Fixed Income Boutique
Citizens’ dissatisfaction with the ruling class amid slow growth in the years preceding the pandemic has led to a strong anti-establishment and anti-incumbent sentiment in Latin America. This has led to the election of populist candidates like Lopez Obrador in Mexico (2018), Bolsonaro in Brazil (2019), Bukele in El Salvador (2019), and the return of Kirchnerismo in Argentina (2019). This has also resulted in violent protests in the Andean region since late 2019.
The pandemic brought a pause to these protests in 2020 as confinement measures and fear of contagion kept people at home. But violent protests are back now in Colombia and while Ecuador has shown us that populists don’t always win in this context, yet another radical left-wing candidate is threatening to destabilize the region, this time in Peru. This sociopolitical context may not sound very investor-friendly, but volatility provides plenty of opportunities for active investors.
The June 6 runoff presidential election is becoming more competitive as the date approaches. Left-wing schoolteacher, Pedro Castillo has been losing his advantage over right wing Keiko Fujimori. Castillo was some 15 percentage points ahead immediately after the first round election in April, but his lead has narrowed to 2 to 6 ppts above Fujimori according to the latest polls. None of them seems like a great choice. Fujimori has extremely high rejection rates as she was imprisoned for corruption and money laundering. Yet, for investors, Fujimori represents continuity of an economic model that has provided remarkable macroeconomic stability and relatively high growth despite the political instability of the last few years. Castillo was on no one’s radar until recently, he is described by many as a Marxist-Leninist, and although he has recently moderated to court centrist voters, he advocates for a much larger role of the state in the economy. Castillo’s party proposes nationalizations, exorbitant taxes of 75% on the all-important mining sector, and even a constituent assembly – yes, this classic soviet idea keeps coming back. However, all of these populist proposals would require a two-third approval of Congress, which Castillo would not enjoy if he wins. In fact, right-wing parties will dominate the new Congress. This is relevant considering that an opposition-led Congress managed to force the resignation of ex-president Pedro Pablo Kuczynski and successfully impeached his successor, Martín Vizcarra. Therefore, the risk of a rapid deterioration in Peru’s solid macro fundamentals and institutions seems relatively low for now.
Peruvian sovereign bonds are now less expensive than usual, but they’re not particularly cheap (neither in USD or local currency), which suggests we’re not the only ones taking a sanguine view of the political risk. The Peruvian sol does appear significantly undervalued on the face of copper prices near historical highs and elevated gold prices (two of the country’s largest exports). We find much better value in Peruvian corporates including Peru LNG, Petroleos del Peru and Hunt Oil Co of Peru.
Colombia’s protests forced the government to rethink its fiscal reform and herald an interesting 2022 presidential election. Several Colombian cities have seen violent protests since late April. There protests originated in late 2019 soon after those seen in Chile, Ecuador and Bolivia. Colombian protests have been mainly against a series of government reforms (tax, labor, and pension) proposed by President Duque’s unpopular right-wing government, and are also related to the unsatisfactory implementation of the peace agreement signed with the FARC in 2016.
President Duque had to withdraw his proposed tax reform, which aimed to preserve Colombia’s investment-grade rating (BBB- with a negative outlook) by raising 2.2% of GDP in additional fiscal revenues. Following the replacement of the finance minister last week, the government is seeking to approve a smaller (1.3% of GDP) and more progressive tax reform in order to reduce the fiscal deficit. We think Colombia will most likely preserve its credit rating this year, but what happens beyond 2021 is less clear. Radical left-wing candidate Gustavo Petro is leading the polls ahead of the May 2022 presidential elections and appears highly likely to make it to the runoff again – he came second in 2018. Meanwhile, the governing right-wing party, Centro Democrático, appears weakened due to Duque’s unpopularity, but centrist Sergio Fajardo may have a better chance at getting the presidency than in 2018, when he came third. Petro may not be as radical as Castillo but insufficient fiscal discipline may prove more damaging in Colombia where macro fundamentals are not as solid as in Peru.
Colombian USD sovereign bonds have partially priced in a downgrade, yet local currency (Coltes) bonds offer higher yields even after fully hedging the currency. Colombia’s external debt bonds have underperformed year-to-date amid rating downgrade risks but do not yet appear cheap on the face of the sovereign’s fundamentals and political uncertainty. Local-currency sovereign bonds have reacted more strongly to the wave of protests, and offer higher yields even after fully hedging the currency risk. We also like Colombian corporates like Credivalores, Avianca, and Pacífico Tres.
