Emerging Markets: Mexico and Brazil could benefit from bigger-than-expected rate cuts

Pendal’s emerging markets team expects significant interest rate cuts in Mexico and Brazil, increasing their attractiveness. Pendal Global Emerging Markets Opportunities fund co-manager JAMES SYME explains

• Our EM team remains overweight in Mexico and Brazil
• Significant rate cuts expected in both countries
• Find out about Pendal Global Emerging Markets Opportunities fund

ONE of the reasons we maintained overweight positions in Mexico and Brazil was the expectation of big interest rate cuts when disinflation was achieved.

When disinflation did arrive after a strict monetary orthodoxy from their respective central banks in 2021 and 2022, rate cuts were initially slow to follow.

(Though this didn’t prevent MSCI Mexico and MSCI Brazil comfortably outperforming the MSCI EM Index over the last three years.)

With Mexico’s central bank Banxico finally cutting policy rates this month, this piece aims to review the current prospects for policies, economies and equities in the two big Latin American markets.

A broad rate-cutting cycle

Although many developed and emerging market central banks have been cautious on lowering policy interest rates, Latin America has seen a broad rate-cutting cycle that expanded this month to include Mexico.

It’s true that some Latin American central banks that were quick to cut are now turning more cautious – notably Chile and Peru.

But we believe Mexico and Brazil should both be able to deliver hundreds of basis points of cuts in policy interest rates over the next 24 months.

Mexico’s outlook

After inflation rose to 7.6%, Banxico hiked Mexico’s official overnight rate to 11.25% in March 2023. Rates remained at that level until February, pushing inflation down to 4.4%.

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In March, Banxico confirmed the beginning of an easing cycle with a broadly anticipated 25-point cut to 11%.

A supporting statement suggested easing would continue through the bank’s next few meetings, which was a positive surprise for markets.

At the time of writing, the consensus holds that Mexican policy rates will decline to 9.5% this year and 7.5% by the end of 2025.

Mexican economic data has softened in recent months, due to a slow in service activity and expectations of reduce agricultural production due to drought.

But overall the Mexican economy continues to do well, supported by a strong US economy.

Mexico’s Purchasing Managers Index (PMI) – a measure of business activity – is well above 50, which indicates manufacturing is expanding.

Fourth-quarter (2023) GDP growth of 2.5% was above expectations and unemployment has declined to near record-low levels.

In addition, we can expect some stimulus ahead of Mexico’s general election, scheduled for June 2.

This economic success comes despite a very high level of real interest rates. A rate-cutting cycle should prove supportive of domestic demand growth and corporate earnings growth.

Brazil outlook

Meanwhile, the rate-setting committee of Brazil’s Banco Central do Brasil unanimously voted for a sixth cut of 50 basis points, bringing rates to 10.75%. (CPI inflation is at 4.5%). A BCB statement shortened the horizon of guidance to only a 50-point cut in May. After this, policy decisions would be data dependent.

Consensus foresees policy rates at 9% this year and 8.5% by the end of next year.

The central bank’s more cautious guidance reflects strong economic growth in the first part of this year.

PMIs look very strong, retail sales and services output have surprised to the upside, and January’s economic activity index rose 0.6%, following an increase of 0.82% in December.

As in Mexico, drought may reduce agricultural output, but not enough to drag down the broader economy.

Lower-than-expected rates

So both countries are experiencing significant rate cuts amid growing economies.

But the Pendal Global Emerging Markets Opportunities team expects a significant positive surprise in the quantum of cuts.

Our model for the interaction between emerging economics and financial markets emphasises reflexivity, where each feeds the other.

We believe the history of booms and busts in individual emerging markets is driven by a process where, generally, everything goes right at the same time, or everything goes wrong at the same time.

In Latin America that tends to mean interest rates overshoot expectations (up or down) through the cycle.

We do not expect this cycle to be any different.

We think interest rates in both Mexico and Brazil will come in much lower than consensus expectations in coming quarters.

This should bring an even more-positive boost to economies, corporate earnings and equity market returns.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
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