Brazil- São Paulo- Latin American economies enjoyed a favorable external environment for most of 2016. Monetary policy in the core economies was supportive, uncertainty over the Chinese economy was diminishing and commodity prices were recovering. Now, the risks are increasing again. Global interest rates remain low, but are already rising, led by the U.S. As the U.S. economy is close to full employment, an expansionary fiscal policy next year (as advocated by Donald Trump) may lead to a more rapid normalization of monetary policy, jeopardizing capital flows to emerging economies. Another risk is the possibility of a more protectionist trade policy from the U.S., which could trigger a trade war that almost every country would lose.
Within Latin America, countries have differing degrees of exposure to these risks. Given its extensive commercial ties with its northern neighbor, Mexico is clearly more vulnerable to U.S. protectionism. Largely for that reason, the Mexican peso has been one of the worst performing currencies in 2016. Countries with external account imbalances (such as Argentina, which has low international reserves, and Colombia, with its high current account deficit) and/or domestic imbalances (like Brazil, with its concerning public debt dynamics) are also exposed. On the other hand, Chile and Peru are less vulnerable, given the importance of copper in their export basket – copper prices are already rising on the expectation of a fiscal stimulus in the U.S. – and their solid macro fundamentals (low public debt and sizable public-sector external assets).
Although Latin America is facing greater uncertainties, the baseline scenario for the region in 2017 is still benign. An economic recovery is likely, led by Brazil and Argentina, which are both currently in recession.
In Argentina, the fading of the impact of the 2016 relative-price adjustment (utility prices and exchange rate) and a supportive fiscal policy will help. In Brazil, the approval of fiscal reforms is allowing for lower interest rates at a time when companies are already deleveraging and an inventory-shedding cycle is coming to an end. Modest recoveries next year are also probable in Chile, Colombia and Peru. On the other hand, the Mexican economy will likely slow down in 2017 due to the negative impact of the uncertainty over protectionism on investment (especially in the manufacturing sector).
The outlook for inflation is also improving. After the sizable currency depreciations in the region over the past couple of years, the evolution of exchange rates in 2017 will likely remain consistent with further declines in inflation in almost every country, even considering that some further strengthening of the U.S. dollar is likely. Spare capacity, too, will likely contribute to curbing the pace of consumer price increases.
In this context, monetary policy stances are becoming looser in South America, and thereby decoupling from the Fed’s stance. In Brazil the central bank will likely quicken the pace of rate cuts. In Chile, the central bank is signaling an easing cycle in 2017, while in Colombia rate cuts have already started. In Argentina, additional easing is likely, but at a more moderate pace than in 2016 as further disinflation will become more challenging to achieve. On the other hand, the central bank of Mexico will probably continue to raise interest rates to counter the inflationary impact of a weaker currency.
Finally, politics in Latin America will require a lot of attention next year. In Argentina, the October mid-term elections will be monitored closely as a sign of President Macri’s strength after the harsh (but necessary) adjustments implemented since his election. The social security reform in Brazil will be a key driver for local assets – but ongoing corruption investigations add a layer of uncertainty to the political scenario. Finally, we will have presidential elections in Chile in November, which have the potential to improve confidence and lift investment in the country.