Brazilian Markets Tumble as Political Turmoil Returns


May 18, 2017 [Brazil, President Temer, politics, economy]

Brazil’s stocks and currency took a beating as President Temer was implicated in a corruption scandal, endangering the government’s reform agenda and fragile economic recovery.

Palacio do Planalto, Brasilia, Brazil

Brazilian asset prices tanked May 18 following a local media report implicating President Michel Temer in alleged hush-money payments to former lower house Speaker Eduardo Cunha, who is now serving a 15-year prison sentence after being found guilty of corruption and other charges. Opposition lawmakers are calling for Temer’s resignation, and failing that, his impeachment.

The market fears that Brasilia’s ability to carry out badly needed government spending, social security and other crucial economic reforms will be knee-capped, hobbling an incipient economic recovery from the deepest recession on record in Latin America’s biggest economy. The International Monetary Fund recently forecast Brazil’s GDP would expand 0.2% this year, after contracting 3.6% and 3.8% in 2016 and 2015, respectively.

Temer served as vice-president to his impeached predecessor, Dilma Rousseff, who was removed from office for skirting Congress and illicitly boosting government spending, effectively cooking the fiscal books. A former law professor and long-time lawmaker who served various stints as head of the Chamber of Deputies, Temer had been pushing to limit public spending, revamp Brazil’s social security system and undertake other market-friendly reforms. But he, too, has been shadowed by allegations of corruption, a spiraling web of which has entangled dozens of jailed executives from Brazil’s business elite along with dozens of top politicians currently under investigation, and in numerous cases charged with graft. That includes former President Luiz Inacio Lula da Silva.

Temer’s office in a statement to the press denied that he ever “requested payments to obtain silence.”

Nonetheless, it now appears that Temer’s political days are numbered, with analysts speculating mainly on the form of his exit. In a best case scenario, he could resign, which would lift some of the immediate political uncertainty. The current Speaker of the Lower House, Rodrigo Maia, who has also been accused of corruption and money laundering and denies the charges, would take over and need to call elections within 30 days. The most likely outcome would then be an “indirect election,” in which Congress decides who will be the next president. Given that the PSDB (Partido da Social Democracia Brasileira) and the PMDB (Partido do Movimento Democrático Brasileiro) coalition enjoys a majority in Congress, it could potentially name a market friendly president, which could mean that the reform process is delayed, but not dead.

However, if Temer tries to hang on and an impeachment procedure is started, as with Rousseff, it could last for several months. If he’s then impeached, an indirect election would follow, further delaying, if not endangering, the passage of reforms.

Alternatively, the ongoing Supreme Electoral Court’s investigation into Dilma/Temer’s ticket during the 2014 election may find that their campaign was illegal due to financing irregularities. In this case, the election results from 2014 would be voided and a new election date determined via a constitutional amendment. A “direct election” by popular vote would then be called to choose a new president, resulting in further reform delays at best, or abandonment at worst.

Other possibilities involve the Supreme Electoral Court bringing forward the next election, which is scheduled for 2018, or perhaps a Supreme Court justice acting as a caretaker president until next year’s elections.

However it plays out, there is clearly risk to the reform agenda, not to mention the possibility that the market-friendly heads of the central bank, Ilan Goldfajn, and finance ministry, Henrique Meirelles, could be replaced by Brazil’s next president, who may prefer to form a new economic team.

Given all the uncertainty, Brazil’s benchmark Ibovespa stock index sank 8.3% Thursday, while the real currency weakened just about as much against the dollar and the country’s 10-year government bond yield dropped.

The central bank has said continued monetary easing is dependent on passage of reforms. It may now be inclined to pause, especially with inflation projected to be at the high end of the target range by next year. Moreover, every 10% depreciation in the real currency likely translates into a 60 basis point increase in inflation, according to JPMorgan. The monetary authority’s key Selic interest rate currently stands at 11.25%, and expectations that it could be cut to 8% or lower by the end of this year will likely have to be tempered.

Brazil’s government debt as a percentage of GDP stands at 75%, and fiscal deficit last year was 9.7% of GDP. Its 10-year sovereign bond yield has declined from around 16% at the end of 2015 to 10% as of Wednesday’s close. Does the fixed income market continue to give Brazil the benefit of the doubt on reforms? Or do we go back into a situation where debt sustainability is again in question? Much depends on the outlook for reforms.

The downdrafts in Brazilian asset prices Thursday have been dramatic, but it’s important to keep in mind that current levels are about the same as at the beginning of this year. On a 12-month basis, Brazil’s benchmark stock index is still up 22%, and the real currency is still about 5% stronger against the dollar. That said, Brazil’s forward price-to-earnings of 12.9x is running above the 10-year 11.1x average, amid expectations that the economic rebound would continue to materialize with reforms further boosting expansion prospects.

As long-term, valuation-sensitive investors, we take a longer-term perspective when political noise affects share prices of companies whose fundamentals and earnings prospects don’t usually depend on political outcomes. Yet balancing portfolio exposures against macro risks doesn’t always compel capitalizing on selloffs when the political dynamics remain fluid. Not every dip is worth buying before the dust settles. But it’s always worth evaluating, monitoring and potentially adjusting those exposures.

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