Latin American markets provide no sanctuary to global market maelstrom
March 17, 2020 |
Are capital controls far behind?
The risk-off trade continues to hit emerging markets hard, with selling accelerating on Monday after a second emergency interest rate cut by the US Federal Reserve in as many weeks in an attempt to hold economies together as the coronavirus pulls people apart.
As the novel coronavirus, COVID-19 continues to spread, with rates of infection increasing rapidly outside of China, where it originated, Latin America is bracing for its turn as governments come to grips with the massive disruption to society, including social distancing, and health care systems are recognized as ill-prepared to cope.
Capital flight from Latin America has quickened, marking a sharp reversal from the later half of 2019 and early 2020 as record low interest rates in advanced economies sent capital looking for a home in the region. Indeed, January saw a record haul of bond issuance, only to see those markets nearly completely shut since mid-February as deal volumes dried up.
“This market reaction to the Fed’s decision is because of instead of providing a light to the end of the tunnel, the market has taken this as a signal that we are entering the tunnel,” said Francisco Campos-Ortiz, Latin America economist at PGIM Fixed Income in Newark, New Jersey.
“The Fed is making it official that yes, we are expecting this big impact on economic activity, so it has failed to arrest all the market jitters about the economic and financial outlook,” he said.
On Sunday the Fed cut benchmark US interest rates to near zero and promised to buy $700 billion in Treasury and mortgage backed securities in order to keep the credit markets from seizing up as demand for safe haven US government credit surged.
“It didn’t have any impact at all. The market dropped. Latin America is still trading on contagion from US equities,” said Siobhan Morden, head of Latin America fixed income strategy at Amherst Pierpont Securities in New York.
While the record low interest rates in the US pushed investors to look for higher yielding assets in Latin American markets, the panic selling as the virus spread has undone that move. Chile also committed to cutting interest rates, stating it would lower them to 1% from 1.75%, bringing it to levels not seen since mid-2010.
Barring the market holiday in Mexico on Monday, which spared the benchmark IPC index from the rout for at least a day, stocks in Latin America have cratered.
The benchmark MSCI Latin America stock index fell 13.71% on Monday, down 44.20% year-to-date. Brazil’s Bovespa index dropped nearly 14% on Monday, off 38.46% in 2020. Since the start of the year benchmark indexes in Colombia, Argentina and Chile are down 40%, 38.3%, and 30.8%, respectively.
Latin American stock market performance - Y-T-D. Source: Refinitiv
Analysts say the push to increase liquidity is going to provide little immediate benefit on reviving the global economy, for the time being.
That is because the crisis is being driven by “a sanitary phenomenon that is complicating the real economy,” said Esteban Domecq, a director at Invecq Consulting, an economic consulting firm in Buenos Aires.
“We are still in the eye of the hurricane with investors continuing to pull out of the region,” Domecq said, adding: “Until the sanitary problem is resolved, it is going to be very hard to contain this capital flight.”
The loss of risk appetite is pushing investors to seek refuge in the safe haven hard currencies like euros, Swiss francs, and yen as well as low-yielding government bonds in Europe, Japan and the US.
In the risk-off environment created by the coronavirus, the region is receiving a mix of shocks: the deceleration of the global economy, the trade impact of declining commodity prices on the back of sliding demand from China and the associated weakness in the global economy and tightening financial conditions in emerging markets in general.
Since the start of the year the greenback has surged in value against the Brazilian real by nearly 25%, knocking it above 5 reais, a record. The real lost 3.7% against the dollar on Monday while the Mexican peso dropped nearly 4%. The dollar has appreciated by nearly 20% against its major trading partner.
“Capital flight in Mexico comes from lower oil prices, and flight to quality. There’s no way to avoid this, and not only in Mexico,” said Miguel Ángel Santos, director of applied research at Harvard University’s Growth Lab in Cambridge, Massachusetts.
“I am anticipating that capital controls will be imposed soon across many emerging markert countries,” Santos said.
The two major economies in the region, Brazil and Mexico, represent 60% of the region’s gross domestic product. They were struggling even before COVID-19. Mexico’s economy contracted 0.1% in 2019 from 2.1% in 2018. Many thought that Brazil’s economy was going to start turning a corner with major pension reforms in place after a 1.1% growth rate last year.
“The underlying dynamics of these economies before the shock were already weak. That’s why they were engaging in this monetary loosening. And now they get this shock,” said PGIM’s Campos-Ortiz.
Brazil’s central bank is due to meet on Wednesday while Mexico’s is scheduled for next week, with analysts predicting they will likely engage in looser policy but that comes at a time when their currencies have suffered severe depreciation. Cutting rates could just exacerbate the capital flight from the region.
USD v. Latin American currencies Y-T-D. Source: Refinitiv
One analyst said the while the US rate cuts contributed to the devaluations there are local factors at play as well.
“In Chile for example, the country has been experiencing an endless social unrest since October that has contributed to the devaluation of the peso,” said Leandro Lima, Brazil and Southern Cone analyst at Control Risks consultancy in São Paulo.
Unrest in Chile, one of Latin America’s most stable countries, started in October over income inequality and the economic downturn in China which is the main buyer of its chief export, copper, has slowed the economy. The government committed to a two-year process for drafting a new constitution and will have elections in November 2021. Fitch Ratings put a negative outlook on Chile earlier this month.
Lima said that Brazil’s approach to COVID-19 is making investors nervous because of the differences in how the government of Jair Bolsonaro has approached the problem versus the state authorities. Federal authorities have minimized the impact while states have been more engaged in tackling the outbreak, he said.
“In Brazil, the conflict between President Jair Bolsonaro and the Congress has made investors afraid regarding the political stability risks,” he said, adding: “While Congress is pressuring the government to put forward stricter rules to contain the outbreak, the president is denying the potential impact,” he said.
“Overall, we can say that political risks in the Southern Cone are heightened compared to last year,”
Still, investors are taking the ructions in stride.
FAMA Investimentos, the Brazilian equity fund manager, tried to soothe clients on Monday with a note reflecting on past crises and how to see through the panic.
“We should always question ourselves if “this time is different”, in fact that is the phrase we most heard during past crises. Even though we have never dealt with a pandemic before, we do not expect this to unfold in a manner much different than in previous moments of history,” the note said.
“In the coming weeks we will do our best to take advantage of the distortions the market might create and at the end we do not expect results to be different than those we delivered in the aftermath of previous crises.”