Recent Brazil Developments Are Mostly Negative

Brazil (2)

Recent developments in Brazil, both economic and political, are worth discussing. Corruption is in the headlines again even as the economy remains in deep recession. External developments are not friendly to Brazil and EM in general, and so we think further underperformance is likely for Brazil assets.   

POLITICAL OUTLOOK

Political risk has been rising. Last month, President Temer’s top congressional liaison was implicated in an influence peddling scandal. Government Secretary Lima resigned after former Culture Minister Calero claimed that he was pressured into authorizing a construction project that Lima had financial interest in. Lima’s exit could potentially harm the government’s efforts to get bills passed by congress.

More than 60 Odebrecht executives have reportedly entered into plea bargains with regards to the Carwash corruption scandal. The agreements will include $2.5 bln in fines paid to both Brazil and the US. More importantly, markets are concerned that as part of the deal, the executives will eventually implicate major government officials and lawmakers.

The lower house passed a watered-down package of anti-corruption measures last week. The bill failed to impose tougher penalties for so-called illicit enrichment. Of course, this is bad optics given the fact that many lawmakers are already being investigated for corruption and kickbacks.

Large-scale anti-corruption protests were seen in several major cities over the weekend. In particular, demonstrators targeted Senate President Calheiros, who is facing three charges of illicit enrichment. It’s worth noting that Calheiros is being viewed as the villain here, not Temer. This is certainly positive, but it remains to be seen if Temer can continue to dodge the wrath of the protestors.

October municipal elections saw gains by the opposition PSDB. The ruling PMDB did not fare well, though not as badly as the PT, which was roundly punished for the same poor economic record and corruption that cost Rousseff the presidency. A lot can happen between now and scheduled national elections in October 2018, but a poor economic outlook is likely to weigh on the ruling PMDB. Temer’s is not expected to run then, but his still-low popularity could weigh on his party’s candidate.

ECONOMIC OUTLOOK

The economy remains mired in recession. From the latest weekly central bank survey, GDP is forecast to contract -3.4% this year before recovering modestly to grow around 0.8% in 2017. GDP contracted -2.9% y/y in Q3. This was slightly better than expected, but it was still the tenth straight quarterly contraction. The slower than expected pace of monetary easing (see below) means that the recovery will most likely be delayed and perhaps shallower as a result. Some microeconomic stimulus measures will reportedly be unveiled soon.

Price pressures are still easing, with IPCA inflation rising 7.64% y/y in mid-November. Full November data will be released Friday, and is expected to rise 7.09% y/y. If so, this would be the lowest rate since January 2015, and suggests that the central bank will continue easing. COPOM cut rates 25 bp to 13.75% last week, as expected. However, it offered hints that the cuts could be accelerated. COPOM next meets January 11, and we see some potential for a 50 bp cut then. However, much will depend on the exchange rate and external developments.

Fiscal policy has been tightened, but recession continues to hurt revenues. October data was boosted by the one-off impact from the tax amnesty program. As such, we believe that the November and December data will revert to the worsening trend. Consensus forecasts see the budget deficit coming in around -9% of GDP in both 2016 and 2017, up from -8.2% in 2015.

Some fiscal reforms have passed, while others remain in the pipeline. The lower house recently passed a constitutional amendment to cap fiscal spending, but it still needs to be passed by the Senate. Pension and social security reforms are likely to be sent to Congress this week. As we noted above, recent political developments could slow or even halt the government’s progress in passing reforms.

The external accounts have improved sharply, but for the wrong reasons. Import compression due to ongoing recession was the main driver behind the improvement. That should change as exports rebound from the sharp bounce in iron ore and oil prices. The current account gap was -1.25% of GDP in October, the lowest since October 2009. The gap is expected to remain low at -1.2% in 2017 before widening slightly to -1.5% in 2018.

FDI inflows currently cover almost 3 times the current account gap. Foreign reserves peaked for the year at $370 bln in September before falling modestly in October. At $367.5 bln, they cover over 18 months of import and are about 5 times larger than short-term external debt. The central bank’s FX intervention is done off-balance sheet, and thus have no direct impact on reserves.

INVESTMENT OUTLOOK

The real has generally outperformed this year after a poor 2015. In 2015, BRL lost -33% vs. USD. This was ahead of only the worst performer ARS (-35%). So far this year, BRL is up 15% YTD and is lagging only the best performer RUB (+16%). Our EM FX model shows the real to have WEAK fundamentals, so this year’s outperformance can be viewed as unwarranted.

Despite the recent bounce, USD/BRL has not yet surpassed the minimal 38% retracement target from this year’s drop near 3.51. The 50% and 62% objectives come in near 3.64 and 3.76, respectively. The central bank should continue to adjust its FX swaps program as needed to help manage the currency.

Brazilian equities have outperformed this year after a poor 2015. Last year, MSCI Brazil was -42% while MSCI EM was -17%. So far in 2016, MSCI Brazil is up 49% YTD, and compares to a7% YTD gain for MSCI EM. This outperformance should ebb a bit, as our EM Equity model has Brazil at a VERY UNDERWEIGHT position.

Brazilian bonds have outperformed this year. The yield on 10-year local currency government bonds is about -434 bp YTD. This is the best performer in EM, and is well ahead of the second best Peru at -162 bp. With the inflation trajectory a bit uncertain due to BRL weakness and the central bank thus likely to remain cautious in easing, we think Brazilian bonds may start underperforming more.

Our own sovereign ratings model shows Brazil to be correctly rated by all three agencies at BB/Ba2/BB. Fitch retained its negative outlook on Brazil last month, and both S&P and Moody’s also have negative outlooks from earlier this year. For now, we do not think further downgrades are warranted.