Peru Tightening Cycle Draws Nearer

new peru

Peru reported higher than expected inflation for June, cementing the end of the easing cycle.  Indeed, markets will have to start thinking about the start of the tightening cycle as the economic recovery picks up.  For now, markets have taken PPK’s resignation well.

POLITICAL OUTLOOK

President Pedro Pablo Kuczynski (PPK) resigned in March and was replaced by his Vice President Martin Vizcarra.  PPK was facing a second impeachment vote but resigned after tapes were released of his allies attempting to buy votes to prevent his impeachment.  PPK had survived the first vote in December triggered by the Odebrecht campaign finance scandal.

Vizcarra has pledged to root out corruption, creating a Secretariat of Public Integrity.  He is also focusing on infrastructure spending.   The Odebrecht scandal led the construction sector to halt projects worth billions of dollars, that now need to be restarted.  Some estimate that the impact shaved as much as 1.5 percentage points off GDP growth last year, and that it could shave off another percentage point this year.

Other politicians have been implicated in the Odebrecht scandal.  A senior Odebrecht said his company donated millions of dollars to the campaigns of at least six Peru politicians between 2006-2013, including opposition leader Keiko Fujimori.  In return, they were expected to award tenders to the company.  Former President Humala has been jailed in connection with this case, while former President Toledo was ordered arrested.  He remains in the US as a visiting scholar.

Parliamentary and presidential elections are scheduled for mid-2021.  2016 runner -up Keiko Fujimori is likely to run for president again.  An independent bid from Kenji Fujimori (Keiko’s brother) also seems likely after he was expelled from Keiko’s Popular Force (PF).  Veronika Mendoza of the left-wing Broad Front came in third in the first round of the 2016 presidential vote with 19%, and so she too may run again.

Peru scores well in the World Bank’s Ease of Doing Business rankings (58 out of 190).  The best components are getting credit and registering property, while the worst are paying taxes and starting a business.  Peru does slightly worse in Transparency International’s Corruption Perceptions Index (96 out of 180) and tied with Brazil, Colombia, Indonesia, Panama, Thailand, and Zambia.  

A BRIEF HISTORY LESSON

Peru saw a period of intermittent military rule after World War II ended.  Fernando Belaunde Terry ran for president several times starting in 1948, but was unsuccessful against the numerous military-backed candidates that ran against him.  Belaunde finally won in 1963, but his first term ended with a military coup in 1968.

In 1980, military rule ended with the re-election of President Belaunde.   Unfortunately, he inherited an economy that was in bad shape from years of mismanagement.  Furthermore, the takeoff of the global coca trade during his term also fed into growing instability in Peru.  Insurgent movements such as the Shining Path and Tupac Amaru Revolutionary Movement grew stronger, helped in large part by alliances with the narcotics traffickers.

Due to the poor economic outlook and growing terrorism, Belaunde lost the 1985 election to Alan Garcia.  This was the first democratic transfer of power in four decades for Peru.  Unfortunately, Garcia was unable to right the economy and so ushered in a period of hyperinflation in 1988-1990.  Terrorism flourished as the economy foundered under Garcia.

Relative unknown Alberto Fujimori was elected President in 1990.  He administered economic shock therapy to end hyperinflation.  Privatization helped bring in foreign investment, but he grew increasingly autocratic.  Fujimori dissolved Congress in 1992 and then eliminated the Constitution before calling new elections.

Fujimori served two five-year terms and ran for a controversial third in 2000.  He won but shortly after taking office, a bribery scandal involving his intelligence chief Vladimir Montesinos brought down the government.  Fujimori fled to Japan that November to escape corruption charges.  However, he was arrested while visiting Chile in 2005 and was extradited to Peru to face trial.  Fujimori was serving time in prison when then-President Kuczynski gave him a humanitarian pardon in 2017.

ECONOMIC OUTLOOK

The economy is picking up.  GDP growth is forecast by the IMF at 3.7% in 2018 and 4.0% in 2019, up from 2.5% in 2017.  GDP rose 3.2% y/y in Q1, the fastest rate since Q3 2016.  April GDP jumped 7.8% y/y, but this was largely due to a low base effect.  If President Vizcarra can jumpstart his infrastructure spending plans, we see upside risks to the growth forecast.

Price pressures are rising, with CPI inflation at 1.4% y/y in June.  This is the highest since November and back in the 1-3% target range for the first time since February.  Core inflation has steadied at the cycle low of 2% y/y, while WPI inflation picked up to 1.3% y/y in May, the highest since August.  This argues for tighter monetary policy ahead.

The central bank meets July 12 and is expected to keep rates steady at 2.75%.  The bank last cut 25 bp in March.  Looking ahead, we see a shift to a more hawkish stance in Q3 and a potential rate hike in Q4.  This would be similar to what we are seeing in neighboring Chile, whose central bank recently signaled that its first hike is likely in Q4.

The fiscal outlook is worsening despite rising commodity prices.  The nominal budget deficit widened to an estimated -3.1% of GDP in 2017, and is expected to rise further to -3.4% in 2018 before narrowing to -3.0% in 2019.  Much will depend on metals prices, as copper and gold account for a large part of the government’s revenues.  Stronger growth would also help the nation’s finances.

Finance Minister David Tuesta resigned recently after the government watered down his plan for tax hikes.  He was replaced by Carlos Oliva, who nevertheless pledged to improve the fiscal trajectory.  Oliva served as Deputy Finance Minister in the Humala administration, and has also sat on the central bank board.  What Oliva does next bears watching.

The external accounts are improving.  The current account deficit was an estimated -1.3% of GDP in 2017, the smallest annual deficit since 2009.  The IMF expects the deficit to narrow to -0.7% of GDP in 2018 before widening to -1.1% in 2019.  Higher commodity prices have helped boost exports, and this has led the external accounts to improve.

Foreign reserves have fallen in recent months but remain near record highs.  Gross reserves were $60.1 bln in May, down from the all-time high of $64.4 bln in January.  They cover nearly 13 months of imports and are about 8 times the stock of short-term external debt.  As such, external vulnerabilities are extremely low.

INVESTMENT OUTLOOK

The sol is outperforming after a subpar 2017.  In 2017, PEN rose 4% vs. USD and was ahead of only the worst EM performers ARS (-14.5%), TRY (-7%), BRL (-2%), IDR (-1%), PHP (-0.5%), and COP (+0.5%).  So far in 2018, PEN is -1.5% and is behind only the best performers COP (+2%) and MYR (+0.2%).  Our EM FX model shows the sol to have STRONG fundamentals, and so this outperformance should continue.

Peruvian equities are outperforming after a solid 2017.  In 2017, MSCI Peru was up 33% vs.  34% for MSCI EM.  So far this year, MSCI Peru is up 4.5% YTD and compares to -8.5% YTD for MSCI EM.  This outperformance should ebb, as our EM Equity model has Peru at an UNDERWEIGHT position.

Peruvian bonds have underperformed this year.  The yield on 10-year local currency government bonds is +42 bp YTD.  This is behind only the worst performers Turkey (+489 bp), Argentina (+226 bp), Hungary (+164 bp), Indonesia (+145 bp), Brazil (+135 bp), the Philippines (+127 bp), India (+52 bp), and Czech Republic (+43 bp).  With inflation likely to rise and the central bank easing cycle over, we think Peruvian bonds will continue underperforming.

Our own sovereign ratings model shows Peru’s implied rating steady at BBB+/Baa1/BBB+.  As a major copper exporter, the fall in prices fed through into weaker fundamentals last year.  However, the outlook has improved and actual ratings of BBB+/A3/BBB+ appear to be largely on target.