Brazil - a long way from Carnival

The near-term outlook for Brazil has taken a dive as political scandals deepen and economic woes mount. Oliver Leyland, Senior Investment Analyst of the Hermes Global Emerging Markets Fund, considers potential outcomes from this turbulence and explains the team’s approach to investing throughout it.

Macro, market malaise

The currency is plummeting, bond yields are rising, and the local stock market is giving up all of its 2015 gains. As a comprehensive barometer of risk, we monitor CDS spreads, which have unsurprisingly moved higher in recent sessions, though are below the heights of March 2015 and yet to price in extreme stress.

Brazil CDS spreads: further to climb?

Source: Bloomberg as at July 2015

Rousseff feels the heat…

The coalition government is splintering and President Dilma Rousseff’s impeachment is becoming a real possibility, after her administration’s approval rating plunged to 7.7% in recent polls. There are two realistic scenarios that could trigger this: first, an accusation of ‘creative accounting’ in the 2014 public accounts, or second, of irregularities in 2014 campaign financing. Should the President be impeached for the former, her Vice President and coalition partner Michel Temer (PMDB) would likely assume the presidency, representing ‘more of the same’ and therefore a continued malaise for the market. Should campaign financing be the cause of impeachment, the coalition government in its entirety would likely have to be replaced, spurring elections and a probable return to power for the opposition and the PSDB under Aecio Neves, the narrow loser in last October’s elections. This outcome would likely result in improved sentiment and risk appetite towards Brazilian markets. An impeachment of the President would not be unprecedented: recall the 1992 impeachment of President Fernando Collor, who was incidentally investigated (with his Lamborghini, Ferrari and Porsche all impounded) as part of the Petrobras ‘Car Wash’ scandal. Not all of Brazil’s institutions can be said to have stopped functioning, however, and in the absence of either growth or stability, at least Brazil’s judicial institutions and democracy remain alive and well.

…As markets go cold on slashed surplus

Compounding the political uncertainty have been economic developments. Last week, the Bovespa lost some of what remaining confidence it had in the Rousseff Administration after the government announced that it would slash the 2015 primary fiscal surplus target from 1.2% of GDP to 0.2%. This is the result of a significant cut to revenue forecasts (lower tax receipts as the recession bites), with no further cuts to spending, and could yet decline to a primary deficit should BRL26bn of ‘extraordinary revenues’ not be realised during the year. A primary surplus of 2% is widely seen as necessary for the stabilisation of the country’s debt. As a consequence, public debt should now continue to increase until at least 2018, raising the risk of a downgrade below investment grade for Brazil’s sovereign debt, which would be the epicentre of economy-wide aftershocks. For 2016, the primary surplus target has fallen from 2.0% to 0.7%, and for 2017 from 2.0% to 1.3%.

In response, the real has hit a 12-year low, and the MSCI Brazil (in dollars) is at levels last seen in November 2008. For an equity market where the short-term bull case is, to a large degree, based upon an improvement in the credibility of economic management and a reduction in the risk premium – rather than a return to sustainable growth – this is certainly damaging.

2015 Budget and first budget directives (BRL bn)

Source: Credit Suisse

For stock pickers, selectivity is essential

August, September and October will be heavy months for news flow in Brazil regarding impeachment, credit ratings, public protests, the ‘Car Wash’ scandal and taxation changes. Several (binary) events could feasibly result in a change of outlook and ultimately government, which could require a reassessment of our views. Brazilian equities are prone to peaks and troughs of euphoria and despair, and overshooting both to the upside and downside is therefore common. Our strategy remains consistent – to wait for good stocks to go on sale, and buy when the price is right (ie. wrong), providing a margin of safety. We currently maintain a material underweight position in Brazil, holding only strong franchises at attractive valuations, including an exporter (which should benefit from BRL depreciation) and two financial companies that will be directly supported by higher interest rates, with the benchmark SELIC interest rate likely to rise beyond 14% in the second half. On a forward-earnings multiple of 11.5x (a 10% premium to its historical average), Brazilian equities currently offer an earnings yield (inverse of the P/E) some 4% below that of the 10-year government bond (13.1%). So a country that may well be attractive to fixed income investors currently offers little valuation support for equity investors, who, like us, must remain extremely selective.

 Calendar of political and judicial events

Source: J.P. Morgan, Arko Advice