Investors in Brazil Still Face Risks

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Brazil is poised to accelerate its easing cycle this week.  The economic outlook remains poor, however, while the political backdrop is deteriorating.  We urge caution ahead for investors with exposure to Brazil, as asset prices appear too rich given growing risks.

POLITICAL OUTLOOK

President Temer has had some success with structural reforms, but his efforts are starting to wane.  Temer was able to get congressional approval late last year for a cap on federal spending.  However, Temer’s (and by extension his PMDB’s) popularity is at record lows.  Fiscal austerity, the ongoing recession, and widening corruption probes have all been major factors working against Temer.

Temer will likely serve out the remainder of his term ending December 2018.  Elections will be held in October 2018, with the new president taking office in January 2019.  The PT is in disarray, with former President Lula under investigation and thus may be unable to run.  Given the PMDB’s poor public standing, we believe the next president will likely come from the PSDB, Temer’s main coalition ally.

The top PSDB contenders are currently Aecio Neves, Jose Serra, and Geraldo Alckmin.  However, given the public’s discontent with the political establishment, some believe there is scope for an anti-establishment candidate to win the presidency.  However, local contacts feel that no such candidate has emerged yet.

Controversial pension reforms are the next items on the agenda, and recent press reports suggest the government will water down its plan.  Facing growing opposition in Congress, press reports suggest President Temer will present a new proposal on April 18 that cuts the potential savings by up to 20%.  The original plan projected savings of BRL678 bln over the next ten years. 

ECONOMIC OUTLOOK

The economy is still struggling.  GDP growth is forecast by the IMF to accelerate to 0.2% in 2017 and 1.5% in 2018.  This comes after -3.6% in 2016 and -3.8% in 2015.  GDP contracted -2.5% y/y in Q4, but monthly data so far in Q1 suggest a possible return to positive growth.  As such, we see slight upside risks to the growth forecasts near-term.  Unemployment rate rose to 13.2% in February, the high for this cycle.

Price pressures are falling, with IPCA inflation decelerating to 4.57% y/y in March.  This was the lowest rate since August 2010 and would also put inflation nearly at the center of the 2.5-6.5% target range.  IGP-M wholesale and PPI inflation have both decelerated sharply, pointing to falling pipeline price pressures.

The economic outlook thus supports the case for a 100 bp rate cut when COPOM meets April 12.  It cut rates 75 bp to 12.25% at its last meeting in February, but minutes highlighted a possible acceleration of the pace.  The latest central bank survey saw expectations for the year-end SELIC rate fall to 8.5% from 8.75% the previous week, and was the second straight weekly fall.  If so, that would represent 375 bp of total easing this year.

Fiscal policy has been tightened by Temer.  However, further improvements will be difficult until the economy picks up.  The consolidated budget deficit came in at nearly -10% of GDP in 2016, up from -8.1% in 2015.  It is expected to narrow slightly to -9% in 2017 and -8% in 2018.  However, we see upside risks given the sluggish economy and growing opposition to pension reforms.

Indeed, the government budget forecasts were just revised.  The 2018 central government primary deficit is now seen at -BRL129 bln vs. -BRL79 bln previously.  This is little changed from the 2017 forecast of -BRL139 bln.  In February, the 12-month total for this series was -BRL151.3 bln.

The external accounts bear watching.  Low oil and iron ore prices have hurt exports, but the ongoing recession has helped reduce imports.  The current account gap was -1.3% of GDP in 2016, but is expected to widen slightly to -1.4% in 2017 and -1.7% in 2018.  FDI more than covers this gap.

Foreign reserves rose to $370 bln in March.  They cover over 15 months of import and are over 7 times larger than the stock of short-term external debt.  Taken in conjunction with strong FDI inflows, Brazil’s external vulnerabilities remain very low.

INVESTMENT OUTLOOK

The real has stopped outperforming so much after a strong 2016.  In 2016, BRL rose 22% vs. USD and was the best performer in EM ahead of RUB (+20%), ZAR (+13%), and COP (+6%).  So far in 2017, BRL is up 3% YTD and is lagging the best performers MXN (+11%), RUB (+7%), KRW (+6%), and TWD (+5%).  Our EM FX model shows the real to have WEAK fundamentals, so underperformance should pick up.

For USD/BRL, the 3.10 area has been a pretty solid base of support.  Near-term target is the March 9 high near 3.20.  Retracement objectives from the January-February drop in USD/BRL come in near 3.1660 (50%), and 3.1960 (62%).  Break above those levels would set up a test of the January 3 high near 3.29.   The 200-day MA comes in near 3.2265 currently.

Brazilian equities have started to underperform after a stellar 2016.  In 2016, MSCI Brazil was up 57% vs. 7% for MSCI EM.  So far this year, MSCI Brazil is up 9.9% YTD and compares to up 11.6 % YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Brazil at a VERY UNDERWEIGHT position.

Brazilian bonds have outperformed recently.  The yield on 10-year local currency government bonds is about -134 bp YTD.  This is behind only Argentina (-249 bp) but well ahead of the next best performers Indonesia (-80 bp), Peru (-63 bp), and Colombia (-49 bp).  With inflation likely to remain low and the central bank likely to accelerate its easing cycle this year, we think Brazilian bonds will continue outperforming.

Our own sovereign ratings model shows Brazil’s implied rating at BB/Ba2/BB.  Actual BB/Ba2/BB ratings thus appear to be correct.  The economy remains weak, but we see scope for some improvement in Brazil’s implied rating if the cyclical recovery begins this year.