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LATAM: 10 Questions for 2023
Ten key questions – and answers – on Latin America’s economy this year.
BY ALBERTO M. RAMOS
"Pelé doesn't die. Pelé will never die. Pelé is going to go on for ever."
Pelé (The King, 1940 – 8), The iconic number 10 of the Brazilian national soccer team. Only player to have won three FIFA World Cups. Voted World Player of the Century by the International Federation of Football History & Statistics
In the first LatAm Economics Analyst of the year we discuss what in our assessment are the most important questions and vectors of the region's macro and asset market performance for 2023.
LatAm's short-term outlook remains complex and challenging given a backdrop of high inflation, restrictive domestic and external financial conditions, deceleration to sub-trend sequential growth, softer external impulse to growth and, yes, still plenty of political and policy risk and uncertainty.
Q1. Can LatAm Deliver Reasonable Growth in 2023?
No, Not Likely. Given a number of headwinds growth is forecasted to decelerate to a subtrend pace across the board in 2023, in particular 1H2023.
Following the 6.9% expansion in 2021 (covid-rebound), real activity surprised to the upside throughout 2022 and was overall more resilient than expected despite much higher-than-expected inflation and tighter domestic financial conditions. Growth in 2022 benefited from a sizeable statistical carry-over from 2021 and is estimated to have settled at 3.9% given a stronger than expected post-covid normalization impulse, positive external impulse from robust terms of trade gains and global growth, inventory rebuilding, gradual normalization of bottlenecks afflicting some supply chains, solid job creation, resilient credit flows, draw-down of pent-up savings, and in some places sizeable fiscal stimulus (e.g., Brazil).
The easy catch-up growth has to a large extent already been realized. By end-2022 all of the LatAm economies under GS coverage have recovered the pre-pandemic real GDP level, including, by a small margin, the laggards Ecuador and Mexico. Our proprietary CAI indicators show that the growth momentum softened significantly during 4Q2022. For 2023, we forecast very modest sequential growth during 1H2023, with real activity firming gradually during 2H2023. At this juncture we do not forecast a recession in LatAm in 2023 (but anticipate negative growth in Chile and possibly in Argentina), but do not rule out one, perhaps two quarters of mildly negative sequential real GDP prints.
All in, real GDP growth for the LA7 group is expected to downshift visibly in 2023: to an underwhelming 1.1% given the rapidly waning impulse from reopening, restrictive domestic and external financial conditions, exigent credit conditions, tighter labor markets, low levels economic slack (output gaps narrowed, and in Chile and Colombia are tracking in positive territory), softer external impulse to growth, lingering political and policy uncertainty, and softer consumer and business sentiment. The dispersion of growth rates across countries is expected to narrow significantly in 2023 compared with 2020-22.
On the positive side, growth in 2023 should benefit from further draw-downs of pent-up private spending, moderating inflation, well-bid commodity prices, and in places like Brazil and Chile, additional fiscal stimulus. At a broader level, LatAm could also stand to benefit from near/friendly-shoring FDI inflows, and the repositioning of EM capital flows away from China and a few other large EMs facing economic and political hurdles.
Q2: Will Inflation Converge to the Target(s) in 2023?
No, Unlikely. Inflation will likely remain high, above-target, particularly core and services. We expect 2023 to be just a transition year towards more moderate close-to-target inflation in 2024.
After a long reprieve, an old foe, inflation, arrived on stage during 2H2021, assumed a leading role in 2022, and most likely will not fundamentally leave the scene until 2024.
We expect inflation to moderate gradually during 2023 driven by high base-effects (in particular food and in some places fuel), below-trend growth, restrictive monetary and financial stances, and further easing of supply chain frictions. However, inflation may ultimately prove sticky/persistent given high levels of inflation generalization, growing contamination of more inertial core and services components, tight labor markets, explicit and implicit backward-looking price/wage setting mechanisms (nominal wage growth has lagged inflation but has been accelerating supported in part by tight labor markets), and unmoored inflation expectations. Overall, we expect to observe a clearer disinflation trend throughout 2023 on headline, more than on core and services inflation.
