Friday, 14 December 2018

Brazil: life after Dilma

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The fall of former president Dilma Rousseff stirred hopes that Brazil can finally move on from a painful period of spiralling public debt and rampant corruption. There is a long and daunting list of reforms on the new president’s to-do list, but investors seem confident he is on the right track.

It has been a year that will probably be defined by the political demise of former president Dilma Vana Rousseff. The political scandal that brought her down weighed on the economy for the first half of the year, as it had for much of 2015, taking Brazil to the edge of a financial cliff. But her impeachment in August has steered the country from the precipice, and as 2016 ends Brazilians can again hope that their country is on the path to recovery and prosperity.

Juan Carlos Rodado, director of LatAm research at Natixis CIB Americas, said: “The Brazilian economy can be viewed in terms of two phases: BD and AD – that is Before Dilma and After Dilma – in terms of market sentiment.”

Under Dilma, Brazil’s main problems were corruption and major macroeconomic mismanagement, with many global investors underweight Brazilian securities as a result. There was widespread concern that her political troubles were creating too much of a distraction for her to effectively govern. But since her political downfall, a new mood of optimism has taken root in Brazil and there has been a visible shift since March, when her coalition began to unravel, as investors have shifted from underweight to neutral.

Capital has begun to flow back into the country and, coupled with a general improvement in emerging market sentiment in the same period, the country’s fortunes have started to turn. While the problem of corruption will not be solved by a simple change of president – indeed, the new president, Michel Temer, has already been subject to corruption allegations – there is at least some hope that the problem is being addressed.

In October Brazil introduced a stewardship code, calling on institutional investors to use their influence to drive reform of local companies, and the economy generally. According to PwC, the code calls on investors to implement mechanisms to manage conflicts of interest, consider environmental, social and governance issues, monitor the activities of issuers, actively exercise their voting rights, and encourage transparency.

Meanwhile, Temer, has taken steps to begin to resolve the macroeconomic imbalances that have been a millstone around the economy’s neck. He quickly implemented reforms in the oil sector that allow greater private investment, such as revoking the sole operator provision that gave state-owned Petrobras the lead role in developing sub-salt oil projects.

“Temer’s economic team benefits from greater credibility in the financial markets, giving it some time to manoeuvre,” S&P said. ”President Temer’s political capital is greater than that of former president Rousseff; he has cross-party support.”

The new president still has to contend with a sceptical public that did not vote for him, S&P said, but he is in a stronger position to push through some of the reforms the country needs to return to the kind of growth in previous years that has seen it compared with China and India.

Positive response

The response from markets has been positive. The Real has strengthened by around 23% year to-date against the US dollar, with stocks and bonds performing similarly. Soon after Temer replaced Rousseff in an interim role in May, Brazil issued a US dollar bond after a four-month hiatus, pricing a US$1.5bn 30-year bond with a 5.625% coupon to yield 5.875%, well inside the 6.125% yield achieved on a 10-year bond issued in March.

Markets have also been responsive to Brazilian institutions, which have been seized the opportunity to raise money. Miner Vale raised US$2.25bn over the course of the summer in two separate deals, a five-year bond in June for US$1.25bn yielding 5.875%, and a US$1bn in a 10-year deal in August yielding 6.25%. Petrobras, beef producer Marfrig and paper & pulp maker Suzano were among the other issuers around that time.

Meanwhile the economic outlook for the fourth quarter and 2017 has improved, with the purchasing managers index for October rising to a nine-month high of 46.3, and local business and consumer surveys showing improving sentiment.

“It’s still early days, but this suggests that the economy could return to positive quarter-on-quarter growth in the fourth quarter,” said Neil Shearing, chief emerging markets economist at Capital Economics.

With the economy having contracted by 3.8% in 2015, that shift in sentiment will not be enough to lift Brazil out of the doldrums entirely. S&P forecasts a further contraction of around 3.6% for this year, but expects the economy to return to growth in 2017, probably of 1%, rising to 2% in 2018.

“Irrespective of the estimate, what’s important is that we don’t assume a V-shaped recovery, as seen coming out of the global financial crisis,” said S&P.

With so much uncertainty in the global economy, especially in the US and Europe, Brazil at least benefits from little direct exposure to those regions, and is therefore somewhat insulated from the political and economic struggles that affect much of the developed world. The surprise election of Donald Trump as US president is clearly another factor that adds to that uncertainty.

Jan Dehn, head of research at Ashmore, said: “The main impetus for growth in Brazil in the coming years will simply come from Brazil putting its own house in order. Brazil has strong reserves, sustainable debt and a lot of growth potential. Commodity dependence is high compared to many other countries, so this risk remains. However, a floating exchange rate means that the country adjusts quite effectively to changing commodity prices.”

Much will therefore depend on how much progress Brazil can make implementing the reforms it needs to put it back on a secure fiscal footing. 

“We need a structural overhaul of the public finances,” Natixis’s Rodado said. ”In Brazil 90% of expenditure is mandatory and rigid given that you need constitutional changes to amend it. That is unsustainable, especially when you have low growth and weak commodity prices.”

The minimum wage is indexed to the previous year’s inflation and to two-year average growth, a model that has many argue has proved too rigid and inflationary. The retirement age will also need to be lifted, though this will require constitutional approval via a two-thirds majority, which will make it a challenge.

Note of caution

Rodado’s optimism is therefore tinged with a note of caution. “You have to be realistic about what can be achieved in the two years until the next election,” he said. “We are not going to see incredible reforms but we can see cosmetic reforms, such as a spending cap. Every year spending has increased at a rate above inflation. Tackling that should be enough to maintain the positive momentum and ensure a recoupling with the broader EM universe.”

He said that by the time the next elections come around in three years, Brazil will be in a more vulnerable position than it is today, given that its deficit is growing. “For now the market is giving the country and its current pro-market government the benefit of the doubt, but there are a lot of problems awaiting the next government. It is impossible to say what is going to happen beyond 2018, which is still a big drag on foreign direct investment. Investors are happy to buy shares, but building a plant is another matter.”

But Dehn is more bullish. “The government does not need to do nearly as much as people think,” he said. “The key is to change the fiscal trajectory, and the reforms under way in Congress now will do that. The reforms in Petrobras are also extremely positive. Given the cheapness of the currency and the fall in real wages, Brazil has now regained much competitiveness and should be in a position to grow strongly as soon as the main reforms are in place.”

Dehn argues the political backdrop now supports reforms and with political interests aligning to allow potentially unpopular but necessary reforms to be implemented, the current political breakthrough could completely change Brazil’s political and economic trajectory for years to come. “The approval of the spending cap has a large majority in the Lower House, which bodes well for approval of the social security reform as well,” Dehn added.

Investment opportunities

According to Dehn, domestic fixed income and domestic corporate bonds and equities present some of the best investment opportunities in Brazil. “Brazil is a recovery story which is entering into a ‘Goldilocks’ period, where inflation will fall, the currency will rise and growth will pick up,” he said.

Sectors that are closely related to domestic consumption have a weaker outlook, in light of the country’s still-high unemployment and expectations of a public finance adjustment. Banks also face increasing losses from non-performing loans but sectors with a greater reliance on exports look better placed.

“Brazil has been through a major cyclical downturn of its own making but it is only a cyclical problem,” Dehn said. “The structural long-term case for Brazil remains bullish: Brazil will soon resume its rightful role as major economic force in the global economy.”

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