➤ Latin American emerging market assets are expected to outperform some of their Asian counterparts' in coming quarters, as portfolios adjust for a broader rally in 2021.
➤ A weaker dollar should be supportive of Latin American currencies next year, with the Brazilian real expected to recover some of the ground lost this year.
Positive vaccine developments have been the most important factor behind the rally experienced by Latin American assets this month, and the region's recover could benefit further in 2021 from a continuing low rate environment and weaker U.S. dollar, according to Alejo Czerwonko, UBS' chief investment officer for emerging markets in the Americas. Low rates in Latin America's major economies make equities preferable to bonds, with the former's returns set to come in at attractive levels over the next few months, he said.
Cautious on Mexico and with minimal exposure to Argentine assets, UBS expects Brazil to successfully rein in its fiscal deficit in 2021, which would allow the real to strengthen, Czerwonko said in a conversation with S&P Global Market Intelligence.
Below is a transcript of that conversation, edited for length and clarity.
What has affected UBS' strategy for Latin America more in November: Joe Biden's presidential victory in the U.S. election? Or positive vaccine developments?
Both mattered greatly, but market moves and betas ... have been higher in emerging markets for the latter, and in particular in Latin America. We maintain a constructive view on risk assets on the back of the global economy continuing to normalize, as well as easy monetary and fiscal policy worldwide, and a more versatile range of medical tools to tackle the pandemic. Our baseline scenario projects widespread availability of a vaccine in 2021, and our portfolios are positioned to benefit from the upside. We have a most preferred recommendation on equities relative to bonds globally, and we are positioning portfolios for a broader rally in 2021.
We may see laggards catching up with leaders, [that is] LatAm and EMEA outperforming Asia in coming quarters. Within fixed income, we have a most-preferred recommendation on dollar-denominated sovereign bonds from emerging markets. This asset class has some additional room for spread compression over U.S. treasuries, particularly on the high-yield segment of the spectrum. Latin America should be part of that compression process. We are projecting a dollar weakening trend into 2021.
What countries are you looking at in Latin America specifically? And have these recent developments changed the asset classes you're looking at?
Uncertainty remains high for the region. Right now we think about broadly diversified LatAm equities as an asset class, mostly in Brazil and Mexico and to a lesser degree... Chile, Colombia, Peru. And minimal exposure to Argentina. Regionally, equity markets can catch up and post a good performance into mid-2021. When it comes to dollar-denominated bonds, our recommendation is actually at the emerging markets level. That asset class can continue to offer good risk-adjusted returns on the back of an attractive carry of close to 4.8% in U.S. dollar terms, plus the potential for close to 40 basis points in spread compression. Within that, we do see opportunities in Latin America. We play them within the asset class, not standalone.
Some countries, like Brazil for example, have racked up record deficits and debt levels to combat the pandemic. Does that influence your decisions?
Of course... Make no mistake, this is a very profound shock that the LatAm economies are experiencing. Countries are recuperating from depression-like levels of economic activity, and the recovery will be slow and uneven. The pandemic will leave long lasting scars on the social and economic fabric. High levels of unemployment are going to take quite some time for the system to digest... Countries that were already experiencing fiscal challenges are seeing them exacerbated, with Brazil and Argentina standing out in this regard. But much of the bad news has been priced in to the region's financial assets. Year-to-date performances of LatAm equities in U.S. dollar terms are at -27% compared to +9% for emerging markets as a whole. So the gap is very significant, and we think there is room for at least some of that bad news to get priced out, thanks to a supportive external environment of easy policy and vaccine distribution in the region. I'm not forecasting an impeccable macroeconomic path ahead, but there is room for assets to catch up.
And what about the record low interest rates in countries like Peru, Chile, Colombia and Brazil?
We are projecting policy rates at zero or negative in the U.S. and Europe for many years to come. In the better managed LatAm economies, without pressing fiscal issues, this would be supportive of low rates domestically for longer. Chile and Peru are two clear exponents of that trend. Countries with more serious macroeconomic challenges, particularly in the fiscal front — think Brazil and Argentina — might face pressures to hike rates. Argentina is already experiencing this and has been tightening financial conditions against the grain of the rest of the world. Brazil hasn't yet, but they might be forced to, particularly if we see a mishandling of the spending cap. These factors make fixed-income assets less attractive. But you need to see where rate differentials stand, and whether it makes sense to take local or hard currency exposure. At the moment, the latter makes more sense and offers a good risk-reward; there's still some risk premia that needs to be priced out. When it comes to equities, lower rates are usually good, and usually justify higher multiples.
With regard to equities, price-to-earnings ratios are low across EMs compared to developed markets. Is that an opportunity?
Multiples are not low almost anywhere in the world. This is in part justified by the low interest rate environment. Emerging market valuations are, relative to developed market valuations, quite attractive still. And that conclusion applies to Latin America. It becomes a matter of suitability for the investor. What needs to be recognized is that the return that the region's equities look set to offer in the next few months is attractive, but it will come hand in hand with high volatility. It's not something that is appropriate for everyone.
You mentioned a weaker dollar. Brazil has had one of the worst performing currencies this year. How do you see Latin America's major currencies unfolding next year?
We are expecting a somewhat weaker dollar in 2021, which should be supportive of LatAm currencies. The picture is more nuanced, of course. The Mexican peso could remain relatively well behaved. Some of the Brazilian real's depreciation can be retraced. But the reality is that the situation is quite binary in Brazil. If they manage their fiscal pressures responsibly, which to this day remains our baseline scenario, then we can see the real coming back closer to [5 reais to a dollar]... by mid-2021. If you see an irresponsible fiscal policy then that prediction could be awfully wrong. There's no middle ground.
Mexico has been somewhat of an outlier in opting for a more austere path in terms of fiscal stimulus, and its recovery is expected to be one of the slowest in the region. What asset classes are you finding attractive there currently?
We are pretty cautious on Mexico overall. We do find opportunities in the dollar bond space, in particular in the quasi-sovereign area. And also in a number of world class corporates that happen to be headquartered in Mexico, but that would be it. The currency should remain well behaved. We are projecting a level of 21 pesos against the dollar by mid-2021.
You also mentioned a slight exposure in Argentina, which is going through a rough economic situation. What are your expectations of the ongoing IMF talks there? And what assets are still an opportunity there?
The negotiations with the IMF are essential to regain investor trust, because they come hand in hand with a debate about the outlook for fiscal accounts in the country, which were challenging before the pandemic, and have become a lot more challenging now... Negotiations won't go down a straight line, but Argentina will have no option but to renegotiate the existing debt stock, a necessary condition for which is the presentation of a macroeconomic plan, with some degree of fiscal consolidation over time. In this context, dollar bonds from Argentina are still trading at quite weak levels, and there's some room for normalization if that scenario pans out.