Headline inflation is projected to moderate from 2H2022 multi-year highs but to remain above-target throughout 2023. Headline inflation realignment with the inflation targets is expected only for 2024. Core and services inflation are expected to be stickier than headline. For the LA7 economies (Argentina, Brazil, Chile, Colombia, Ecuador, Mexico and Peru) inflation is forecasted to moderate from a cyclical high 18.2% in 2022, to a still high and very uncomfortable 15.0% in 2023, impacted to a significant extent by the very high-inflation environment in Argentina. Excluding Argentina and dollarized Ecuador, inflation in the five inflation-targeting economies (LA-IT5) is expected to moderate but remain high and above the individual targets: headline inflation ended 2022 at a decade-high 7.9% and is forecasted to moderate gradually to a still high 5.6% by end 2023 and further down to the 3.0%-3.5% range in 2024-25. By end-2023, inflation is forecasted to remain above 5% in Brazil, Chile, Colombia, and Mexico.
Against this backdrop, being patient and conservative with the calibration of monetary policy is key, particularly in the current context of unusually high uncertainty around the trajectory of inflation, around key non-observable structural parameters of the economy (neutral real rates, output gaps, and the NAIRU), and evidence that inflation is turning stickier (more auto-regressive, backward-looking).
Q3: Can the LatAm IT5 Central Banks Cut Rates in 2023?
Yes, we expect moderate rate cuts backloaded towards 2H2023 but with policy rates remaining in restrictive territory (above-neutral).
The LatAm central banks were among the early hikers and in most places are now ready to reap the benefits of early decisive action. Rate hikes were aggressive and the normalization/tightening cycles long and deep. Some central banks are still hiking (Colombia, Mexico), others are already on hold (Brazil, Chile).
We expect the regional central banks to be conservative in 2023 given the expectation of moderating though still visibly above-target inflation, in particular core and services, still unanchored inflation expectations, high core global yields, and in several places inadequate fiscal policy support and heightened political, fiscal, and policy risk premia. Central banks are expected to hold the policy rates at peak/restrictive levels throughout most of 1H2023. The central banks of Colombia and Mexico are likely to extend the rate hiking cycles through 1Q2023, but are now close to ending their tightening cycles.
We expect central banks to deliver moderate rate cuts starting around mid-2023, with the pace and depth of cuts a function of progress on the disinflation front and the evolution of the overall balance of risks and global monetary and financial conditions. Overall, financial conditions and ex-ante real rates are expected to remain above-neutral across the LatAm landscape.
Q4: Could Rates in Brazil Rise Further?
No, Difficult. The bar for additional rate hikes is quite high, but the Copom could certainly delay rate cuts.
Inflation moderated significantly towards the end of 2022 but remains well above-target, particularly core. The underlying inflation dynamics remain challenging given disseminated core and services inflation pressures against a backdrop of a tight labor market, sizeable fiscal expansion in 2023 and renewed upward drift of 2023-25 inflation expectations. Inflation may prove inertial/sticky given intensifying backward-looking price- and wage-setting mechanisms (with resetting wage contracts incorporating cost-of-living adjustments).
Early policy signals by the Lula administration and key cabinet picks point towards heterodox/interventionist macro, micro, and regulatory policies. We expect the Lula administration to pursue an expansionary tax-and-spend strategy given the strong conviction that the public sector and the SOEs should be key engines of growth and investment. Such strategy could lead to higher consumption growth in the short-term but also high inflation, and weaker fiscal and current account balances. These evelopments rekindled fears around medium-term fiscal sustainability, adding pressure on market rates, the BRL, and inflation expectations.
