Political and Economic Risks To Weigh on Brazil

brazilBrazil’s central bank has unexpectedly turned more dovish.  This comes at a bad time, as political risk remains high even though the Supreme Court has cleared the way for the imprisonment of former President Lula. 

POLITICAL OUTLOOK

The Supreme Court just rejected former President Lula’s plea to remain free while appealing his 12-year prison sentence for corruption.  The vote was 6-5.  Sergio Moro, the judge who prosecuted Lula, can now order him to prison even as the appeal remains ongoing.  We think this latest ruling effectively ends Lula’s chances of running for president again.

Despite his legal woes, Lula still leads the entire field.  A recent MDA poll shows him with 33.4% support and puts him ahead of Jair Bolsonaro (16.8%), Marina Silva (7.8%), Geraldo Alckmin (6.4%), and Ciro Gomes (4.3%).  Lately, President Temer has dropped some hints at making a run, but his low approval rating of 9% suggests his PMDB will not allow this.

Indeed, Finance Minister Meirelles just announced that he is joining the PMDB.  Ostensibly, this sets up his candidacy for the party.  He originally mulled a run as a candidate for his former PSDB party.  Meirelles is well-respected by the markets, but his association with the current and very unpopular Temer administration would likely prevent him from garnering much support from the voters.

Elections will be held on October 7.  At this point, it appears that no presidential candidate will win more than 50% of the first round vote.  A second round vote with the two biggest vote-getters would then be held on October 28.  The entire Chamber of Deputies will be elected, and there is risk of another fractured makeup that prevents passage of structural reforms.

The most important determinant for the election outlook is how Lula’s support is distributed amongst the leftist candidates.  Expect to see new polls emerging soon that exclude Lula.  However, these polls will hold little meaning until Lula picks his successor for his PT.  Whoever it might be, we do not think markets would take kindly to another PT government.

On the right, Bolsonaro is a former army captain with populist leanings.  While that could resonate with voters tired of the seemingly same old corrupt choices, a Bolsonaro presidency entails potentially significant risks.  Much will depend on who Bolsonaro chooses as his economic team.  All in all, we believe markets are underestimating political risk in Brazil.

Brazil ranks poorly in the World Bank’s Ease of Doing Business rankings (125 out of 190).  The best categories are protecting minority investors and getting electricity, while the worst are paying taxes and starting a business.  Brazil does slightly better in Transparency International’s Corruption Perceptions Index (96 out of 180 and tied with Colombia, Indonesia, Panama, Peru, Thailand, and Zambia).

ECONOMIC OUTLOOK

The economy is recovering.  GDP growth is forecast by the IMF at 1.9% in 2018 and 2.1% in 2019, up from 1.0% in 2017.  GDP rose 2.1% y/y in Q4, the strongest since Q1 2014.  PMI readings remain firmly above 50.  With the central bank still easing, we see upside risks to the growth forecasts.

Price pressures remain low, with IPCA consumer inflation at 2.8% y/y in mid-March.  This is down from a peak of 3.02% in mid-January, and remains near the bottom of the 2.5-6.5% target range.  IGP-M wholesale prices rose 0.2% y/y in March is back in positive territory after nine months of y/y decline.  PPI manufacturing is accelerating too.  At 4.7% y/y in February, it’s the highest since July 2016.  We believe caution is warranted with regards to monetary policy.

Yet COPOM continues to cut rates.  After the last 25 bp cut to 6.5% on March 21, it signaled concerns about persistent below-target inflation and signaled further easing.  As such, the CDI market is now pricing in another 25 bp cut to 6.25% at the May 16 meeting.  The dovish tilt took most by surprise, as COPOM had hinted at its February meeting that easing had ended.  We think it is a mistake for the central bank to be so dovish in this current environment where Brazil has many home-grown risks.

The fiscal outlook bears watching.  We are seeing a cyclical improvement in the budget numbers as the economy recovers, but the structural outlook remains poor now that pension reforms are dead in the water.  The nominal deficit was equal to -7.3% of GDP in February, the lowest since April 2015.  The Bloomberg consensus sees the nominal deficit at -7.2% in 2018 and -6.2% in 2019.

The external accounts remain strong.  The current account deficit was -0.38% of GDP in February, the smallest since February 2008 but due mostly to the deep recession.  The IMF expects the deficit to widen to -1.8% of GDP in 2018.  This remains manageable, and should be covered entirely by FDI inflows.

Foreign reserves remain near record highs, at $380 bln in March.  They cover nearly 17 months of imports and are about 8 times the stock of short-term external debt.  As such, external vulnerabilities are extremely low.

INVESTMENT OUTLOOK

The real continues to underperform.  In 2017, BRL fell -2% vs. USD and was ahead of only the worst performers ARS (-14.5%) and TRY (-7%).  So far in 2018, BRL is -1% and is ahead of only the worst performers ARS (-8%), TRY (-6%), PHP (-4%), INR (-2%), and IDR (-1.5%).  Our EM FX model shows the real to have STRONG fundamentals, and so it should start to outperform more.

After a brief relief rally due to the Lula ruling, the real has since given up all its gains.  We believe USD/BRL will move into a 3.35-3.40 range in the coming days, with an eventual target of the May 2017 high near 3.41.

Brazilian equities are outperforming after a subpar 2017.  In 2017, MSCI Brazil was up 21% vs. 34% for MSCI EM.  So far this year, MSCI Brazil is up 10% YTD and compares to up 1% YTD for MSCI EM.  This outperformance should ebb, as our EM Equity model has Brazil at a VERY UNDERWEIGHT position.

Brazilian bonds have outperformed.  The yield on 10-year local currency government bonds is -57 bp YTD and is the best EM performer.  This compares to the next best EM performers Russia (-44 bp), Mexico (-38 bp), and Peru (-34 bp).  With inflation likely to remain low and the central bank seen on hold this week, we think Brazilian can continue to outperform near-term.  Longer-term, rising inflation will likely take a toll and lead to great underperformance.

Our own sovereign ratings model shows Brazil’s implied rating steady at BB+/Ba1/BB+.  Actual BB-/Ba2/BB- ratings remain vulnerable, however, due to the failure to pass pension reforms.  Indeed, Fitch cut Brazil one notch to BB- with stable outlook, citing this failure as a primary reason.  Moody’s has noted that lack of pension reforms is credit-negative and so a downgrade from that agency seems likely too.