Heightened risk aversion and the stronger USD resulted in a persistent weakening bias to LATAM FX in recent weeks. An eventual resolution of the US-China trade-war impasse could add material upside to local currencies, particularly the COP, which touched multi-year lows recently despite the supportive oil price environment
But other risks may lurk for EM assets. Apart from a more persistent-than-expected USD strength, a spike in political risk in Argentina, should Cristina Kirchner announce her presidential candidacy in the coming weeks and consolidates a solid lead over President Macri in opinion polls, or in Turkey, with the repeat of the Istanbul election, could affect investor sentiment towards EM assets in general.
In the case of Brazil, domestic drivers should continue to dominate, and the BRL could experience the largest appreciation in the region over the next 3-6 months. Investors will continue to focus on the fate of the social security reform. The reform is now in its second-stage Lower House approval process, at the Special Committee. Approval in this committee is expected for next month, but investors will be watching for the amount of changes lawmakers will make to the government’s proposal, which could reduce materially the proposed savings from the reform.
Given the government’s tentative command of a Congressional majority, the reform’s approval process is unlikely to be smooth, with uncertainty about reform passage exacerbating local asset volatility and creating a weakening bias in the nearer term. The BRL may continue to trend closer to 4.0, before the proposal is finally approved by the Lower House. Our base-case scenario is that the reform will be approved around August, when the currency could experience a considerable, but temporary rally towards 3.4.
Apart from the COP and the CLP, which, as commodity currencies could benefit the most from a resolution of the US-China trade-war, the Mexican peso also stands to gain from a reduction in risk aversion. The return of a more favourable environment towards EM assets could push the USDMXN below 19 once again, supported in large part by the highly attractive carry.