Overall, the balance of risks for inflation has deteriorated. However, the bar for the Copom to hike further is quite high, in our assessment. At 13.75% the Selic policy rate is already highly restrictive, with the ex-ante real policy rate topping 8% and the economy is transitioning towards below-trend growth. Hence, rather than starting to cut rates by mid-2023, the Copom may elect to be more conservative given the recent increase in macro/fiscal risk and backload even further any potential rate cuts. That is, unless the policy noise and perceived fiscal risk improves, the central bank may elect to start to cut rates later and/or cut less in 2023 than our updated baseline entailing the first cut in Aug-23 and an end-2023 Selic rate at 11.50%.
Q5: Will We See Major Structural/Fiscal Reforms in Brazil in 2023?
No, Not Major Reforms. A streamlined tax reform appears feasible but there is also the risk of dilution of prior reforms.
Our macro baseline scenario assumes no tangible progress on the lagging structural reforms front beyond the approval of a tax reform based on two proposals already extensively debated in Congress during 2022 to unify in a single- or dual-VAT tax several federal and state-level indirect taxes and contributions. Later, we do not rule out changes to the personal and corporate income tax code to make the system more progressive and raise more revenue.
Beyond that, our baseline assumes no tangible progress on the structural reforms front. In fact, we expect a gradual deterioration of the macro and micro policy mix, virtual interruption of the privatization drive, significant loss of momentum and deterioration of the terms for public concessions, and tangible risk of a dilution and/or weakening of several reforms approved over the last 6 years.
Q6: Argentina Won the 2022 FIFA World Cup, Can it Now Win the Macro Rebalancing Game in 2023?
No, Very Unlikely. The macro picture is getting messier, and Massa is no Messi even with an assist from the IMF. Reforms and macro adjustment best hope is post-election, in 2024-25.
Argentina's macroeconomic backdrop remains a case apart in LatAm. Macro policy remains deeply heterodox. Loose fiscal and monetary policy amidst rising levels of financial repression are leading to wider macro and financial imbalances (inflation close to triple-digits, increasingly misaligned currency, intense FX and international reserves pressures, and growing micro distortions and inefficient allocation of resources due to a wide and expanding set of distortionary capital, financial, trade, labor market, and price controls.
Policy credibility remains weak, and the IMF program has not been able to steer macro policy towards more conventional polices and to rebalance the economy. Deep political and social polarization and a pivotal presidential election in October 2023 are likely to keep uncertainty high and appetite for macro adjustment policies very low. Hence, given the authorities' manifest low inclination to embrace a stronger policy mix, macro rebalancing and reforms will likely have to wait until after the elections (i.e., 2024-25), an even then they are not givens.
Q7: 2021-22 Was 'Very Exciting', Can Investors Now Relax About the Politics?
No, Not Yet. The 2023 election calendar is light, but the risk of political/social conflict is high.
The 2023 political calendar is relatively light: presidential and legislative elections later in the year in Argentina, and gubernatorial election in the pivotal State of Mexico. There is, though, also a rapidly growing risk of early general elections in Peru given the increasingly violent social dynamics and very tense political backdrop. In Venezuela, we also do not rule out bringing forward into 2023 the scheduled May 2024 general elections.
In Chile, there will be a second attempt to reform the constitution, a complex and lengthy process that is likely to take the entire year and which is scheduled to conclude with a mandatory plebiscite in December to ratify/reject the proposed new constitution. This, alongside the discussion of highly consequential tax and pension reforms, and public security flare-ups, should keep political noise and policy uncertainty high.
The most recent elections in LatAm have been highly polarized, and political tension and discord do not seem to have subsided in a significant way following the election of populist left-leaning administrations in Brazil (2022), Chile (2021), Colombia (2022), and Peru (2021). For instance, political gridlock and policy paralysis are prevalent in Ecuador, and also in Peru where President Castillo was impeached and removed from office by Congress after attempting a self-coup. Renewed social activism and political strife in Peru, the Jan 8 events in Brazil, and friction between the government and Supreme Court in Argentina are just the latest examples of how unsteady the social and political backdrop remains.
Q8: Will the LatAm Overall Macro Policy Mix Turn More Heterodox?
Yes, Likely but Gradually So.
