Here is an update on the fast moving developments in Brazil, and our take on them.
Firstly, the rally in all assets over the last few sessions has been impressive; the question is whether it is sustainable. In short, we are inclined to view the moves in local rates and sovereign risk premium as most sticky, while those in equity markets and FX less so. The country’s 5-years CDS price fell from a high of 528 bp at the end of September to around 410 bp today. Importantly, the spread has narrowed dramatically against other “risky” sovereigns. We have long advocated that the magnitude of the widening of the spread between Brazil’s and Turkey’s CDS, for example, was unjustified. That spread has now fallen from around 200 bp to 120 bp currently. We think the convergence will continue.
The move in local yields has been just as dramatic. The graph shows the change in shape of the local swap curve over a 1-week period. Contracts expiring in January 2017, for example, are down some 100 bp since their peak in late September. This is the market removing some of the exaggerated risk premium that was implying multiple interest rate hikes over the next few COPOM meetings. Moreover, the move also reflects government intervention in the fixed income markets through bond buybacks. Although we don’t discard the chance of a rate hike, the price action looked more to be panic-driven than anything else. We still think there may be some risk premium to be taken out, especially if the real remains under control.
We are less convinced about equity and FX markets. This is not so much a reflection of our own views on valuation, but rather that these markets are more susceptible to swings in global risk appetite and the broader dollar trend. As such, they offer a less precise way to express changes in the idiosyncratic variables that pertain to Brazil. That said, the step-up in FX intervention by the central bank (and the implicit threat of interventions in the spot markets) should help keep subsequent BRL selloffs in check.
The most important development is the cabinet changes. In short, it happened more or less how we had expected: Rousseff’s PT government ceded huge concessions in exchange for support from its coalition partner, the PMDB. According to calculations by a local newspaper (Valor), the amount of the discretionary budget controlled by the PMDB increased from 6.1% to 21.7% now that it commands important ministries such as Health and Science & Technology. The PT now has 33.5% of the budget under its control. This increases the odds that the government will be able to implement its fiscal agenda, and it also reduces the chances of an impeachment process going through – at least in the short term.
However, one casualty of the reshuffle could be Finance Minister Levy. This is a significant negative risk, in our view, even though his departure is not our base case. The problem is that his replacement is likely to come in the context of a re-gearing of pro-growth policies that are more in line with the PT’s philosophical tradition. Although speculation of his departure is not new, it seemed to have picked up strength as former president (and likely future candidate) Lula becomes more active.
To summarize, Brazil was likely oversold during the September panic that gripped most of EM. Recent developments, both domestic and external, have helped Brazilian assets gain some traction, but it is a fragile balance. While the near-term looks more positive, the country’s fundamental problems and economic challenges are far from being resolved.