Ecuador’s sovereign bonds have returned a mind-boggling 41% total return since the surprising victory of center-right Guillermo Lasso in the runoff presidential election in April. This is not a typo. Yes, you can still get equity-like return in some special situations in EM fixed-income. We came into the election with an overweight position confident that the risk-rewards were highly asymmetric given that a victory of left wing Andrés Arauz was mostly priced in even though the race was becoming tighter through March. Moreover, we held a couple of conversations with Arauz ahead of the election and felt confident that he would not have been as bad as feared. We have gradually taken profit on our position as we acknowledge that further gains will be much more limited, but remain constructive on the sovereign.
Governability will be challenging for Lasso. The general elections resulted in a National Assembly divided in three minority blocks: ex-president Correa’s left-wing party (UNES) on the potentially obstructionist opposition side, Izquierda Democratica (center-left) and Pachakutik (indigenous/conservationist left) forming a center-left coalition, and Lasso’s CREO together with the Social Christian party allied on the right of the political spectrum. Lasso will face similar challenges to Colombia’s Duque on the fiscal front, i.e. he will have to rein in the fiscal deficit in the after-math of the pandemic, following years of low growth after the end of the commodities super-cycle in 2014-15. To succeed, Lasso will have to renegotiate the current IMF program, but that’s probably the easy part once politics are sorted out. Ecuador is supposed to approve tax reform this year to increase revenues by 2.5% of GDP and turn its fiscal deficit into a surplus by 2022, according to the IMF program. But Lasso has promised not to raise taxes. The IMF has shown flexibility during the pandemic and the ongoing protests against tax hikes in neighboring Colombia will surely serve to convince the Fund that a more gradual approach is necessary during the pandemic.
The good news is that Lasso will inherit a much more sustainable debt burden than his predecessor. President Moreno saw his initially high popularity collapse because he was forced to undertake austerity measures to steer the sinking ship he had taken over from ex-president Correa, and ultimately, he could not avoid a debt restructuring when the pandemic (and ultra-low oil prices) hit in 2020. Lasso will face no significant debt maturities during his mandate thanks to that restructuring. The fiscal adjustment is about two-thirds done on the back of Moreno’s fuel subsidy reduction and other expenditure cuts. And the current account may remain in surplus thanks to moderately high oil prices, and booming non-oil export – the latter is courtesy of Moreno’s free trade deals and China’s insatiable demand for Ecuadorian seafood.
El Salvador’s Bukele may be an anti-establishment populist, but he’s neither far left nor far right. If you like stories of dollarized countries paying high-single-digit yields for their external debt, here is another one, and this time it’s not a serial-defaulter like Ecuador. Like AMLO and Bolsonaro, president Bukele was elected president on an anti-establishment platform, but unlike his counterparts, the millennial president is difficult to locate in the ideological spectrum. Authoritarianism is strong with this one, we give you that, but he’s rather orthodox on economic policies. Bukele is also the most popular politician in the Western Hemisphere with approval ratings north of 80%. No more governability issues here. After almost two year’s fighting with the opposition-led Legislative Assembly. Bukele obtained a qualified majority in the legislative elections in February. This is important for investors because the previous legislature had limited the government’s ability to borrow externally in 2020, and as a dollarized economy, the country could not monetize its deficit like Argentina. Investors were thus, looking forward to Bukele’s legislative majority, as this would open the door to an IMF program that had been under quiet negotiations for months.
Assault on the judiciary is unlikely to impede an IMF program agreement. Instead of prioritizing the economy, Bukele used the first day of his new legislature to consolidate political power by replacing the magistrates of the Supreme Court of Justice and the Attorney General. Apparently, the move was legal, but the optics are terrible. This is certainly a faster institutional deterioration than we had been expecting, but we don’t think this should prevent El Salvador from obtaining an IMF program and additional multilateral loans. The Biden administration may not like Bukele, but it would be politically costly to take a hardline on El Salvador because additional economic hardship in Central America could intensify migration to the US. Moreover, we don’t think that Bukele has had a sudden change of heart regarding his intention to pursue an IMF sponsored fiscal adjustment. In fact, the finance minister spoke to investors a couple of days later to clarify that nothing has changed regarding their IMF plans. We think the government simply underestimated the international political backlash that the move would cause. We’re thus cautiously optimistic on El Salvador in the short-term as the IMF program appears highly likely to materialize. But we do acknowledge that the drift towards authoritarianism significantly reduces El Salvador’s investment appeal in the medium-term.