonds in the opening two and a half months of the year, according to Thomson Reuters data, including a euro and US dollar deal from Mexico that raised an equivalent of US$3.2bn and a US$1.5bn deal from Brazil.

Bond prices in the secondary market have barely budged either. Average hard currency yields in Latin America have risen just under half a percentage point to 7.10% since the start of the year, according to JP Morgan’s emerging market bond index, roughly in line with movements in the 10-year US Treasury. Mexico’s hard currency yields were 44bp wider through March 19 than at the start of the year, a couple of basis points inside the widening seen in Brazil and Colombia.

Local currency markets, meanwhile, have actually tightened, with average Latin American yields falling almost 20bp since the start of the year to 7.40%, the index data show.

“The market is not assigning much risk to elections,” said Baruc Saez, managing director of Latin American debt capital markets at Itau BBA in New York. “When we talk to investors, we don’t see political uncertainty as one of those top-of-mind issues. Top of minds is interest rate volatility in the US and how the Fed reacts to any pick-up in inflation – those are the variables people are most interested in, and that determines how open or closed the market is in terms of demand for Latin America.”

The head of Latin America DCM at a New York-based bank reckons that money managers, buoyed by continued flows into the asset class, are more focused on the improving economic backdrop in the region than any political distractions.

“Everybody is looking at the glass being half full,” he said. “There are definitely risks, but the market doesn’t seem too concerned about them. It does feel like people are being complacent.”

Bankers say the relative calm in the region is a departure from election cycles in the past when markets were typically far more erratic.

Defying history

“Historically, elections in Latin America create more noise for the region’s financial markets than those in the US or Europe,” said Robert Carlson, director of Latin America DCM at MUFG Securities in New York. “However, regional market volatility has subsided as LatAm governments have gradually improved their systems of checks and balances, making it more difficult for a president to implement unexpected changes.”

For some investors, that means worrying less about the political leanings of a candidate and focusing more on the havoc they could cause once they assume office by attempting to dismantle those checks and balances.

“It doesn’t matter if it’s the ultra-left or the ultra-right or even a centrist candidate that wins, it’s more about what it means in terms of confrontations with institutions and establishments,” said Andrew Stanners, an emerging markets fund manager at Aberdeen Standard Investments.

“An important part of assessing emerging markets is the fragility of those institutions and the ability of a president to overrule them. Can the legislature stand up, can the opposition withhold the power of presidency in these places, and if they can, then we don’t need to be as worried about who comes next and whether they are populist or not.”

That is part of the reason Mexico’s bonds are not suffering, even though leftist candidate Andres Manuel Lopez Obrador, more commonly referred to as AMLO, is looking like the probable victor in July’s election.

Mexico’s institutions have improved dramatically over the past 20 years, said Stanners, and that is helping temper concerns of an AMLO win despite, for instance, his promise to cancel the construction of the capital’s new airport (which international bond investors have already chipped in for). And while his advisers have publicly stated that AMLO intends to honour oil contracts awarded as part of the country’s reform efforts, it is still unclear how his economic policies will shape up if elected.

Bankers and investors say his commitment to weeding out corruption, coupled with his relatively successful stint as Mexico City’s mayor, means many are giving him the benefit of the doubt. Others point to former left-wing Brazilian president Luiz Inacio Lula da Silva, whose more extreme campaign policies were quietly shelved during his first term in office

“Nobody in the market knows what Lopez Obrador will do, but there is a possibility that he becomes like Lula during his first mandate, not doing anything that will upset the market and naming someone orthodox to be his finance minister,” said Henry Stipp, head of emerging markets fixed income at Columbia Threadneedle Asset Management.

Uncertainty about Nafta negotiations with the US and Donald Trump is another reason to be cautious – particularly if AMLO wins and seeks to start talks afresh, Stipp says.

Yet even that potential outcome has not weighed heavily on Mexico’s domestic bond market, which remains roughly flat on the year, according to JP Morgan’s index data. Foreign investors still hold around 60% of Mexico’s local currency bonds, and while that positioning has softened slightly in recent months, Stipp says many investors are clinging on to their Mbonos and hedging out the risk in the swap market instead.

Fears resurrected

There are concerns in Colombia, too, where the hard-leftist candidate Gustavo Petro has been riding high in the polls. While few people expect Petro to win a majority in May’s election, he could make it through to the second-round run-off in June, and that is enough for some investors to take his chances seriously.

“Colombia is going through the same type of anti-establishment process we are seeing elsewhere,” said Tim Alt, a fund manager at Aviva Investors. “The focus has turned more towards economics and away from the peace agreement or concerns over things like war. This has been a significant shift in Colombian politics that broadly speaking investors haven’t had to worry about for the past 20-odd years.”

The fear with Petro is mostly fiscal related. Given the country’s budgetary dependence on oil and the need for higher prices than a barrel will currently fetch, any increase in public spending could put its prized investment-grade credit rating under threat. Alt says Petro also favours a weaker currency, which could trigger inflationary pressures that would slow the economy.

“Colombia has a tough time getting the exact fiscal and monetary policy mix correct and it’s going to be difficult to achieve all their goals,” said Alt. “They can under the right leadership and guidance, but the concern is that somebody like Petro would come in and steer them off the track they are on, and end up with a negative outcome.”

Brazil, too, has potential issues, where foreign investors have a relatively heavy overweight in local debt, according to Alt. While the election is not until October – and even though former president Lula looks likely to be out of the running following the recently upheld corruption charges against him – investors are still uneasy given the economy’s recovery in the wake of Dilma Rousseff’s ill-fated tenure remains fragile and largely hinges on reforms such as an overhaul of the pension system. If a new government were to abandon that reform agenda, Brazil could be plunged back into crisis.

“Most of the candidates in the field, maybe with the exception of [Ciro] Gomes, do support the pension reform, which is the biggest risk from a fiscal standpoint, so as long as that risk is somewhat muted, it matters less who the winner is,” said Alt. “The thing to watch there is if Lula can push someone like Gomes up in the polls, similar to the way he generated support for Dilma – that’s maybe an under-appreciated risk to watch.”

Bond markets might start pricing in more risk as the elections edge nearer, but funding concerns are contained by the fact Latin American countries in the most part have improved their debt management profiles, reducing their dependence on dollar financing and issuing more local currency bonds.

“All of these countries have very low funding needs in the external markets – they have access to their own domestic markets or they’ve already issued at the beginning of the year,” said Saez. “If there is political noise, say, if a candidate makes a comment out of place that rattles the market, then they can wait for the right window.”

And while any market-unfriendly outcomes might prompt a sell-off in that particular country, any contagion is likely to be limited; the mess in Venezuela, for example, has caused little volatility elsewhere in the region.

But the broader threat from a return to populism could be unsettling for a region that has a long and turbulent history with such policies.

“It’s interesting to see how quickly populism has become a political option again,” said the head of Latin America DCM at a New York-based bank.

“We went through that in Argentina and Brazil with very bad results in the last 10 to 15 years, so that’s going to be a geopolitical concern, in the sense that if some of these countries go back to populism, to what extent the rest of Latin America will be tempted by populism again.”