Brazilian markets reflect investor resilience
When Michel Temer, Brazil’s president, was recently caught on tape allegedly endorsing bribes, markets briefly went into a tailspin, as investors feared an ambitious reform programme aimed at restoring fiscal health for Latin America’s largest country was in jeopardy.
Fast-forward one month, and although Mr Temer still faces a criminal investigation and calls for his resignation, resilience defines Brazilian markets. The benchmark Bovespa equity index has for now stabilised above its lows of last month, while government bond prices and the currency have bounced.
Crucially, investors have not shut the door on the country and its reform efforts. Since the tapes became public in mid-May, roughly $1.1bn has flowed into Brazilian equities, the highest level in five years, according to data tracker EPFR.
“There is not exactly optimism; there is a feeling of investors giving the benefit of the doubt to the government, since much has been advanced in this past year,” says Zeina Latif, chief economist at XP Investments. “But the government should not rest on its laurels — markets can quickly review their positions.”
The main reasons for a sense of market insulation from the latest political tempest, analysts say, is solid external accounts. This helps protect the economy from any sudden halt in foreign financing or changes in market sentiment. Coupled with inflation falling to a decade low of 3.6 per cent, this allowed the central bank to cut interest rates at the end of May and help support market sentiment.
“Brazilian markets have been relatively resilient, for several reasons,” says Michael Gomez, head of emerging markets at Pimco. “We have seen a very large adjustment in the current account deficit, which was chronic in the prior years and now for the most part is closed.”
With foreign direct investment still buoyant, David Beker, economist at Bank of America in São Paulo, says that “the external side of Brazil looks pretty fine”.
Brazilian bonds offer a mirror of the optimism among investors that government reforms will return the country to economic growth after a deep recession in the past two years.
The 10-year benchmark yield currently sits at 4.70 per cent, down from a spike above 5 per cent when the latest political crisis erupted. Falling inflation and the prospect of further rate cuts by the central bank are highly supportive for the debt market.
Economists forecast that the central bank will cut the current benchmark Selic rate of 10.25 per cent to 8.5 per cent by the end of 2017, helping bolster the economy, which in the first quarter grew 1 per cent after eight consecutive quarters of contraction.
“Brazil is going through a surprisingly stable moment,” writes Carlos Langoni, a former central bank governor with consultancy Projeta. “Substantial progress in the external adjustment and in controlling inflation, although still incomplete, helps explain the market’s low volatility in a stressed environment.”
While confidence has been rocked by the danger of Mr Temer being caught up in scandal, anything short of catastrophe has been greeted with relief by investors.
Even if Mr Temer’s pension reforms and other fiscal measures are diluted — as they already have been — any reform at all counts as an improvement of the steadily worsening public finances under his impeached predecessor Dilma Rousseff, and a further reassurance that Brazil will honour its debts.
Still, there is a concern that the recent improvement in Brazil’s external accounts and market resilience may not last.
As the embattled government reels from the scandal, Mr Gomez says that “the outlook for the reforms is less certain today than it was before the flash crisis”.
Moreover, amid a yawning budget deficit at 9.2 per cent of gross domestic product, Paul McNamara, an emerging markets investment director at GAM in London, believes “the reason why people get so obsessed about the politics, is that the fiscal side in Brazil is very vulnerable; fixing it is an absolute priority”.
Although falling inflation and lower interest rates help cut the borrowing costs of some 62 per cent of public debt, another 34 per cent remains fixed at a higher rate. Brazil’s debt service costs are thus much higher compared with other emerging markets. In the first four months of 2017 interest costs were 6.7 per cent of GDP, and 6.5 per cent for 2016 as a whole. In contrast, the figure for South Africa is 3.3 per cent and 1.5 per cent for Poland.
Mr McNamara added: “The reason people get much more upset about Temer than, say, [President Jacob] Zuma in South Africa, [President Recep Tayyip] Erdogan in Turkey, big places who are pursuing various degrees of irrational policy, is because Brazil is the one country where fiscal [policy] needs to be fixed.”