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Economic activity held up well in the first half of the year, but a slowdown in GDP growth is coming and expected to intensify over the second semester. The recovery of the labour market continues. However, the retreat of unemployment has come at the cost of a temporary drop in productivity. Inflation, which has registered double digits growth over the past nine months, is spreading more widely throughout the economy. Looking forward, monetary policy could be increasingly constrained by the announcement of new fiscal support. The latter coupled with the continued weakening of the main fiscal rule could weigh on risk premia and inflation expectations. The enthusiasm that prevailed earlier in the year for Brazilian assets is losing steam.

Peruvian GDP returned to its pre-crisis level thanks to the strong upturn in activity recorded in 2021. However, the country’s capacity to rebound further is limited and short-to-medium-term growth prospects are moderate. Firstly, inflation pressures are weighing on private consumption and disruptions in the value chains are hampering the export sector. Secondly, the continuing political crisis is dampening the investment outlook. In addition, public finances have deteriorated over the past two years. It is not so much the level of debt, which is still moderate, but its composition which is worrying and is making the country more vulnerable to changes in investor sentiment.

As of late, political risk has not weighed as heavily as expected on investment flows into Colombia. The strong rise in oil prices this year (+50% for a barrel of WTI crude year-to-date) coupled to the country’s distance from the Ukrainian conflict and the Central Bank’s more aggressive stance since January (+300 bps rate hikes) have helped support investment inflows and have trumped, so far, concerns over the high level of uncertainty surrounding the upcoming presidential election (1st round on May 29th). Foreign direct investments (FDI) in the hydrocarbon sector (2/3 of total FDI on average) have continued to recover quite strongly and have not been fazed by the possible interruption of new oil and gas developments – proposed by poll-leading candidate Gustavo Petro.  Meanwhile, foreign portfolio investors – despite episodic sell-offs – have remained net buyers of Colombia securities.      The prospects of potentially higher public spending and taxes are however affecting credit risk premia and feeding outward capital flows by households.  The 5-year sovereign CDS spread – after widening in 2021 on the back of social protests and the loss of Colombia’s investment grade status – is still about 100 bps above its historical average despite the economy’s strong recovery from Covid-19 and a favourable commodity price cycle. Gustavo Petro’s promise to tax the rich is also prompting some households to increasingly hold assets overseas. An additional USD +1.5 bn in currency and deposits was held abroad in 2021 compared to the average over the period 2016-2020. This trend could further accelerate depending on the outcome of the election.

Brazil ended 2021 on a stronger footing than expected, but the economic picture remains fragile. Activity tends to progress in spurts, curbed by internal brakes (Omicron wave, climatic vagaries, elections) and a more degraded external environment (war in Ukraine, trading partners’ economic slowdown, etc.). Meanwhile, inflationary pressures are building up and raise the specter of continued monetary tightening.  Since the start of the year, the improvement in Brazil’s terms of trade and wide interest rate differentials with developed economies have fueled the rebound of the equity market and spurred a strong appreciation of the real. Such developments highlight a form of dissonance between the real economy and assessments of financial markets.  

The direct consequences of the war in Ukraine on the Mexican economy should remain limited, because trade links are almost non-existent. However, indirect consequences could have a significant impact on an economy that has already been weakened by the Covid-19 crisis. Higher commodity prices will increase inflation pressure and worsen the current account deficit in Mexico, which has been a net importer of energy since 2015. In addition, supply chain disruption arising from the conflict and new coronavirus variants could drag down exports. The investment outlook is continuing to deteriorate as discussions about reforming the energy sector continue.  

Colombia’s public finances have come under the spotlight in recent years amidst recurrent adverse external shocks, rising social spending pressures, ongoing challenges in raising revenues, persistent (optimistic) biases in fiscal planning and, as of late, the back loading of fiscal consolidation plans following the Covid-19 shock. The rapid progression of the public debt ratio and the capacity for future policy adjustment have, in particular, become points of concern and have, since the summer 2021, materialized in Colombia losing its investment grade status. However, overly focusing one’s attention on debt levels, debt dynamics or the speed of fiscal adjustment to assess fiscal sustainability in Colombia can lead to overlook important risk-mitigating aspects of the sovereign’s credit profile. Despite facing a challenging scenario of its underlying debt drivers, the sovereign maintains a solid capacity to support debt backstopped by a favorable interest-to-growth differential, low contingent liabilities, a manageable debt-servicing burden and a sound institutional framework. Looking forward, engaging the broadest swath of society in shaping fiscal policy represents a significant challenge that could – if done inclusively – pay important dividends in terms of both economic and fiscal outcomes.

Despite the acceleration of the vaccination campaign, the anticipated rebound of growth in H2 2021 did not materialize. Instead, the economy fell into a recession in Q3 while available indicators for Q4 continued to show signs of weakness. Meanwhile, binding aspects of the spending cap have been called into question translating into an increased defiance of the market towards the sovereign. As the general election looms (October), economic prospects are expected to be very mild.  Uncertainties regarding the evolution of the epidemic, the electoral cycle, the fiscal trajectory, the persistence of inflation and the tightening of monetary and financial conditions are all expected to act as potential brakes on the recovery.