Just as political risk seemed confined to developed markets, Brazil sent a stark reminder yesterday that presidential upheavals are not something buried in Emerging Markets’ past. Read what our affiliates say.
The country’s stocks, bonds and currency tumbled on Thursday as a new political crisis threatens to derail the government’s plans to take the country out of recession. Brazil’s federal police carried out arrests and searches after news reports indicated that President Michel Temer approved bribes to silence a key figure in last year’s corruption scandals, which led to the impeachment and ousting of former president Dilma Rousseff. Temer has denied the allegations. The Ibovespa stock index came to a halt after plunging 8.8% on Thursday, while the real posted its biggest loss since 1999, despite the central bank’s intervention to support the currency. The yield of US-dollar denominated sovereign bonds surged by 56 basis points to 5.09%.
Although contagion to other Emerging Markets has been limited, the developments in Brazil warrant the experience and expertise from active managers. Please see below the comments from our affiliates:
Brazilian markets rocked by bribery claims:
- The real posted its biggest decline since January 1999 and both equities and bonds fell sharply (circuit breakers were activated to halt trading on the stock market).
- Companies that did fare well were mainly exporters, which saw positive drivers from the increased US dollar-real exchange rate. However, most firms saw a negative impact.
Does this change our views?
- Investors had been driving up the prices of Brazilian assets since former president Dilma Rousseff’s impeachment last August, on the belief that Temer’s caretaker government could deliver an ambitious reform package. We had viewed the rally with caution, as we considered no one in the Brazilian cabinet entirely beyond reproach.
- From a strategy point of view, most of the assets we favour are not considered ‘market proxy’ stocks, so we are confident they should weather this storm.
- We don't favour Brazil, but the investment case for certain assets is based on company fundamentals and we believe the assets we favour are well positioned in the long run.
- The promise of reform has been the main driver of inflows into both Brazilian bonds and equities, so any delay in the process is likely to trigger further sell-offs. In this scenario, we will be looking at the potential opportunities.
What happens next?
- Temer has so far refused to resign and it seems likely he will try to fight the allegations in the Supreme Court. However, he could be removed from office if the accusations are proven.
- The much-anticipated pension reform was two weeks from its final vote, but the direct impact from these allegations is that the reform agenda is now on hold at least. The best case scenario is a swiftly concluded investigation and Temer (or a replacement elected by Congress) moves to quickly pass pension reforms. The worst case, is a slow and expensive inquiry, leading to Temer’s removal. In any case, Presidential elections are scheduled for October 2018.
- The country’s attractive socio-demographic profile remains and there are many very attractive companies. However, pension and tax reform are needed in order to facilitate fiscal consolidation and encourage investment, in order for consumer and business confidence to improve and set Brazil on the path to achieving its potential.
Source: Bloomberg as of 19 May 2017. Please find definitions in the disclaimer.
While not unaccustomed to political quakes in Brazil, yesterday’s news came as a shock, and it’s plain that in President Michel Temer’s government, support has been lost and confidence broken.
Therefore we assume, as do others, that the ambitious, but essential reform process has been delayed, perhaps even stalled. Were Temer to step down, Rodrigo Maia, Speaker of the Lower House, would take office, but naturally the focus of members of Congress will move from reform to electing a new president and building a strong coalition to get the reforms back on track.
The situation remains fluid, changing by the minute, and experience advises caution in reaching conclusions, and implementing hasty adjustments. Indeed, such events create opportunities for astute investors, and at Western Asset, we are fortunate to have an experienced team of investment staff based in Sao Paolo, monitoring events.
Financial markets are already reassessing the situation, and we remain vigilant and prepared to address all outcomes in an important market.
How does this news impact Brandywine Global’s views?
Given the information we have at this juncture, we do not plan to change our exposure to Brazil—a decision that holds true across all of our strategies. We may reconsider our positioning if the country’s fundamentals deteriorate. Otherwise, we will move forward with our focus on long-term investing. Real rates remain attractive in Brazil, and we are comfortable with being compensated to wait for volatility to subside. We applied this same outlook to another position —South Africa— which recently faced its fair share of political uncertainty. Bear in mind this is hardly the first scandal that Brazil has faced in recent years, so a knee-jerk reaction is not prudent nor part of our investment process. As we have seen in the first day of trading following the scandal, the real has recovered some of those initial loses.
Does Brazil pose an Emerging Market contagion risk?
We believe the global economy is in good enough shape to contain the selloff in Brazilian assets and prevent a contagion from spreading across emerging markets. Developed market reflation has in part helped soften the blow of this selloff. Investors piled into emerging markets in search of higher-yielding assets this year, so we expect there could be a short-term selloff.
Brazil Scandal Doesn't Change Long Term View
News that a recording may reveal Brazilian President Michel Temer discussing paying hush money to a jailed associate caused a ripple effect across Brazilian assets recently, as investors rushed to pull capital out expecting the worst. The MSCI Brazil Index dropped more than 14% (though it recovered somewhat Friday), and the country’s currency, the real, fell the most since 1999.
Brazil has been recovering nicely under Temer, who had pledged labor and pension reforms following a deep recession and the impeachment of former president Dilma Rousseff. Inflation has been curbed by two-thirds to 4%, GDP growth recently moved into positive territory, and recent months saw the first employment gains in some time. Furthermore, Brazilian companies reported improved performance in the first quarter, with roughly flat top-line growth, and strong margin expansion and earnings growth.
We like Brazil’s underlying fundamentals. The country is still a massive economy with a meaningfully large and growing middle class. Unfortunately, fundamentals may matter less in the near term, as attention yet again shifts to politics and investigations into corruption.
We foresee several potential outcomes to the current political scandal. Temer could resign, with caretakers running the country until the 2018 elections. This would push back any major economic reform efforts Temer had been pursuing, with uncertainty about the next leader’s agenda. The prospect of the country’s second impeachment in two years is also another possibility. This could be the worst outcome for economic sentiment in Brazil and for outside investors interested in the country. Finally, Temer could be found not guilty and resume his reform agenda in short order. However, even if he is cleared, the likelihood that it happens quickly is low, meaning political uncertainty will linger and ensure further delays of his reform agenda.
Regardless, the Brazilian equity market is likely to be range bound in the near term, with some downside risk and volatility. However, the scandal and its fallout could represent an opportunity to buy or add to high quality companies to hold over the long term, as we expect the fundamental story of Brazil’s economic growth and middle-class expansion to remain intact.