Like Shakespeare’s Hamlet, who considered big questions about life and death, central bankers throughout Latin America are deliberating their future monetary policies.
Some market participants believe that key countries in the region might have run out of room to lower their policy rates. Yet we beg to differ—and hold a positive outlook for government bonds in those countries.
The Economic Case for Accommodation
In our view, the economies of Brazil, Chile, Colombia and Peru stand to benefit from below-neutral1 (i.e., more stimulative) policy rates given their current conditions. Their central banks have already lowered interest rates after inflation and policy rates had peaked on the heels of economic shocks (e.g., the draughts that triggered inflation and the oil-price collapse in 2015, among others) and have since gained more solid economic footing. But we believe they have room to ease policy even further in light of the disappointing growth they have exhibited, the rapid deceleration in their inflation rate, and below-target inflation expectations that appear to be anchored. In fact, we deem Exhibit 1 to illustrate one of the most bullish cases for emerging markets in current times.
Will the central banks of Brazil, Chile, Colombia and Peru indeed pursue accommodative policies (i.e., lower their policy rates below neutral)? That’s anyone’s guess—but we have good reason to believe they will.
For starters, some central banks (such as those of Chile and Colombia) have already exercised the freedom to test neutral policy rates—a sign of credibility in their policymaking: They have shown the willingness and resolve to deploy monetary measures in order to tackle economic challenges and spur growth. What’s more, their rate-cutting policies have not resulted in higher inflation—or in higher inflation expectations—and thus validate the case for accommodation. Declining food and energy prices (which have brought down headline inflation) could help, though they don’t provide justification per se for easier policy or a more flexible monetary stance.
What about the strength of the macroeconomic framework of those countries? For the most part, their fiscal accounts are strained. But while their budgets have yet to be balanced in the aftermath of economic shocks they had experienced, they have demonstrated fiscal restraint and enacted a range of reforms—with more anticipated in the near future. Additionally, the benign global economic environment for foreign direct investment (FDI) is stimulating Latin American economies and helping strengthen their currencies. As a result, we expect future inflation to be contained—another factor that may grant central banks more leeway to pursue accommodative monetary policies.
Finally, we believe Argentina and Mexico are exceptions. In our estimation, they likely won’t embark on any path of monetary easing in the near future because of persistent inflationary pressures in the former and peaking inflation in the latter.
The Political Landscape
In some developing markets, institutions of the state—including central banks—tend to have less independence and are more susceptible to shifts in the political climate, such as through elections. Any decision about further policy accommodation throughout Latin America may depend on how the political landscape shapes up in specific countries over the months and years to come.
We continue to follow political developments in tandem with economic ones—particularly given the coming election calendar that could bring regime changes affecting economic policy. Such changes, in our view, may lead to market dislocations that in turn open investment opportunities. At the same time, they may also undermine the prospect of monetary accommodation if they result in runaway inflation.
Our view is that Latin American economies could actually benefit from monetary accommodation for two reasons:
- Many of them are fiscally constrained.
- Lower policy rates would spur an undertaking of public-works projects (such as infrastructure) and other investments, which would benefit the broader economy.
In all, we think the central banks of Brazil, Chile, Colombia and Peru may be incentivized to test below-neutral policy rates geared toward sustainable growth in their economies.
Our portfolios are currently positioned for such an outcome:
- We remain constructive on government bonds in these countries, with an emphasis on short-term paper.
- We have tactically lowered our exposure to Argentina in light of inflation trends and political currents.
- We have increased our exposure to Mexican government bonds (MBONOS) of 3–5 year maturities.
- ^A neutral rate is the policy rate at which a central bank can achieve its inflation target without choking off growth or stimulating the economy.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall, and the value of the portfolio can fall. Emerging and developing market investments may be especially volatile. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks.
The mention of specific countries, currencies, securities or sectors does not constitute a recommendation on behalf of OFI Global.
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