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March 2017

Update on Brazil

From Rio to Brasilia

  • With the Olympic Games underway, many eyes are on Rio de Janeiro. Yet it is the developments in Brasilia that will likely be more important to investors.
  • Economic data suggest the recession in Brazil is bottoming out, but the country remains fragile. Ultimately, politics continue to be the key variable in the outlook.
  • Stocks have risen sharply this year. Further gains will likely require stronger earnings, continued progress on reform and resolution of political turmoil, but Brazil may be worth a second look.

Figure 1. Inflation down and confidence rising

Figure 1: Inflation down and confidence rising

Source: Bloomberg, as of 8/2/2016.

After two years of deep recession, the economic fundamentals of Brazil are showing signs of bottoming out. Industrial production has started to turn, and so have sentiment indicators, with business confidence indexes leading the way (see Figure 1). Particularly encouraging are the improvements in the inflation trend. Prices have been easing since early 2016, and the central bank’s renewed focus on bringing down inflation has also helped lower inflation expectations for the year ahead. This has raised hopes for monetary policy easing: according to Bloomberg, investors now anticipate that the central bank will start cutting rates in the fourth quarter, which may be supportive of a recovery in economic activity. But Brazil remains in a fragile situation. Economic imbalances such as weak fiscal accounts, high levels of debt and unemployment need to be addressed (see Figure 2). The reforms necessary to fix the Brazilian economy are complex and in many instances unpopular with the public, making this a significant challenge for any government.

Figure 2: GDP and fiscal balance

Figure 2: GDP and fiscal balance

Source: Bloomberg, as of 8/2/2016.

The political variable

Ultimately, political developments continue to be the main variable to the outlook for Brazil. We are approaching the final vote on President Dilma Rousseff’s impeachment, which will likely happen in late August to early September. Back in May, Interim President Michel Temer took office when Rousseff stepped down to face an impeachment trial. Since then, Temer has had a few successes. His cabinet appointments were well-received by both investors and politicians, which helped strengthen the relationship with Congress. This relationship has been and will be key for the cabinet’s ability to pass policy measures. An impeachment vote is likely to prompt an acceleration of much-needed reforms, which include cutting fiscal spending and revamping the pension system. We believe that a Temer presidency, committed to policy changes, may go a long way towards restoring confidence of both consumers and investors.

Figure 3. Brazilian stocks rising as perception of risk declines

Figure 3: Brazilian stocks rising as perception of risk declines

Source. Bloomberg, as of 8/2/2016. The Bovespa Index represents Brazilian stocks. Brazil’s 5-year sovereign credit default swaps are in essence insurance taken by investors against possible non-payment of government bonds and represents risk perception. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Risk implications

Nevertheless, while there is a significant probability that the Senate will follow through with Rousseff’s impeachment, we cannot rule out the opposite outcome, which would likely be adverse for risk assets, especially given high market expectations.

Investment implications

Equities have rallied significantly over the year, with the MSCI Brazil 25/50 Index up over 50% YTD (Source: MSCI, as of 7/31/2016). It seems that good news has been embedded into markets and therefore, there is much room for disappointment. Continued support for the equity market will require earnings to recover on the back of the economic turnaround and effective execution on the reform front. Overall, Brazil may be worth consideration for investors who are willing and able to accept the risk.