After a tumultuous first quarter, the emerging market (EM) complex has shown tentative signs of stability, which continued over the course of last week.
Why?
Well, importantly for emerging markets there has been somewhat of a release of the pressure valve; with the Federal Reserve continuing to affirm its commitment to an easy monetary stance – and kicking suggestions of tapering into the long grass – the upward march in core-market yields and the USD rally has paused. That said, I would describe the stability in EM as more arithmetic or mechanical as a result of the core market moves; the broader tone in EM is still very cautious - it is worth checking out HSBC’s latest positioning and flow data, which signals record cash balances and light flow into our asset class. At the same time, risk sentiment continues to be clouded by ongoing idiosyncratic risks on the ground, particularly in Latin America (LATAM), with the increasing likelihood of an extreme left President in Peru and the ongoing reform deadlock in Brazil. LATAM specific risk intensified last week with the political unrest in Colombia and El Salvador.
Colombia
Colombia suffered a significant setback to its fiscal reform agenda when the government was forced to retract its official tax reform proposal in the face of civil unrest and overwhelming opposition from lawmakers. The ambitious reforms, which earmarked 2.2% GDP in extra revenue, is highly likely to be watered down, with increases in VAT and income tax for middle class families now expected to be excluded from the revised bill. Estimates suggest that the adjusted bill may only be worth 0.5% to 1% GDP of extra revenue. Looking forward, downside risks remain; lawmakers could be forced to approve the full social expenditure programme outlined in the original bill, completely offsetting the boost to revenue. Likewise, in the worst-case scenario, the bill could fail altogether.
Why does this matter?
The rating agencies are circling, with Colombia on the brink of losing its investment grade status; the Fitch review is expected at the end of the June legislative session, while the S&P appraisal is expected sometime between December 21 and March 22. The erosion of investor confidence was clear to see last week; COP is now one of the worst performing currencies this year, while the local rates market gapped almost 50bps wider in the 5-year tenor of the curve, although this has retraced slightly during the week.
Looking forward to next week, the immediate challenge is the scheduled $185m COLTES nominal auction on Wednesday (27s, 36s, 50s); this will be the canary in the coal mine for market sentiment. We also await the refreshed iteration of the reform bill and its impact on the social unrest on the ground.
Colombia (COLTES 7.5 26)
El Salvador
Last week’s political unrest was not restricted to Colombia. Further tensions were clear in El Salvador, where the President Bukele’s Ideas Party voted to dismiss the five judges that formed the Constitutional Court. Lawmakers alleged the constitutional court was impeding the President's ability to confront the COVID pandemic. The move has attracted international criticism, particularly from the United States, with VP Kamala Harris stating “the US must respond”* to attacks by El Salvador's leadership on the independence of its judiciary. President Bukele’s chosen judges entered office early last week, a move which now enacts Presidential control of the highest public institutions. The move may have knock on implications for El Salvador’s negotiations with the IMF for a $1bn program to help plug budget shortfalls through to 2023. While an agreement with the IMF is still likely, negotiations could now become more protracted; the President has since been forced to deny rumours that he is negotiating with China as a backup. Furthermore, the move could also damage relations with the United States and limit external aid and investment. In response to the political turmoil, El Salvador Eurobonds tumbled, with the 5-year yield at one stage gapping over 150bps wider. Looking toward to next week, we remain alert to news on El Salvador’s negotiations with the IMF and signs of further acts of aggression by Congress.
Republic of El Salvador (ELSALV 6.375 27)
On the desk, we remain cautious when it comes to emerging markets. Ongoing US exceptionalism is highly likely to result in further market tests of the accommodative stance of the Federal Reserve, higher core market yields and episodic pressure on emerging markets. Likewise, market participants have the added complexity of idiosyncratic risk that we are seeing in LATAM and further afield. That said, we still believe there is money to be made in our asset class on a selective basis; we favour the emerging markets which have strong underpinnings to withstand the volatile backdrop, have a strong beta to the global recovery and the ongoing demand for commodities and capital goods. Likewise, we are on the lookout for emerging markets which have the following factors; solid underlying fiscal dynamics, monetary policy capacity and stable domestic politics. At present, the aforementioned countries in LATAM do not fit that criteria.
Sources
Data sourced from Bloomberg, Refinitiv Datastream & Eurizon SLJ Capital Ltd as at 7th May 2021.
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