- There is a strong fundamental case to be made to back up the truck on the long side of Brazil.
- That being said, however, a slew of policy pitfalls remain.
- As such, we’d only sign off on getting long Brazil to the extent the Rousseff impeachment process goes as consensus expects it will; we would be buyers of a “sell the news” event in the face of a positive outcome.
In response to this morning’s Early Look in which we detailed our latest thoughts on country-picking in emerging markets, we received a number of replies asking for our thoughts on Brazil, which itself failed to make the cut in our most overvalued/undervalued analysis. Given the level of interest, we thought we’d share our revised outlook for the Brazilian economy and its financial markets more broadly.
It’s easy to recap where we’ve been on Brazil lately: wrong (at least until we closed all of our positions in EM last Tuesday). Specifically, as part of the thematic investment conclusions outlined on slide 94 in our 3/16 presentation titled, “Is This a Generational Buying Opportunity in Emerging Markets?”, we were explicitly negative on LatAm equities and FX, which we expressed through the currency un-hedged SPDR S&P Emerging Latin America ETF (GML). That instrument moved -18.4% against us throughout the course of our bearish bias.
Mitigating this disaster is the fact that we’ve been the axe on the bear side of Brazil since mid-July ’14. Inclusive of its +65.9% YTD return, the iShares MSCI Brazil Capped ETF (EWZ) still declined -30.8% from 7/14/14 through last Tuesday. For reference, the MSCI All-Country World Index declined only -2.6% over that timeframe. I’ll take +2820bps of long-term alpha generation any day.
With all that baggage and glory now squarely in the rearview mirror, we can now focus on our call on Brazil from here: patience. Specifically, we think it’s best that uninvolved investors remain neutral for now. To the extent an investor is currently involved on the long side, we believe the best course of action is to book gains and look to redeploy capital upon further notice.
In GIP Model terms, Brazil has definitely earned its outperformance in the YTD; in fact, it’s one of the best GIP setups I’ve ever seen (more on this below). Moreover, the confluence of a material rally in commodities and the Rousseff impeachment saga have proven particularly positive for a sharp reversal of what had been pervasively bearish sentiment.
Supporting Brazil’s sexy GIP Model setup are:
- Consumer spending growth that appears to be breaking out of its YTD basing pattern from historically depressed levels;
- Industrial production growth that is accelerating on a sequential and trending basis off of historically depressed levels;
- Export growth that is accelerating on a trending basis off of historically depressed levels;
- Composite PMI readings that appear to be breaking out of their YTD basing pattern from historically depressed levels;
- Consumer and business confidence readings that have each completed full-cycle bearish-to-bullish reversals… both are now accelerating on a sequential and trending basis off of historically depressed levels;
- Headline and core inflation readings that have each completed full-cycle bullish-to-bearish reversals… both are now decelerating on a sequential and trending basis off of historically elevated levels;
- A currency that is down -25% on a REER basis, which goes a long way towards mitigating the “Dutch Disease” we highlighted several years ago;
- A current account deficit that has improved +190bps off of its 1Q15 cycle-trough of -4.4% through 1Q16; and
- An improving primary deficit picture per the latest monthly data… (R$10.1B) in JUN vs. a Bloomberg consensus estimate of (R$15.3B).
But are Brazilian financial markets priced to perfection? No one knows the answer to that, but my inclination is to side with the “yes” camp. I do know one thing’s for sure, however: I don’t bet on “open-the-envelope risk”, which is effectively what you’d have to do to put a positon on today given the uncertainty surrounding the outcome of Rousseff’s impeachment trial (which will be held across four sessions spanning AUG 25-26 and AUG 29-30). A two-thirds majority (i.e. 54 out of 81 senators) is needed to fully remove her from office, which would allow interim president Michel Temer to remain in power through 2018.
Indeed, the confluence of the market-friendly leadership style of Temer, the bold fiscal reform drive of his acting finance minister Henrique Meirelles and the steady hand of CBR governor Ilan Goldfajn has been a boon to Brazilian capital and currency markets in the YTD. Key reform initiatives include:
- Narrowing the primary deficit to (R$139B) in 2017 from a projected [record] (R$170.5B) in 2016;
- Capping the growth rate of public expenditures to CPI;
- Implementing a broad-based freeze on tax hikes; and
- Changing the structure of the Finance and Planning ministries in order to put the offices responsible for budget planning, government spending and tax collection all under the purview of Meirelles.
The major issue we see with each of these reforms is that Rousseff’s Workers Party (PT) may not acquiesce to the fiscal reform demands of Temer, who hails from the Brazilian Democratic Movement Party (PMDB). Recall that her own fiscal reform drive fizzled out amid PT infighting over what were widely viewed as draconian fiscal consolidation measures despite near-peak sovereign indebtedness and a slew of ratings downgrades.
Moreover, the tax hike freeze isn’t set to be decided upon until the end of this month; a failure to implement the proposed changes would go a long way towards resetting Brazil’s economic recovery expectations structurally lower given its existing status as one of the world’s most over-taxed economies; the World Economic Forum’s 2016 Doing Business Report ranks Brazil’s tax efficiency 178th out of 189 countries.
Source: World Economic Forum 2016 Doing Business Report
All told, there is a strong fundamental case to be made to back up the truck on the long side of Brazil. That being said, however, a slew of policy pitfalls remain. As such, we’d only sign off on getting long Brazil to the extent the Rousseff impeachment process goes as consensus expects it will; we would be buyers of a “sell the news” event in the face of a positive outcome.
Best of luck out there,