The political, social, and policy spheres remain unsettled in most places and there has been a very sharp and quick erosion of popularity ratings of incumbents. This adds uncertainty and risk to the LatAm macro-outlook and increases the risk of a populist policy swing.
More than a risk, in several places that is already a reality as many of the new left-leaning administrations have openly embraced more interventionist policies and are keen to promote large expansions of the role of the State in the economy through regulation, ambitious tax-and-spend strategies, and state-centered reforms (e.g., legislating a major overhaul of the social security system with stronger government involvement).
Building governability and preserving social peace will be key challenges for most policymakers (some recently elected), even more so given the very slow socio-economic progress over the last decade, deep distrust of the political establishment, and heightened perception that the economic and political "system is broken".
Q9: Will Mexico Outperform in 2023? Will Near/Friendly-Shoring Dynamics Spark a Mexico Moment?
No, Not Quite. The macro picture has fewer potholes than elsewhere in LatAm. Mexico shows a more balanced macro and stable political profile than regional peers and therefore milder macro and asset price left-tail risks. But there are also policy idiosyncrasies that cap the upside and room for macro-outperformance.
The economy shows no major macro imbalances (with the exception of the high inflation environment facing every other economy), appears more politically stable than regional peers, exhibits a strong fiscal profile at the flow (fiscal deficit) and stock (public debt) levels, has a strong current account (record remittances) and balance of payments, a competitive currency, a conservative central bank, and stands to benefit from high oil prices (Pemex and the budget). Mexico should also benefit from near/friendly-shoring FDI inflows and diversion of EM capital flows away from China and a few other large EMs where the perception of economic and policy risk has increased. This would otherwise set the stage for macro-outperformance and well supported asset prices, including the high-carry and high-Sharpe ratio MXN and long end rates. Despite the recent rally, 5yr TIIE rates are still tracking above 8%, vs 5yr Treasuries at 3.5%, preserving the scope for further receiving opportunities.
Despite the above, the room for macro-outperformance is expected to be limited. The difficult business and regulatory environment (particularly in key sectors such as oil, gas, and mining) and weak investment outlook underpin the soft growth profile. Furthermore, we are of the view that the near/friendly shoring investment dynamics, while real, will play out only gradually. It will likely be a multi-year process. In addition, Mexico does not benefit from China's reopening as much as the South American economies given the limited trade linkages with China and the fact that it is a manufacturing rather than a commodity-based economy. Finally, Mexico will be impacted by softer growth in the US, and while not our baseline, in case of a US recession, it would be disproportionately impacted given the close integration of the Mexico and US real business cycles.
Q10: Will Large Current Account Imbalances in Chile and Colombia Disrupt the Macro Picture?
No, but large external deficits are a source of macro vulnerability. The large imbalances will partially correct in 2023 but in the short-term may condition the calibration of monetary policy.
Across the LA7 economies, we expect current accounts to improve in 2023 where the imbalances are large and to remain well anchored elsewhere. Current accounts widened in 2022 despite solid terms of trade; a reflection of vigorous import demand and outward remittances of profits and dividends (part reinvested and therefore recorded as an FDI capital inflow). Where current account deficits are low/moderate we expect them to remain well anchored, and where the imbalances have been wide (over 6% of GDP in Chile and Colombia) we expect a gradual reduction of the large deficits in tandem with the forecasted moderation of domestic demand, the lagged effects of currency depreciation, and well bid commodity prices (copper for Chile and oil prices for Colombia).
Beyond inflation, the large external imbalances and positive output gaps in both Chile and Colombia are an added reason for the respective central banks to act conservatively. This will likely require additional hikes in Colombia 1Q2023 and resisting premature monetary easing in Chile.
Overall, outside potentially Colombia the external accounts are not expected to be a major policy concern or binding external restriction in 2023-2024. In Colombia, the large current account deficit is of added concern given the risk of a significant deterioration of the macro and micro policy mix.
Alberto Ramos is chief Latin American economist at Goldman Sachs Group.
This article is based on a client note by Goldman Sachs. Republished with permission.
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