Latam FX Outlook 2023: Too good to be true?

How fiscally aggressive can Lula be? A ‘resurrection’ is how President-elect Lula describes his return to office after narrowly beating the incumbent Bolsonaro in a second-round run-off. His pitch for a return to office was very much one based on welfare support and also a complete reversal of Bolsonaro’s free-market approach to the Amazon. Brazilian assets initially responded positively to Lula’s win in that he may be fiscally limited due to right-wing politicians having done well in congressional elections. Hence, Congress could prevent fears of unfunded social giveaways exacerbating what is likely to be an annual budget deficit of 7% of GDP and debt to GDP heading towards 90% next year.

Why we are more bearish on BRL: Consensus expects USD/BRL to head back down to the 5.15 area by the end of 2023. The view here is that inflation has topped and that Brazil’s central bank can embark on a 200bp easing cycle in the second half of 2023, which should be good for the local currency bond market. We are a little more concerned that the legacy of a near 14% policy rate will be much weaker growth in Brazil next year, which will bring fiscal pressure to the fore in what will still be a challenging year for bond markets. After all, Brazil’s five-year sovereign CDS trades near 280bp for a reason. Any changes in the fiscal rules would be negative.

Greater links with China?: The return of President Lula could also re-invigorate the BRICS geopolitical grouping. Where that goes in 2023 remains to be seen, although there was at some stage a suggestion of working towards some kind of BRICS currency arrangement. We doubt that Brazil would want to get entangled with such a venture, but any higher profile of the BRICS would serve as a reminder of Brazil’s heavy trade links with China – 31% of Brazil’s exports went to China in 2021. Sluggish Chinese growth could prove a headwind to Brazilian exports and push Brazil’s current account deficit towards 2% of GDP next year.

High yields, less volatility: In tracking Fed tightening this year, Banxico deserves a lot of credit for keeping USD/MXN stable. Here, three-month realised volatility is just 9.9% compared to 19.3% for USD/BRL. In response, expected volatility is substantially lower for USD/MXN as well. This has implications for the ‘carry-to-risk ratio’ – or risk-adjusted yield which is now 50% higher for the Mexican peso versus the Brazilian real. Barring Banxico ending its tightening cycle well ahead of the Fed, we expect USD/MXN to remain relatively well-contained near or under 20.00 over the next three-to-six months even as external market conditions deteriorate.

Mexico well-placed for nearshoring: Disruptions to global supply chains from the pandemic and this year’s Russian invasion of Ukraine have questioned globalisation and raised the prospects of ‘friendshoring’ or ‘nearshoring’ – i.e. moving supply chains closer to home. Mexico stands to benefit from US nearshoring, sharing as it does a land border with the US and now engaged in a new USMCA trade deal. Mexico features prominently in the White House’s supply chain resilience plan, focusing on semiconductors, batteries, critical minerals, and pharmaceuticals. At $3.50/hour, Mexico’s average manufacturing industry wage compares very favourably with the US ($30/hr), but also with Latin America, e.g. Brazil and Chile at $4.71 and $5.74/hr, respectively.  

Remittances still rising: Remittances back to Mexico from the US are still rising and are currently worth $5bn per month. Presumably these slow at some stage when US unemployment turns higher, but they have proved remarkably resilient so far. Mexico also has a relatively modest current account deficit of less than 1% of GDP – making remittances quite meaningful. In terms of politics, it is not clear how much President Andres Manuel Lopez Obrador can get done before elections in the summer of 2024, but his fiscal rectitude during the pandemic certainly provides insulation as global borrowing costs continue to rise. Investors continue to see Mexico as a good quality credit, trading its five-year sovereign CDS at around 140bp, compared to 280bp for Brazil. 

Controlling social tension in a recession: Left-wing President Gabriel Boric was voted into office in March 2022 on a ticket for social reform. This followed the widespread social uprising in 2019. President Boric has struggled to make progress here, with his constitutional reform package widely rejected in September – providing somewhat of a reprieve to the mining industry. 2023 stands to prove a difficult year for Chile. The IMF projects the economy will contract 1.3% next year and unemployment will rise. Balancing how to advance social reform, while keeping the mining industry onside – softening mining taxes being a recent example – will be a major challenge.  

Where’s copper heading? As the largest copper producer in the world, the Chilean peso is very much driven by these prices. USD/CLP hit 1050 in July and had to seek IMF support when copper fell 25%. Our commodities team believes copper will struggle over the next six months. Incidentally, participants at the recent London Metal Exchange (LME) gathering were quite split on copper’s path. Our house view is that the continued weakness in China’s construction sector amidst the over-supply in the residential sector will keep copper on the back foot for the next three-to-six months. Equally, widespread labour unrest in the industry is hitting Chile’s copper production, recently running at a 16-year low.

Limited scope for FX intervention: The exchange rate has proved a useful shock absorber for Chile’s economy. The macro imbalances created by strong consumption during the pandemic – leaving Chile with an 8% of GDP current account deficit – make the peso vulnerable to the international environment. Chile has lost 17% of its FX reserves in defence of the peso this year. And whilst it does have the precautionary support of an $18bn IMF Flexible Credit Line, it will not want to use it. A strong dollar environment into year-end and potentially through 1Q23 can see USD/CLP head back to 1000 and perhaps also drag the local central bank into some further tightening. Interestingly, the IMF has also said that Chile needs to rebuild FX reserves, suggesting USD/CLP struggles to trade under 900 on a sustained basis over the next couple of years.