Thierry Larose, Senior Portfolio Manager, Vontobel Asset Management
- Brazilian markets surge on news of pension reform bill taking major hurdle in Congress just before the winter recess and with larger majority than expected
- The Brazilian real still has potential upside against the USD dollar since its appreciation has so far been hampered by local investors piling into long US dollar positions to hedge their local bond and equity exposures
- Brazilian short-term rates have some further room to compress
- Long rates (nominal and real) now look fairly priced
At the beginning of the year, the Brazilian real (BRL) tanked before going on a rally making up for all its previous losses in the second half of May. Investors, who bought the dip, did well. Since May 20, the BRL has returned about 10 percent against the US dollar (USD) (incl. carry) and local bonds and stocks have gained about 14 and 25 percent respectively (incl. 10% FX appreciation). While it is never a bad idea to take some chips off the table, we believe that the rally still has some steam left.
The main drivers of the market’s enthusiasm
Despite the ailing economy of the scandal-prone country, investors are celebrating a much hoped for pension reform clearing its most significant hurdle in the lower house of Parliament on July 10. Perceived as a major success, this has increased the likelihood of the draft legislation receiving approval from the Senate, which would pave the way for significant government savings over the next 10 years and an improvement of the country’s fiscal metrics and debt sustainability. Markets surged on this news for mainly two reasons. Not only was timing ideal with the bill passing a first round in the lower house with an unexpectedly high majority just before parliamentary recess starting next week. But also the approved amount of government savings of 800-900 billion Brazilian reals turned out to be higher than analysts’ previous estimates, who had mainly been fearing a watered down bill devoid of any serious reformative verve. Market optimism has grown to such an extent that similarly positive results are expected for other essential reforms such as the tax reform and the liberalization agenda. Now that significant progress has been made on the reform front, the central bank finally has its path cleared to embark on a monetary easing cycle, with an estimated 100 basis points (bps) of interest rate cuts until the end of the year to give a boost to the economy. With the prospect of Brazil returning to the path to growth, local investors initiated the rally attracting also international investors who have started to return to the Brazilian markets in larger numbers.
Riding the rally
Brazilian rally still has legs, so sticking with it a little longer is
beneficial to investors who are able to resist the urge to cash in now. Brazil
is one of the very few emerging-market countries whose growth-stimulating
reform agenda is still powering on which has the potential to attract more
participation of crossover investors in Brazilian assets. The BRL still has
upside potential, not only thanks to a healthy balance of payments and
supportive terms of trade, (export vs. import prices) but also because local
investors have so far hampered its appreciation by piling into long USD
positions looking to hedge their long equities and bonds exposure in BRL to a
certain extent. On the local sovereign yield curve, the front end still seems
attractive since we see the SELIC rate reaching 5% by the first quarter of next
year, which is 150 bps below the current level and 50 bps below the level that the
market is currently pricing in for the end of the easing cycle. At the same
time, the long end of the nominal curve looks fairly priced and we do not
expect it to compress much further, especially now
 Data as of 11 July 2019
that the 10-year yield has fallen below its Mexican, Indonesian and Russian equivalents that are rated investment grade. Real rates (NTN-B inflation-linked bonds) have rallied and reached a fair price level too now that they have stabilized below their Mexican peers (UDI bonos). In addition, long rates (both nominal and real) are unlikely to tighten much given the local rebalancing between bonds and equities with fund flows expected to favor equities in the light of falling short-term rates.
Beware the devil of politics
While market sentiment is buoyant, any loss of political capital could bring the Brazilian market rally to a screeching halt. The government’s communication might have improved but is still interspersed with ideological rhetoric, which continues to polarize the population. One of the government’s weak links is the iconic justice minister Sérgio Moro who is at the center of a scandal over his role as a federal judge in the so-called “Operation Car Wash” that led to the impeachment of Dilma Rousseff in 2016 and the imprisonment of former president Lula last year. Moro is not involved in the economic reform agenda but is worshipped by the partisans of president Bolsonaro so that a resignation, even if still unlikely, would unleash a devastating political storm. So far, the government’s strategy has been to dismiss the accusations as fake news but it is unclear what plan B would be, should the allegations turn out to be more substantiated. Finally, infighting between governmental factions remain a material risk as President Bolsonaro tends to systematically protect and cater to the needs of selected parts of his electorate, who are represented in the National Congress by the conservative interest groups of farmers, evangelicals and pro-gun lawmakers. Therefore, there is a risk that the rest of his electorate might start to feel being left by the wayside which could result in an uprising given the fact the government has no formal majority in Congress. This would severely damage the economic reform agenda and likely scare off international investors.