Apart from a couple of swimming pools turning an unfortunate shade of green and men’s tennis silver medalist, Argentina’s Juan Martín del Potro, being stuck in an elevator for 40 minutes before his first-round match against world No. 1 Novak Djokovic, the 2016 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 leading up to the end of June, Brazil’s economy had shrunk for the fifth consecutive quarter, heralding its 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, which eventually saw her impeached yesterday. To add insult to injury, the outbreak of the Zika virus looks set to dampen the country’s tourism and hospitality industry, which accounts for about 9 percent of gross domestic product.
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, then–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. We at Investec Asset Management believe that Temer is on the right track. His administration plans to introduce an expenditure ceiling, which will be determined in the coming months. Further spending reforms around social security, education and health are set to be agreed on by early 2017, and we believe that these will help slow or even halt Brazil’s downward economic spiral.
Nonetheless, Brazil’s debt-to-GDP ratio remains a cause for concern. Rousseff’s government sharply increased gross public debt, to 67.5 percent of GDP by mid-2015, from just over 52 percent 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 the 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. We wonder, however, if 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.
We’ve been impressed with the new president of the Banco Central do Brasil, Ilan Goldfajn. He has been more hawkish than we expected, building up the central bank’s credibility, improving its communications and paving the way for the government to formalize the bank’s autonomy. He seems determined to bring inflation under control. Prices in Brazil rose 8.74 percent year-over-year in July. Although this rate may be down from 8.84 percent in June, it is still well above the central bank’s 4.5 percent target, despite a 14.25 percent basic interest rate and a sharp economic contraction. Much of the stickiness in inflation has been on the back of the slide in the real and a surge in the cost of food, including an unexpected spike in milk prices.
The challenges to cutting inflation have pushed back the interest rate–cutting cycle. We do not believe the central bank will reduce the rate from its current ten-year high until the fourth quarter of this year. Further cuts are likely in the first half of 2017. We expect that the cumulative cut over that period will be about 350 basis points. This magnitude of rate cut seems to be largely priced into short-dated bonds, though we are more constructive on the intermediate maturities of the yield curve, such as five-year paper. We are also positive on real yields. In this global environment, we believe they could fall to the 5 percent range from the present 6 percent.
We are still modestly positive on the Brazilian real, despite the fact that the currency has surged 25 percent this year against the U.S. dollar amid optimism that Temer can restore confidence in the ailing economy. In early August Temer told the domestic financial newspaper of record, Valor Econômico, that he was worried about the real’s recent appreciation, as it could smother any nascent economic recovery by curtailing exports. Temer said that his government would “look for an equilibrium” in the exchange rate. Goldfajn has said that the bank will cautiously intervene in the foreign exchange market while sticking to a floating exchange rate. We believe that Brazil’s balanced current account and high carry will help Brazil’s policymakers keep the exchange rate stable.
In terms of Brazilian corporate debt, we view Petrobras spreads as relatively cheap, given the partially state-owned petroleum company’s continued ability to repair its finances and pay off debt through the sale of its deepwater assets to foreign companies. Also, given the much better than expected pickup in iron ore prices this year, we also see opportunities in the debt of metals and mining company Vale. Finally, spreads of beef producer Minerva Foods also appear compelling in light of the company’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 toward Latin America. We do not believe that Temer will be able to pull off an economic miracle, but we do believe the economy is at a turning point and will gradually improve over time. Who knows? Perhaps the afterglow of a successful Rio Olympics may get the economy feeling a little less green.
Mike Hugman is a strategist on the emerging-markets fixed-income team at Investec Asset Management in London.
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