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Analysis
Brazil banks on Temer

Brazil banks on Temer

After the investor flurry, a possible shock

by Bhavin Patel

Thu 8 Sep 2016

Brazilian financial markets have seen a flurry of inflows as investors bet on economic recovery. The Bovespa equity index has risen 65% this year – the best performance of equities globally. The real has appreciated by more than 22% since January, making it the highest performing major currency in 2016. Brazil’s finance ministry projects GDP growth of 1.6% in 2017, against an expected 3% contraction in 2016.

Political change has driven the momentum. Markets have anticipated an economic turnaround, bullishly tracking the impeachment process of Dilma Rousseff, unseated as president by the Senate on 31 August. Michel Temer, who has now taken over, has pledged to restore market confidence by reining in fiscal spending, spurring job creation, in a bid to stabilise debt levels and re-establish Brazil’s credit rating. The previous vice president’s policies of limiting budget increases in line with inflation and raising the retirement age are popular among investors, a lot less so with the broader electorate.

Investment rating agency Moody’s, which has downgraded Brazil’s bonds to junk status, conceded that Rouseff’s impeachment has removed some political uncertainty, but her removal provides ‘no guarantees’ that Temer will see Congress approve his reforms.

‘While the proposals have had a positive impact on business confidence, a tangible improvement in Brazil’s fiscal accounts has yet to materialise,’ the agency said.

Brazil still has plenty of economic and political difficulties. The reason why the country has become popular among investors lies in the premium. The overarching preoccupation for global investors is the low-yield environment. With more than $13.4tn worth of bonds in developed markets yielding below zero, investors are inevitably moving up the risk scale.

In particular, pension funds engaged in liability-driven investment strategies are favouring riskier asset classes compared with traditional low-risk (and now very low- or negative-yielding) fixed-income assets. Achieving adequate protection against inflation is becoming a growing issue for investors.

Although central banks are still some way from achieving their 2% inflation rate targets, prices are starting to accelerate – and bonds in developed countries offer scant compensation. Forecasts by the Federal Reserve and the European Central Bank show inflation reaching 1.9% and 1.3% in the US and euro area respectively by 2017. Brazil’s supply of yields delivers the returns the investment funds so eagerly desire.

However, Brazilian government bond yield differentials have narrowed sharply as demand for Brazilian debt has surged. In a possible danger signal for investors, 10- and five-year bonds now yield 11.9% and 11.8%, their lowest in over a year, well below the central bank rate of 14.24%.

Politics are still a giant headache. Rousseff’s removal left a nation divided. Government intervention, corruption, fiscal indiscipline and overgenerous pensions are all to blame for the country’s parlous state. GDP shrank by 3.8% last year and unemployment increased to over 9% – a sharp turnaround from previous years’ buoyancy before setbacks from falling commodity prices and deteriorating competitiveness turned Brazil’s former growth into decline.

The question now is how long the positive trend will last. Brazil’s financial market recovery could be generating asset bubbles. If the Fed raises interest rates more quickly than expected, market sentiment could change abruptly, capital inflows could turn into outflows – and Brazilian investors could be in for a shock.

Bhavin Patel is Research Assistant at OMFIF.

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