Brazilian assets have rallied strongly this year; perceived improvements in the domestic political arena have reinforced a wider improvement in the market’s appetite for emerging market investments. While the macroeconomic picture remains dismal, a resolution of the current political crisis would be a much-needed first step toward an eventual recovery.
The Brazilian real has been the best performing emerging market currency, gaining 13.8% in total return terms and the average yield on the local curve rallied by an astonishing 260 basis points, while the sovereign CDS spread has fallen by 129 basis points, all over the first quarter of 2016. While at current levels, we would argue valuations no longer look particularly cheap, we do see potential for a further positive reaction to headline news on both the political and economic fronts.
Exhibit 1: The Brazilian real has been the best-performing emerging market currency year-to-date through 11/04/16.
Source : Bloomberg 11/04/2016
The path to the potential removal of President Rousseff from office has taken many twists and turns over the past year but none so dramatic as have been observed over the past 6 weeks. First, a high profile member of the ruling PT party, Senator Delcídio do Amaral, agreed to a plea bargain deal with federal prosecutors in exchange for his testimony against former President Luiz Inácio Lula da Silva. Lula was arrested and questioned while several properties linked to him were searched by police attempting to find evidence linking him to the Petrobras 'car wash' corruption scandal. Subsequently, President Rousseff named Lula to a ministerial post in an attempt to shield him from prosecution, with the details of the plan being made public by the release of wiretap recordings between the two.
A change of the guard in Brazil?
These events have been seen by many Brazilian followers as signaling the final death knell for the ruling PT party (Workers' Party) as members and coalition partners leave and the government’s approval rating remains mired in the single digits. There are now three potential mechanisms for a change of leadership in play with impeachment being the most likely.
Firstly, Rousseff could resign: with a fractured party, a strong opposition and the corruption scandal investigations getting closer, governability has reached new lows at a time when deep structural reform is needed.
Secondly, there is the possibility that the Electoral Court invalidates the 2014 election due to breaches of campaign financing rules which would trigger new elections within 90 days of such a ruling. If this was delayed until 2017, an interim president would be elected by Congress rather than voters.
Thirdly, she could be removed through the impeachment process: the required Lower House Committee has been formed and has formally recommended that the case proceed to a full house vote, while polls show 68% voters approve of impeachment. Congress could hold a vote as soon as this coming Sunday (17 April), which if successful, would force Rousseff to step down for 180 days while the process is taken up by the Senate (see footnote below for the outcome). With such an array of obstacles against her, it is becoming less and less likely that the President will finish her term.
Markets welcome the prospect of 'new brooms'
The market has taken a very constructive view of the PT’s demise, and we think the headline effect of Rousseff actually leaving power would be further market positive. Rousseff’s administration has coincided with a period of slow growth, high inflation and abandonment of monetary and fiscal “anchors”, and a change of government increases the probability of a U-turn in economic policy. The likely outcome in any scenario of Rousseff dismissal would be a temporary period of leadership under Vice President Michel Temer of the PMDB party (Brazilian Democratic Movement Party), which has embraced a more conservative economic platform.
Economic news may improve on its own in the meantime. A stronger Brazilian real this year and the roll-off of year-ago effects from the devaluation should show a lower inflation number in coming months: current inflation has already peaked and is falling from last month’s 10.7%. Due to the economic downturn, trade and current account balances have turned up decisively.
Exhibit 2: In our view, the pace of inflation has peaked and has further to fall (graph shows monthly change in Brazilian consumer price inflation via the IPCA (Broad National Consumer Price Index) from 30/04/2010 through 31/03/2016).
To its credit, the central bank employed strong counter-cyclical monetary policy, hiking interest rates during the inflation acceleration, and stands poised to complement the recovery with substantial easing once the fiscal situation is addressed. For 2015, interest payments totaled 7% of GDP on top of the primary deficit of 1.9%. This year should be slightly better on its own, particularly with the currency impact which effectively results in profits on the central bank’s outstanding US dollar swaps position.
We think the real could strengthen to 3.5 to the USD before the unwinding of these positions absorbs financial inflows and curbs appreciation. The carry is attractive relative to other emerging market currencies and we expect further flattening of the curve in the belly as inflation drops back into single digits. Credit spreads remain elevated both by historical standards and relative to Brazil’s ratings peer group, even after recent compression. Despite the recent sharp turn for the better in market sentiment, we do not think that Brazil has run out of good news just yet.
Exhibit 3: The Brazilian real has strengthened in the foreign exchange markets and is now (as of 11/04/16) trading at below 3.5 real to the US dollar.
Source : Bloomberg as of 11/04/2016
Lastly, a word on institutional development and the long-term view for Brazil. Let us not lose sight of what has developed in Brazil over the past two years. Yes, the corruption case has laid bare to the world that Brazilian politicians are not immune to misconduct. It has also made plainly clear that Brazil boasts surprisingly strong institutions that transcend any one government or any one politician:
- an independent judiciary that has investigated and prosecuted the case without hindrance;
- strong rule of law, free from dictatorial infringement;
- freedom of the press, and a healthy and vibrant civil society;
- and once again, peaceful change of leadership following a democratic process according to its constitution.
Note: On 17 April, Brazilian lawmakers in the Chamber of Deputies voted 367-137 to impeach President Rousseff, moving the proceedings to the Senate. See for example Brazil's Rousseff Impeached by Lower House of Congress or Brawls, Sermons and Confetti: Brazilian Impeachments Have It All
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