Latest Thoughts on Brazil (and EM)

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Temer’s presidency is in jeopardy, as is the crucial pension reform bill.  Markets opened in panic mode, but have since calmed after circuit-breakers were triggered. We see further losses ahead.

POLITICAL OUTLOOK

Local press reported that meat-packing company JBS has submitted compromising tape recordings to the Supreme Court.  They reportedly have President Temer approving “hush money” payments to jailed former lower house Speaker Eduardo Cunha.  Temer denies any wrongdoing, but many observers (including us) have long felt that it was only a matter of time before the ongoing “Car Wash” corruption scandal implicated him.

If the recordings are true and released to the public, we see no way that Temer can survive as president.  Some opposition parties are already calling for Temer to step down.  If he does not, then the opposition will push for an impeachment trial.  Some are even floating the idea of annulling the 2014 election.  Fresh elections are not due until 2018.

We think it’s safe to say that if Temer is forced out, the economic reform agenda is dead in the water.  The pension reform vote has already been suspended.  Many were looking for a late May/early June vote, but now it remains to be seen whether a vote will ever be held.  While the situation remains fluid, we think it’s safe to say that markets should be braced for more bad news ahead from Brazil.

 

INVESTMENT OUTLOOK

The real has come under significant pressure today.  BRL futures trading on the BM&F was initially halted by a 6% limit up for the first USD/BRL contract.  The limit was temporarily raised to 9% for today only, but that circuit-break was also triggered.  With the central bank offering 40k swaps contracts today, FX markets have calmed and some BM&F trading has resumed.  However, bid-offer spreads remain wide across Brazilian FX markets.

USD/BRL trading at 3.10 was predicated on successful passage of pension reform and other structural reforms.  That is no longer the base case.  As we’ve long complained, 3.10 was pricing in perfection.  Now, in this imperfect situation, the big question is where should it trade now that this basic assumption of perfection has been turned on its head?

Indicative pricing shows spot USD/BRL high at 3.41 today, though transactions have been extremely limited.  The November/December high near 3.50 seems like a reasonable target.  However, a clean break of the 3.41 area would set up a test of the May 2016 higher near 3.64.

Brazilian equities have also sunk today.  For the Bovespa, the 10% limit down was triggered earlier, halting trading for 30 minutes.  Trading has since resume and the Bovespa is now down “only” 9% on the day.  Here too, equity markets were pricing in perfection, with passage of structural reforms seen allowing aggressive rate cuts to continue, thereby helping the economic recovery.

Currency weakness likely has implications for monetary policy going forward.  We assume that COPOM will have to consider slowing down its aggressive easing cycle, as that was explicitly predicated on significant fiscal reforms being passed.  Next COPOM meeting is May 31, and before these political developments, most were looking for a 100 bp cut to 10.25%.  Some were even looking for 125 bp.  If BRL remains under pressure, we think COPOM will opt for a smaller cut and slow the pace of easing in H2.

Brazilian bond yields spiked today.  The yield on 10-year USD debt is up nearly 50 bp on the day.   The Treasury canceled planned auctions of local currency debt today due to market volatility.  We believe local yields will move higher in the coming days, as bonds too were pricing in perfection with regards to fiscal reforms and rate cuts.

Our own sovereign ratings model showed Brazil’s implied rating improving a notch this quarter to BB+/Ba1/BB+.  Actual BB/Ba2/BB ratings now have some upgrade potential.  The economic outlook is poor, and we now see very limited scope for improvement in Brazil’s implied rating as the virtuous cycle of fiscal tightening, rate cuts, and economic recovery has reached its limits for now.

 

WIDER EM IMPLICATIONS

There is clearly some “contagion” from Brazil developments but it’s hard to say exactly how much, given that EM was already softening yesterday ahead of the Temer news.  The first Globo headline broke last night around 6:41 PM ET.  MXN sold off in several separate waves, as did ZAR and TRY.  EM FX did recover a bit as the Asian session wore on.  Then, the biggest wave of EM selling came during the European morning, just as Asian markets were closing.

So we’d say that Asia EM FX did not feel the full brunt of the negative sentiment yet.  How Asia opens tonight will depend on how markets close today and we think it’s too early to say.  MXN, TRY, and ZAR are off their worst levels of the day but we can’t sound the all-clear yet, to state the obvious.

Let’s face it, EM was due for a correction.  BRL at 3.10, MXN near 18.50, the list goes on.  Markets were pricing in perfection, and we just think there are way too many risks (both country-specific and globally) to warrant such rich valuations across so many markets.  I don’t know yet how far this EM selloff can go, but my gut feeling is that it will not end soon.  To be continued……