Brazil Goes From Bad to Worse

Brazil Goes From Bad to Worse

Due to a perfect storm of economic, political, and global factors, Brazil is the clear underperformer in EM across all asset classes.  We believe this will continue well into 2016, with little relief seen in any of the problem areas.

INTRODUCTION

Due to a perfect storm of economic, political, and global factors, Brazil is the clear underperformer in EM across all asset classes.  We believe this will continue well into 2016, with little relief seen in any of the problem areas.  The latest trigger for Brazil selling stems from reports that the government now expects a primary deficit in 2016 instead of a surplus.

POLITICAL OUTLOOK

The source of tension in Brazilian politics may be shifting.  The risk of an imminent impeachment process is not has high as many fear, in our view.  Our understanding is that Dilma’s opponents have no desire to take power while the economy is still in freefall.  Rather, they are likely content to let Dilma continue to take the heat for the poor economy and then sweep into power in the 2018 elections.  Latest poll shows that only 8% think she is doing a good job, while two thirds said they support her impeachment.

While we downplay impeachment risks, the political backdrop is still deteriorating enough to scuttle any hopes of deep fiscal adjustment.  The most important member of the government coalition (the PMDB) is threatening to split from the ruling PT.  In particular, Vice President Temer is reportedly set to leave his post as political coordinator.  This would only compound the growing concerns of fiscal slippage relative to the initially ambitious plans of Finance Minister Levy.

The “Carwash” corruption scandal is likely to continue generating negative headlines.  The latest reports from local press suggest that former President Lula used his influence to boost BNDES financing to win projects for Brazilian companies in Cuba.  Lawmakers will reportedly ask Lula and company officials to testify on this matter soon.  If Lula is drawn deeper into the quagmire, the chances of him running for president again in 2018 will fall, which markets would see as a positive development.

ECONOMIC OUTLOOK

Press is reporting that the government now expects a primary deficit in 2016, instead of the previously expected surplus.  If true, this suggests that Dilma is no longer confident that the necessary fiscal adjustments can be made.  An even more negative take would be that she no longer WANTS to undertake the needed fiscal tightening, which would set up a clash with Finance Minister Levy.

We think the case for Brazil losing its investment grade rating keeps getting stronger and stronger.  That loss is possible in Q4, but becomes very likely by Q1 2016.  The fiscal numbers keep getting worse, so why should the agencies wait?  The nominal budget deficit was -8.8% of GDP in July, the highest since January 1998, when the data series first began.

Simultaneous pro-cyclical monetary and fiscal tightening has had the expected impact on the economy.  GDP contracted a worse-than-expected -2.6% y/y in Q2, while the weekly central bank survey now shows consensus for 2015 at -2.3% and for 2016 at -0.4%.   We think risks to these forecasts remain to the downside.  And yet inflation continues to make new cycle highs, with IPCA rising 9.57% y./y in mid-August.  This is the highest since December 2003, and above the 3-7% target range.

Meanwhile, COPOM meets Wednesday and is expected to keep rates steady at 14.25% after hiking at every meeting since last October.  We think there is a small chance of a hawkish surprise here, as inflation and inflation expectations continue to rise.   However, higher rates have so far done nothing to support the currency and so the central bank may be tempted to stand pat.

INVESTMENT OUTLOOK

The real is the worst performer this year in EM, down 27% YTD.  The next worst are COP at -23% and TRY at -20%.  A new cycle high near 3.68 was established today, and the pair should eventually test the all-time high near 4.0 from October 2002.  Indeed, we see a risk of an overshoot that establishes new all-time highs for this pair above 4.  Our EM FX model taps BRL to underperform in EM over the next three months.

Brazilian stocks have underperformed within EM this year.  MSCI Brazil is -34% YTD, and compares to -15% YTD for MSCI EM.  The only worse performer in EM is Colombia at -37% YTD.  Our EM equity model taps Brazil to underperform in EM over the next three months, and is at the bottom our league table.  Foreign equity investment (as reported by Bloomberg) had been fairly strong through mid-July, peaking at $7.4 bln YTD.  Outflows have since picked up, dropping the YTD total to about $6 bln now.

Brazilian local currency government bonds have underperformed this year.  Its 10-year yield has risen 192 bp, the second worst EM performer and behind only Turkey at +209 bp.  The group of worst performers also includes Peru (+191 bp), Colombia (+104 bp), and Indonesia (+96 bp).  We think that a potential end to the COPOM easing cycle coupled with a rising inflation environment will continue to be factors behind further underperformance, with a bearish curve steepening likely to continue.