With the Olympics over, the world’s attention is beginning to shift away from Brazil – but investors looking for emerging market exposure would be wise not to move on so quickly, writes Investec’s Mike Hugman.
Apart from the unfortunate incident of two green swimming pools, and men’s tennis silver medallist Juan Martin del Potro being stuck in a lift for 40 minutes before his first-round match against world number one Novak Djokovic, the summer Olympic Games in Rio de Janeiro went off pretty much seamlessly.
Only weeks before, however, with preparations for the world’s biggest sporting showcase behind schedule and over budget, the situation looked far less rosy.
In the three months to the end of June 2016, Brazil’s economy shrunk for a fifth consecutive quarter, heralding the nation's worst recession in decades.
Latin America’s largest economy was also grappling with a political crisis, following the removal from office of President Dilma Rousseff to face charges of breaking budget rules.
To add insult to injury, the outbreak of the Zika virus looks set to dampen the country’s tourism and hospitality industries which account for around 9 per cent of GDP.
But as the Olympics drew closer, some leading economic indicators ticked up slightly, or at least stopped deteriorating, raising prospects for a return to growth.
In an attempt to tighten a ballooning budget deficit, acting President Michel Temer has focused on fiscal discipline, reining in the excessive spending plans of the Rousseff administration that had been designed to appeal to voters of her left-leaning Workers’ Party.
Temer’s administration plans to introduce an expenditure ceiling, to be agreed on in the coming months. Further spending reforms around social security, education and health are set to be agreed by early 2017 and these should help slow, or even halt, Brazil’s current downward economic spiral.
But Brazil’s debt-to-GDP ratio remains a cause for concern: Rousseff’s government sharply increased gross public debt to 67.5 per cent of GDP by mid-2015 from just over 52 per cent a year earlier by granting ad hoc tax breaks and intervening in the economy.
We are remaining vigilant in case the market becomes too sanguine on the fiscal adjustment outlook. In July, three-month implied volatility on the Brazilian real and credit default swap spreads hit their lowest level in a year.
Brazilian assets have also led gains globally in 2016 amid speculation that Temer will be able to turn around the country’s economic fortunes.
Whether the benefits of the reform program will take longer to manifest than the market generally predicts and whether the economic bump from holding the Olympic Games will be either lasting or material are still, however, areas of focus.
Impressively, the new president of the Banco Central do Brasil, Ilan Goldfajn, has been more hawkish than we expected, building the central bank’s credibility, improving its communications and paving the way for the government to formally enshrine its autonomy.
Mr Goldfajn seems determined to bring inflation under control: prices in Brazil rose at 8.74 per cent year-on-year in July and while this rate may be down from 8.84 per cent in June, it’s still well above the central bank’s 4.5 per cent target, despite a 14.25 per cent basic interest rate and a sharp economic contraction.
The challenges to cutting inflation have pushed the interest-rate cutting cycle back, and a reduction from the central bank’s current 10-year high is unlikely until the fourth quarter of this year.
Further cuts are likely in the first half of 2017 and the cumulative cut over that period will likely be around 350 basis points.
This magnitude of rate cut seems to be largely priced into short-dated bonds, but we are more constructive on the intermediate maturities of the yield curve, such as five-year paper. In this global environment, real (inflation-linked) yields could fall to around 5 per cent over time from their current level of around 6 per cent.
We are modestly positive on the Brazilian real, despite the fact the currency has surged 25 per cent this year against the US dollar amid optimism that Temer can restore confidence in the ailing economy.
In early August, Temer told the local financial newspaper of record Valor Econômico that he was worried about the real’s recent appreciation, since it could smother any nascent economic recovery by curtailing exports.
Temer said his government would “look for an equilibrium” in the exchange rate. Central bank President Goldfajn has also said that the bank will cautiously intervene in the foreign exchange market, while sticking to a floating exchange rate.
Nevertheless, Brazil’s balanced current account and high carry should help Brazil’s policymakers keep the exchange rate stable.
In terms of Brazilian corporate debt, Petrobras spreads look relatively cheap given the company’s continued ability to repair its finances and pay off debt through the sale of its deep water assets to foreign companies.
Vale (metals and mining) bonds also seem attractive, given the much better-than-expected pick-up in iron ore prices this year, which is unlikely to be fully reflected in the company’s valuation yet.
Finally, Minerva spreads also appear compelling given the beef producer’s diversified global revenue streams.
We are cautiously optimistic on Brazil over the medium term and have a modest overweight as part of a general overweight tilt towards Latin America.
While it’s unlikely that Temer will be able to pull off an economic miracle, we do believe that the economy is at a turning point and will gradually improve over time.
Who knows, the economic afterglow of a successful Rio Olympics may restore confidence and shine across a suffering Brazil.
Mike Hugman is an emerging market debt strategist at Investec Asset Management.