Back in 2007, Latin American equities made up 26% of the SPDR Emerging Markets Portfolio ETF, a capitalization weighted index of emerging markets equities. Today, markets in the region account for only 9% of the same Index. Asian equities, on the other hand, represented 39% of the same market index 15 years ago. Today, they account for 77%.
These figures reveal the relative stagnation experienced by Latin America since the Global Financial Crisis. Even in the countries such as Brazil, Peru, Chile, Colombia and Mexico, where, for most of this period, macroeconomic stability was sustained and a Neo Liberal economic model remained in force, growth has failed to meet people´s—and markets’—expectations.
Many of these countries have succeeded in reducing poverty, but lower growth, inequality and widespread corruption have led their populations to search for drastic political change. Beginning with the election of leftist Andres Manuel Lopez Obrador in Mexico in 2018, these countries have gone through a period of severe social confrontation, instability and political change that brought to power extremist leaders of both left and right wings.
In 2021, Peruvians elected Pedro Castillo as president and Chileans chose Gabriel Boric to lead them. Previously, in 2020, Chileans had elected the 154 members of a Convención Constituyente to rewrite the country´s constitution. In 2022, Colombians elected Gustavo Petro as president. These three Presidents and the Constituyentes came to office with a populist left wing leaning distant from the center left or center right inclinations that their predecessors had. In Brazil, Jair Bolsonaro, took over the presidency in 2019.
Except for the case of President Petro in Colombia, who has just started his term, these populist leaders have all suffered major setbacks or have failed completely in a very short period of time. Last year, Jair Bolsonaro was not reelected in Brazil, and Peru’s Pedro Castillo was ousted from office on corruption charges. A new constitution written by Chile’s Constituyente was rejected in a national referendum and President Boric is already registering rock bottom approval ratings.
Despite his high popularity, President Lopez Obrador has been unable to pass any major reforms through an opposed congress in Mexico.
The failure of these populist options has left the voters in these countries divided, disappointed and even more eager for change. Symptomatic of this are the riots that have taken place in the southern region of Peru since Castillo´s impeachment in early December and the riots in Brasilia that followed the inauguration of Luis Inacio Lula da Silva, Brazil´s elected President.
Finding a balance
When facing their discontented fellow citizens, Latin American leaders such as Lula find themselves between a rock and a hard place. They need to provide quick solutions to an impoverished population but their governments lack the resources to do so. In Brazil, years of populism and lower growth have taken the government’s indebtedness to a perilously high level. The need to serve this debt puts substantial pressure on the fiscal budget and leave very little room for further transfers to the people. On top of tight government finances, Lula also faces a Congress and many local governments controlled by the opposition.
In order to succeed he will have to tread carefully between the aspirations of the people who have elected him, foreign investors, government creditors and the opposition. According to the Institute of International Finance, Brazil can increase government spending by 1.2% of its GDP, but no more. A greater increase would set the Brazilian government on a path towards long-term insolvency.
In order to reignite growth, however, Brazil needs a much larger demand shock.
After his election, Lula was originally welcomed by markets on the expectation that he would adopt a conciliatory and pragmatic approach to his new term in government. The tone changed sharply after his inauguration on January 1st when he mentioned his willingness to remove the existing constitutional cap on government spending and to use government-owned oil giant Petrobras and the development bank BNDES as engines to reactivate Brazil´s economy.
Brazil´s IBOVESPA equites index fell almost 8% after that first speech, delivering a clear message: in a region where populism and intolerance have set the tone of the political discourse; macroeconomic stability, lower debt levels and better functioning institutions will be the key factors for successful reactivation.
Government solvency, however, will not be enough: private investment will be essential for the recovery. In particular, the drive of foreign investment which is easily scared by political or macroeconomic instability.
Maintaining government solvency is likely to be hard in Brazil considering that its gross public debt is likely to have reached 92% of GDP in 2022. Lula´s administration will have to run a substantial surplus before interest payments to stop this ratio from growing, leaving him little space for increased fiscal spending.
A new ‘third way’
Despite the challenges, Lula has a golden opportunity to establish a new, more conciliatory way to run government and rule by consensus in a highly divided political landscape. He is a moderate and previously led a very popular “third way” administration that coincided with a remarkable period of economic and asset valuation growth in his country. Though his previous period was tainted by several accusations of corruption that led him to spend several years in prison, his two terms in government were also socially peaceful.
If Lula adopts pragmatism, he will break with the pervasive confrontational political discourse that has characterized Latin America recently. This should feed into foreign interest for the region´s assets as it drifts toward the center. In Brazil, the real would definitively benefit from this and would likely recover much of the value lost during the past few years.
Brazil still has a strong external position and relatively small foreign debt levels. Yields on Brazilian corporate and sovereign debt are quite attractive currently and credit spreads have ample room to narrow as political uncertainty dissipates. Lower financing costs and more upbeat prospects will also result in increased demand for benchmark stocks that trade currently at rather attractive valuations compared to historical levels.
If Lula is successful at bringing opponents out of the streets and back to the negotiating tables—and in generating higher growth and economic wellbeing—he could blaze a trail that other Latin American leaders could follow, initiating a new period of political consensus built around the center of the spectrum.
It could mark the beginning of the end of the populist extremism that has tarnished the region´s appeal to foreign investors.
Jose Pedro Martinez Sanguinetti is chief investment officer at Rimac Seguros.
Research on this story was conducted by Lorenzo Antonio Martinez Roveda.