Argentina and Brazil: Markets at an Inflection Point
Over the last decade, while emerging Asia has thrived, Latin America has languished. As Asia has risen to dominate the MSCI Emerging Markets Index, accounting for close to three-quarters of its capitalization weight, Latin America’s representation has fallen by half, from 24% to 12% (Exhibit 1).
Government dysfunction spilling over to the state-directed economies in Brazil, with the region’s largest GDP, and Argentina, with the third-largest after Mexico, precipitated much of the underperformance. Additionally, a strong US dollar exacerbated the weakness in both countries’ currencies. Today, the two nations find themselves at potential inflection points. In Argentina, a new administration (with many of the same faces from a previous administration) will confront the challenge of reversing the economy’s precipitous decline. Meanwhile, Brazil has taken the decisive first steps toward putting its economy on a path to sustainable growth.
Exhibit 1: South America Heads South
MSCI Index Weights by Region
As of 30 October 2019
Source: MSCI
The Four Argentina Questions
Argentina, which has endured six sovereign bond defaults since the 1980s, most recently the largest sovereign default ever in 2002, is staring down the barrel of a seventh. In the recent presidential election, voters rejected the market reforms of the incumbent Mauricio Macri in favor of a return to the Peronist party, whose price controls, protectionist trade policies, and inflation-stoking budgets we believe set Argentina’s sovereign debt back on the path to default.
We will be watching how the new administration addresses several questions including the following which we hope will bring more clarity about what may lie in store:
- Which Fernández will be running the country? Newly elected President Alberto Fernández or former President Cristina Fernández de Kirchner?
- How "Peronist" will the new Peron administration be?
- Who will be in charge of the economy?
- When and under what conditions will the International Monetary Fund (IMF) release the balance of funds committed to Argentina under the Macri administration?
Brazil Gets Real
Brazil emerged from a deep recession in 2015 and 2016 but just barely. GDP growth has hovered around 1% in the years since. Though the lingering non-recovery has many causes, it arose in no small part from the excesses of an overly generous government. Pension transfers consume 45% of the federal budget, an amount equal to 8.6% of the nation’s total GDP. The 20-year budget caps enshrined in a 2016 constitutional amendment already need adjusting, and at the current pace, growth in non-discretionary items could force a government shutdown by 2021. The government’s largesse not only crowds out discretionary spending and infrastructure investment, it also places a heavy burden on Brazilian taxpayers, who labor under some of the world’s highest tax rates, not to mention cumbersome filing processes.
The unsustainability of the situation has compelled the Bolsonaro administration and Congress to set aside political infighting and move forward on a package of reforms. In October, the Senate approved a pension reform capping decades-long efforts. The reform, which lifted retirement ages by nine years, may save up to $200 billion in the next 10 years. As impressive as that number is, even more impressive is the fact that the bill made it through a Congress of 26 different parties pretty much intact. Though the government was hoping for US$240 billion in savings, it was willing to declare victory if it got only half that. Additional "ancillary savings” may add another $65 billion to the total.
Paulo Guedes, Brazil’s finance minister and the guiding force behind the pension reform, is not stopping with pensions. In the coming year, he is eager for Congress to take up a proposed tax overhaul, which would largely replace the current complicated system with across-the-board value-added and financial transaction taxes. Congress was also set to consider a reform package to streamline the civil service, with estimated savings comparable to those of the pension reform. In mid-November, however, the administration delayed submitting the proposed legislation.
Green Shoots or Dead Roots?
Argentina and Brazil both face indisputably formidable challenges. The new administration in Argentina must renegotiate the terms of its debt to the IMF while ending a chronic inflationary spiral. Brazil’s Bolsonaro administration must maintain in its second year the reform momentum it generated in the first against deeply entrenched opposition. We believe the tariffs recently imposed by the US on steel imports from the two countries can only add to the obstacles.
Yet we see potential opportunities as well. Though the value of both Brazil’s real and Argentina’s peso has tumbled against the US dollar in the past two years,1 by 22% and 69% respectively, either currency could rebound with minimal progress in its respective country. Reversing the downward course could, in turn, pave the way for large-scale equity rerating. That turn in the markets may be difficult to foresee now, but the large upside headroom makes it a possibility we’ll be watching for.
The preceding is an excerpt from Argentina and Brazil: Markets at an Inflection Point. Read the full paper to learn more about the opportunities and challenges ahead for their economies.
Notes
1 1 December 2017 – 2 December 2019
Important Information
Originally published on 10 December 2019.
The MSCI Emerging Markets Index is a free-float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI Emerging Markets Index consists of 26 emerging markets country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. The index is unmanaged and has no fees. One cannot invest directly in an index.
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