Brazil Update

In this piece we provide a cross-asset, high-level take of our view on Brazilian markets. Our time horizon is the next few months. In short, we are positive on equities, negative on the currency and take a neutral position on local rates, resisting the temptation to push against the steepness of the curve.

 

EQUITIES

Despite a grim economic outlook, we see several potential tailwinds for Brazilian stocks from a top-down perspective. We think that Brazil has some ground to catch up and it could outperform in the near term. That said, we recognize that the broad direction will be dictated mostly by exogenous factors in these uncertain times. Here is a non-exhaustive list of the positive factors, in no particular order:

  • The rise of domestic retail investors: The rapid decline in Brazil’s interest rates has driven a large cohort of savers to search for returns elsewhere. The latest figures show a dramatic jump in registered retail trading accounts to nearly 2.5 mln as of May, up over 40% from last year. And of course, these investors are likely long biased and seem to be brave enough to buy on dips. They could represent a continued inflow of funds into the market as lower rates push them out of fixed income investments.

 

  • Brazil is unloved by foreigners. Both flow data and anecdotal reports suggest that foreign investors have been cutting exposure to local assets for some time. Their share of transacted volume had been declining for most of last year, though it picked up again in the last few months. In any case, the still elevated foreign investor volume has been mostly due to them divesting of local assets. This means that foreigner investment flow represents a potential upside risk to local markets, especially now that hedging the currency risk has become so cheap. We are not saying this inflow is going to happen, just that positioning looks favourable from this point of view.

3) Recovery basket: Some of the bigger names in the Brazilian index could enjoy a post-Covid global reflation trade boost. Think Petrobras and Vale, for example. The former has already seen substantial gains on the back of higher oil prices and output cut by some of its competitors. The latter could be a big beneficiary of global government led-spending during the next stage of the recovery, especially if there is a focus on infrastructure. Moreover, many Brazilian exporters could still see positive spillovers from a rekindling of the US-China trade war, or even a gradual decoupling of their economies. Lastly, exporters are enjoying a sizable competitiveness boost from the trade-weighted real exchange rate depreciation.

CURRENCY

We don’t think the recent gains in real will continue for much longer and we are inclined to trade USD/BRL with a long bias. This is a consensus view, which we fully support. Again, in no particular order:

  • No carry: Long gone are the days in which Brazil was a carry currency. Brazil implied rate (3-month NDF) has fallen to an incredible 1.7%, from 15% in 2015. It’s now several percentage points below the equivalent rates for MXN, ZAR or IDR.

  • FX as a reliable hedge: The equalization of rate differentials means that local investors have been using the currency as a hedge for their long local risk positions. This was one of the many factors weighing on the currency towards the end of last year and the pre-pandemic part of 2020, and we imagine it will be a more or less permanent feature of the local investment mentality from now on. Moreover, should investment flows from foreigners turn positive, we suspect they will do the same – hedge the currency risk from local exposure. This means that we could get a prolonged rally in local assets but see the real decoupling or even depreciating at the same time.

 

  • Less central bank support: We infer from the actions and communication of the BCB that they are comfortable with a weaker real. This makes sense, in our view. There is no visible risk of inflation passthrough and a weaker currency could help the economy do some of the adjustment after the crisis.

 

LOCAL RATES

We remain neutral on the local yield curve, resisting the temptation to receive rates because of fiscal concerns. The remarkable steepness of the local yield curve stands out against the country’s weak growth prospects and subdued inflation outlook. The risk premium in the CDI curve is such that it implies a small rate hike as early as January 2021. We doubt this will happen, yet the risk-reward for receiving rates is still not good enough. To visualize this risk, just imagine what would happen to the yield curve should Economy Minister Paulo Guedes leave. This is not our base case, but it’s not a tiny tail risk either. A more likely scenario is that President Bolsonaro – having lost much political capital during the pandemic and from corruption allegations – will depend more on centrist political parties to govern. This will further limit the prospects of any meaningful fiscal or reform progress. The curve is steep because there is no fiscal anchor.