Politics and Economics Continue to Kneecap Brazil

The economic and political backdrops for Brazil have conspired to keep its assets underperforming this year. We believe this toxic mix will continue and perhaps even worsen, keeping downward pressure on Brazilian markets ahead.

INTRODUCTION

The economic and political backdrops for Brazil have conspired to keep its assets underperforming this year. We believe this toxic mix will continue and perhaps even worsen, keeping downward pressure on Brazilian markets ahead.

POLITICAL OUTLOOK

There is still a lot of uncertainty regarding the political landscape.  Recent reports that former President Lula is being formally investigated for corruption has a mixed narrative, depending on the time frame.  Over the short run, it’s clearly negative.  Rousseff’s government remains deeply unpopular, and Lula’s potential exit from the political narrative will most likely hurt the current government more.  Members of her own party and of coalition partner PMDB are already balking at fiscal tightening efforts, and this would only get worse.

From a longer-term perspective, we think that the potential removal of Lula from the equation in 2018 (if Rousseff lasts that long) has positive implications if it means that the PT is voted out of office.  While many believed that Brazil was prospering under PT policies, it’s become clear that Brazil was prospering DESPITE the PT.  It was largely a matter of luck that Lula came into office just after the commodity boom started in 2002.

On top of this, authorities have continued to expand the ongoing “Carwash” probe.  Today, police detained Eletrobras Termonuclear CEO Pinheiro da Silva in connection with the alleged bribery scheme involving construction companies building a nuclear plant.  Officials from Brazilian builder Andrade Gutierrez have also been arrested.  All in all, police are complying with 30 court orders for arrests, searches, and testimonies in this latest phase.

Bottom line:  politics are likely to distract the government and/or prevent it from undertaking the needed measures to get the economy back on track.  We believe impeachment remains a tail risk, but that tail is getting fatter as the corruption probes expand.

ECONOMIC OUTLOOK

Brazil central bank meets tomorrow and is widely expected to hike the SELIC rate 50 bp to 14.25%.  After that, expectations for one last 25 bp hike to 14.5% at the September meeting are mixed.  CDI rates are pricing in one more hike, while the weekly central bank survey shows analysts have pared back expectations now to no more hikes.  We side with the former.

Earlier Wednesday, Brazil reports June PPI.  On Thursday, it reports July IGP-M wholesale inflation, expected to rise 7.0% y/y vs. 5.6% in June.  Mid-July IPCA rose 9.25% y/y, the highest since December 2003.  Price pressures should continue to build, and will keep pressure on the central bank to continue hiking rates.

Yet the recession is deepening.  GDP is tracking at -4% y/y in Q2, down from -1.6% y/y in Q1.  The external accounts have stabilized, but only because imports are collapsing faster than exports.   The effects of ongoing monetary and fiscal tightening have yet to be fully felt.  Add in the continued swoon in commodity prices, and it seems likely that growth forecasts are being overly optimistic.  IMF sees -1.5% in 2015 and 0.7% in 2016, while Bloomberg consensus is -1.5% in 2015 and 0.8% in 2016.

On the fiscal side, central government budget data for June will come out Thursday, followed by consolidated budget data on Friday.  With the economy getting worse, we see downside risk for the fiscal numbers ahead.  We think that the government’s recent adjustment to the primary surplus target could be the trigger for a Brazil rating downgrade.

In our most recent round of our EM sovereign ratings model, Brazil’s implied rating fell a notch to BB+/Ba1/BB+.  Actual ratings of BBB-/Baa2/BBB are thus subject to increasing downgrade risk as the fiscal numbers continue to worsen.  Indeed, the government’s recent cut in the primary surplus target for this year could be the trigger for a downgrade.  Brazil has been rated investment grade by all three agencies since 2009.

INVESTMENT OUTLOOK

Brazil bonds have largely underperformed, with 10-year local currency government bond yields up 70 bp YTD.  This is behind only Turkey (+171 bp), Peru (+132 bp), and Indonesia (+71 bp).  With domestic inflation set to move higher, we think the long end of the Brazil remains vulnerable.

Sinking commodity prices and concerns about the political and economic backdrop have all conspired to drag Brazilian stocks lower.  It’s the second worst performer this year in EM, second only to Colombia (as measured by MSCI, at -22.7% and -26.7%, respectively).  The Bovespa had fallen 7 straight days before today’s bounce.  However, this year’s low near 46485 from January is still within sight.  The 2014 low near 45000 is right below that, as is the 2013 low near 44100.  Clean break below the 46116 area would target the 2008 low near 29435.

USD/BRL has fully retraced all of the March-April drop and is making new multi-year highs above 3.40.  Using a long-term time frame, charts suggest a test of the October 2002 all-time high near 4.00.  Given that we are still seeing the ongoing end of the commodity super-cycle that began back in 2001-2002, there’s no reason to think that BRL (and many other EM currencies, for that matter), won’t revisit the lows from that period too.