10/13/2016 15h28

Brazil is on the ascent as investors eye further gains

With its currency and benchmark index surging, the country has become an emerging market favourite

Financial Times

Brazil has shot from global pariah among investors to emerging market favourite in less than 12 months — and many analysts believe Latin America’s biggest economy could be set for further gains.

Brazil’s real has already strengthened nearly 23 per cent against the dollar this year while the benchmark equities index Ibovespa has gained nearly 41 per cent on the impeachment in August of former leftist president Dilma Rousseff for budgetary violations.

But analysts say further upside is likely as the new market-friendly government of President Michel Temer, Ms Rousseff’s replacement, pushes ahead with promised economic reforms.

Congress early on Tuesday approved the first of these changes, a constitutional amendment that would limit real increases in budget spending to zero for up to 20 years. This would help ensure Brazil’s public finances recover from a blowout under Ms Rousseff.

“The momentum is very strong and they [the new government] are delivering on what they have promised,” said Alejo Czerwonko, emerging market equity strategist at UBS Wealth Management.

The enthusiasm for Brazil is beginning to eclipse even that for market favourite Argentina, which captured investors’ imaginations after business-friendly president Mauricio Macri replaced his populist predecessor, Cristina Kirchner.

New hints and tips

Ms Rousseff was criticised for interventionist policies that led to an explosion in the budget deficit and a rapid increase in gross public debt to nearly 70 per cent of gross domestic product — unsustainable given Brazil’s high interest rates.

This scared away investors and ushered in the country’s worst recession in more than a century, with the economy expected to have shrunk more than 7 per cent in two years by the end of 2016.

Yet there are signs the economy might be bottoming out. Consumer confidence in September increased for the fifth consecutive month and is now at the highest level since January 2015. Meanwhile, business confidence in the industrial sector is at the highest level since July 2014.

Inflation, the old scourge of the Brazilian economy, recorded its lowest monthly increase in September in 27 months, giving the central bank room to begin bringing down its benchmark Selic rate from a high of 14.25 per cent.

The expected decline in interest rates would provide a welcome boost to the economy and could provide a further leg-up for Brazilian asset prices, analysts say.

“We think there is room for further upside,” said David Beker, economist with Bank of America Merrill Lynch. He said he was forecasting a possible central bank easing cycle of 450 basis points compared with 350bp for the market consensus, with rates eventually coming to rest in the high single-digits with inflation at the central bank’s target of 4.5 per cent.

More than the economic fundamentals, it is politics that is driving Brazilian asset prices, analysts say. Mr Temer is showing the ability to slowly overcome the hurdles facing his government with his Brazilian Democratic Movement Party emerging from the first round of municipal elections in October largely intact.

The reasonable showing in the elections, in which the PMDB won the most mayoralties although it missed out on the biggest cities of São Paulo and Rio de Janeiro, has cleared the way for Mr Temer to push the market-friendly budget reform through congress. This bill is expected to be followed by others such as social security and labour reform. Micro reforms, such as opening important oil exploration blocks to operators other than state-owned oil company Petrobras, are also being considered by congress.

Brazil's post-Rousseff plans

The solid reform pipeline suggests that Brazilian equities have further upside in spite of the 12-month forward price/earnings ratio of the MSCI Brazil trading at 1.3 standard deviations above its historical average, said Alejo Czerwonko of UBS Wealth Management.

“There is going to be continued good performance,” he said, stressing, however, that the upside from here would be more restrained than earlier in the year.

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Analysts said the remarkable part of the Brazil story would be the size of the turnround in the economy — with a contraction of 3.5 per cent expected this year that would revert to growth of about 1.5 per cent next year.

Still, there remained many uncertainties. Mr Temer’s more ambitious reforms, particularly changes to the pension system and proposals to alter labour laws, could run into fierce opposition from society. This could spook congress and lead to a stalling of the reform process.

His window for approving the reforms was also short, with campaigning for the 2018 election expected to begin late next year. Congress would be unlikely to consider unpopular changes once the election season began.

Finally, he and members of his party and government continue to face scrutiny from investigators probing a vast corruption scandal at Petrobras that helped bring down Ms Rousseff’s government.

But even considering these risks, Brazil remained the best investment story of the region this year with valuations still not reflecting the likely upside, said Walter Molano of BCP Securities.

“Brazil is the most promising market in Latin America right now, more so than Argentina, given the low valuations and the policy direction,” Mr Molano said.