Outlook Brazil

Brazil is in recession territory. The country’s fiscal consolidation plan had a major set-back in July as the finance minister Joaquim Levy announced a significant downward revision of the government’s primary fiscal surplus targets. In august, S&P placed Brazil’s foreign currency rating, on negative outlook. Last month, after realizing the deterioration in tax collection, negative GDP output and the eminence of a political crisis, S&P anticipated the rating downgrade of Brazil, from Investment Grade to junk. Since the change in S&P’s outlook and further rating downgrade, capital outflows intensified and the currency de-valuated very rapidly.

Fiscal adjustment vs. political crisis

The country economic recession is being aggravated by a political crisis. Brazil has a growing nominal deficit that needs to be properly addressed. However, the Government is not finding support in the Con-gress to implement a fiscal adjustment plan.

The current government was elected in the end of 2014 promising to continue a benevolent social policy while there is no funding for it. They are trying to promote a soft fiscal adjustment via tax increases while the low tax collection and economic growth calls for more serious expenses cut. Their posture is generat-ing a big discomfort in the Congress and the first attempts to pass forward the fiscal package have failed.

The opposition is calling for an impeachment, claiming the Government broke the fiscal responsibility law, but there is not yet enough evidence or consensus to start a formal process in the Congress. Therefore the opposition is deliberately voting against all fiscal measures proposed by the Government to make them weak and force a resignation. The Government coalition is also broken as there is a wide perception the Government is not fulfilling the mandate for which they were elected for. The president’s last attempt to recover Congress support was a ministry reshuffle to please allies. It is yet to be seen if this move is enough to buy Congress support. It all remains very fragile, especially when the President has less than 10% of population approval, the GDP is contracting more than 2.5% this year and it is likely to con-tract in 2016 as well, and unemployment is increasing very rapidly.

The recent S&P rating downgrade puts pressure on the government to deliver a realistic fiscal consolida-tion plan and we don’t think they are there yet. It has also contributed to bring back discussions of neces-sary reforms in the fiscal and pension systems. However, how to push for reforms in this political scenario? In the event there is neither a fiscal consolidation, nor approval of reforms that can improve the fiscal deficit picture in the long run, we can see other credit agencies downgrading Brazil to junk and ultimately further rating cuts and currency devaluation in 2016. Interest rates would be likely to remain at the cur-rent high levels in order to control inflation expectations. As a consequence we would continue to see low investments and poor economic activity numbers, extending the current recession throughout 2016.

Liquidity environment in Brazil

Financial markets in Brazil have seen volatility increasing in the past months with the deterioration of the macroeconomic fundamentals. Liquidity has decreased in the equity and bond markets, new share or bond emissions are delayed while buybacks and tender offers have increased. The market is pricing more risk premium given the lack of visibility on a more sustained solution to the fiscal issue. Adding to that, after the rating downgrade, the international debt markets is closed for Brazilian corporates. There is a growing fear for the rollover of external debt that some Brazilian companies need to do in 2016. If Brazili-an corporates cannot find international credit, locally there is not enough space to absorb such financial needs. So if we don’t see in the next couple of months a plausible solution to the fiscal issue, there is a credit crunch risk affecting Brazilian corporates.

Impact of lower commodity prices on Brazil

After having bottomed in early summer, oil prices resumed their downward path again as US producers are still seeing massive productivity gains and break-even costs continue to move lower. We are still not seeing the effect of lower development spending on production growth but some price sensitivity on the demand side is kicking in.

Other economically sensitive commodities are doing worse still, with especially Iron Ore showing weak performance on the back of lackluster Chinese demand. Falling commodity prices have eased inflationary pressures across the board, and with limited economic growth in most regions, this allows the Central Banks of commodities importing countries to maintain an easing stance.

Brazil currently benefits from lower oil prices as it is a net oil importer but given its vast oil reserves it could become a net oil exporter at some point in the future and clearly lower oil prices hurt the present value of those reserves. As for other hard commodities (ex-oil), Brazil is among the Emerging countries with the biggest exports exposure, being negatively impacted by low commodity prices.

Positioning

Given the complex economic, political and global scenario, we keep a cautious view on Brazil. We are currently underweight Brazil in the Emerging Markets Equities portfolio.