Latin American currencies are at record high levels against the USD. Since the millennium started, the currencies of Argentina, Brazil, Chile, Colombia, Mexico and Peru, have never been so depreciated, even considering the crisis of early 2000s especially hitting Brazil and Argentina, and the global financial crisis of 2008.
This has an impact on companies that have exposure to Latin America and can be a good opportunity for investors that have the option to add foreign exchange risk to their portfolios. The current exchange rates make me wonder if Latin American currencies are peaking.
When looking at this pool of countries, Argentina and Brazil can be placed in the same segment in terms of economic fundamentals and apparently governance. Similar to what happened in the beginning of the millennium, both are in or near recession with high inflation levels, budget deficits above 4%, depreciated currencies and a credibility problem. In the last few weeks, media reports have been increasing coverage of the situation in Brazil and economic indicators continue to disappoint, namely those of inflation, which shot over 10%.
Other Latin American countries like Colombia, Mexico, Chile and Peru, have also experienced severe foreign currency depreciation, but at a less aggressive pace. Economic growth in these countries is positive and above 2%, expected to improve in 2016 and inflation is controlled. At fiscal level, things are in a better shape, although in terms of primary budget balance, Brazil still compares favorably to its Latin America peers.
With low commodity prices, most of the current account balances in Latin America are in deficit, something a weak currency should contribute to soften or even revert.
This disastrous foreign exchange performance is not fully consistent with local equity markets, where equities have lost value in the last year but not as much as their currencies against the USD. For example, Brazil was clearly the worst performer at currency level, but in terms of equity, countries like Peru and Colombia lost a lot more.
This suggests that although sentiment towards these countries is negative, namely because they are commodity producers exposed to China and that has been translating into negative equity performance, for the currency to be depreciating at a much stronger pace, other factors may also be in place.
Source: Bloomberg data.
Thinking of factors that could add further depreciation pressure to currencies, we can name: (I) outflows in the current account, (II) loose domestic monetary policy, aggravating the interest rate spread to US, (III) FOMC pricing of the tightening cycle.
In 2015 most Latin American countries with relevant foreign exchange markets posted current account deficits, deficits which are expected to decrease in 2016 as a reflex of bottoming or reverting commodity prices and stronger export sectors on the back of weak currencies. In some countries, such as Brazil, it is already evident the outperformance of exports over imports.
Monetary policy tightening should contribute to the appreciation of currencies. Brazil, Chile, Mexico, Colombia, Argentina and Peru, all have a tight monetary policy; most of them have been raising rates, while most of them are likely to continue doing so, to a larger or lesser extent. Countries that suffered the largest currency depreciations are those that tightened monetary policy the most and those that have higher benchmark rates - Argentina and Brazil, followed by Colombia.
What about FED's influence? Following the release of recent economic indicators in US and the last minutes of the FOMC, it is evident that although the economy is sound and wage pressures are building, inflation is still very low and somewhat reluctant to pick up.
This means that the tightening cycle will continue, but the pricing of a monetary policy tightening, stronger than 3-4 rate rises in 2016 is unlikely in my view. This pace is currently the one priced by the market (implied in CME futures) and expected by a large pool of analysts. In light of a strong USD, low commodity prices and moderate acceleration of wages, it will be hard to trigger an effect similar to the one experienced throughout 2015 and potential for substantial USD appreciation is limited, if any.
The Big Mac Index shows that some Latin American currencies are among the most undervalued against the USD, namely Venezuela, Argentina, Mexico and Chile. The BRL, although not being as undervalued according to this index, as other Latin American peers, it is among the currencies that moved faster from over to under valuation in the period considered - July 2014 to January 2016. It's also interesting to see that the BRL is not as undervalued by this measure as other Latin American peers, which may be a consequence of high inflation levels.
In this environment, I expect to see a reversal of USD appreciation against Latin American currencies. Although current market conditions don't support the immediate beginning of such movement, it is likely to start in the end of the first quarter, after some moderation of expectations towards emerging markets, which currently are suffering the influence of events in China and recurrent headline news about commodity prices.
It is also hard to explain further depreciation of the currencies from current levels, given local and global monetary policy stances. Among these currencies the BRL may appear very attractive given the strong depreciation experienced in 2015, but political noise in Brazil, may limit a more pronounced appreciation.
2016 will be a peak year for foreign exchange depreciation in Latin America, as both US and local monetary policies feed through, and that may well mark the first quarter.
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