NN IP: Divergence in emerging markets

Anlagestrategie

Divergence in emerging markets: Brazil is making serious efforts to reform, while uncertainty is paralysing Mexico.

14.12.2018 | 13:30 Uhr

Growth and policy divergence in EM continue to be key market themes. During recent visits to Brazil and Mexico, we met policy makers, corporate leaders and market participants. In both countries we are seeing a dramatic shift in policy direction. In Brazil, a populist right-wing government has been elected, which promises to carry out far-reaching economic reforms. And in Mexico, a populist left-wing government has just been installed with a more interventionist policy course that has big implications for the overall business and investment climate.

We returned from our research trip a bit more positive about the Brazilian market, as reform hopes are likely to persist in the coming months thanks to the new government’s numerous initiatives to start shaping its ambitious reform agenda. However, we are more negative about Mexico, where we are considering an increase to our existing underweight position. This is mainly on the back of a more disruptive attitude from the new president and a higher risk of fiscal slippage. In this article we will share our main conclusions.

Brazil: a serious attempt to reform

The mood in Brazil was much better than expected. The local investment community continues to be excited about the combination of the “ultra-liberal economic agenda”, as the new government calls it, and the Bolsonaro government’s well-respected economic team. This positive assessment is widely shared among investors, economists and corporates. In contrast, we met people less involved in economics or financial markets who are so worried about the new president’s disrespectful attitude towards women and the LGBT community that they are considering emigrating. Plans to liberalize the ownership of weapons and allow the soy tycoons to accelerate the exploitation of the Amazon region are other key reasons for people to turn their back on the new government.

The economic agenda of the Bolsonaro government consists of three pillars: a strong commitment to fiscal prudence and a gradual reduction of the high public debt ratios; an ambition to implement far-reaching pension reforms; and an aim to privatise as many public companies as possible in a bid to increase corporate efficiency and use the proceeds to reduce the 7%-of-GDP fiscal deficit. With a public debt amounting to 83% of GDP, and the average interest rate on this debt as high as 10%, action is urgently required. Apart from pension reforms, the government wants to cut salaries and jobs in the public sector. It also wants to change the minimum wage regime, abolishing the rule whereby the minimum wage is determined by past GDP growth and inflation. The latter is particularly relevant as many public wages and social security transfers are linked to the minimum wage.

The need for pension reform has become more urgent due to Brazil’s rapidly ageing population, higher levels of public debt and the dire state of local government finances. One of the planned measures involves increasing the minimum pension age for men from 55 to 65.

The problem remains that there is no clear political majority that supports the new government’s reform agenda. Its economic team wants to get the pension reform proposal through Congress in the course of 2019 but in our view, the probability of a far-reaching package being approved before the end of next year remains below 50%. One complicating factor is that neither the president-elect nor his powerful chief of staff Onyx Lorenzoni was ever in favour of pension reforms before joining this government.

A late and watered-down version of the initial plans would likely mean that Brazil’s fiscal accounts remain unsustainable and that the country remains vulnerable to ongoing market pressures. But for now, given the high confidence in the new economic team, to be led by Paulo Guedes, the current market excitement about future reforms is likely to last a bit longer. After all, Jair Bolsonaro will not be installed as Brazil’s president until 1 January. It should take some time before the first disappointments emerge.

Mexico: paralysing uncertainty

For the first time since the 1994 Tequila Crisis, Mexico is facing serious pressure on its economic institutions. The new president, Andrés Manuel López Obrador (AMLO), wants to rapidly reduce economic inequality, eradicate corruption and solve security issues. His proposals, announcements and decisions have so far been highly disruptive. He wants to double pensions and scholarships, plans to index the minimum wage to inflation, and has presented a list of large infrastructure projects that must be paid for with public funds.

So far, AMLO has committed to not spending additional money without having secured new savings. Nevertheless, the risk of fiscal slippage is high. It is unlikely that the new social projects and the high-profile infrastructure projects, which include a new train through the Yucatán peninsula and one that crosses the Tehuantepec Isthmus, will be properly financed. Making quick savings by fighting corruption or cutting high-paid public sector jobs will not be easy.

Postponing the promised social spending is not an option for the president. However, he is likely to delay most of the infrastructure plans. Still, the problem here is that he and his team of economic advisors, whom we met, target a GDP growth rate of at least 3%, up from the 2% recorded in recent years. Given the collapse of business confidence due to the high level of uncertainty, particularly following cancellation of the big Mexico City new airport project, we are unlikely to see any positive growth in private fixed investment in the coming year. This means AMLO will be driven to quickly launch public investment projects in hopes of meeting his GDP growth targets.

We expect a sharp deterioration in the fiscal accounts in the coming years, most likely through a combination of higher primary deficits and new lending schemes by the public development banks. At the same time, we should expect more government pressure on the highly profitable private banks. Indeed, forced lending schemes can no longer be ruled out. All in all, the investment climate in Mexico is deteriorating rapidly. This should continue to put pressure on Mexican assets. The peso and the equity market look particularly vulnerable. Fixed income markets perhaps less so, because real interest rates are already at 5%, which is an attractive carry in EM.

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