Brazil: Rousseff may be on her way out

Market analysis - 4/4/2016

Political developments have given a boost to equities.

Every year the emerging stockmarkets bring new surprises, good and bad. For example, despite Russia's severely weakened economic fundamentals, its RTS index defied the odds and finished 2015 with the top ranking for emerging equity benchmarks. Now it is Brazil's stockmarket that is baffling the world with hefty returns against a backdrop of deep political worries. The turnaround is all the more peculiar as it apparently has little to do with the country's economic momentum.



Brazil has sunk ever deeper into recession in recent quarters and seems unable to rise to the challenges facing its economy. Wage-indexing, price controls and currency depreciation have led to galloping inflation that prevents the Central Bank of Brazil front cutting interest rates. Meanwhile any fiscal stimulus applied by the government simply increases the primary deficit, now running at 2.1%, and the budget deficit including debt servicing charges, now running at 9.7% (see left-hand chart below). Finally, in addition to undermining the confidence of consumers and business leaders, the imbroglio created by corruption scandals has often led to political gridlock, forcing the authorities to scrap or defer much needed tax and budget reforms.


In an economy mainly driven by domestic consumption, there is little gratifying news on this front (see right-hand chart below). Inflation is gouging real wages and driving debt-servicing costs to record levels, deterring households from borrowing. Moreover, they are saving money in anticipation of higher taxes. So far the weakness of the national currency, the real, has not given a substantial boost to exports.   



So there is no shortage of worries and the few bright spots have, in most cases, already been priced into assets by investors. Low debt levels in foreign currency and the central bank's relatively large reserves will shield Brazil from an insolvency crisis on a scale that could seriously jeopardise its international standing. Confidence indices have bottomed out recently, providing a degree of reassurance, but they remain near all-time lows (see left-hand chart below).


It will not be easy for the authorities to pull the economy out of recession. They will probably have to do so by maintaining currency weakness and introducing structural reforms. It is the hope of progress in this latter area, symbolised by the possible impeachment of President Dilma Rousseff, which has lifted Brazilian equities and the real recently. The common denominator across emerging countries in cases like this is that political developments are able to leverage the markets more than economic trends. The same kind of anticipation can also be observed in Brazil at the company level: after large downward revisions in earnings forecasts, the movement had barely bottomed out when the stockmarket came roaring back nearly 30% (see right-hand chart below).


While the need for structural reforms is great in most of the emerging economies, it is an inescapable in Brazil. In a country used to seeing 4% annual GDP growth for over a decade, productivity gains have been wiped out by wayward government budgets, an inflationary spiral fuelled by wage-indexing, persistent weakness in a manufacturing sector ridden by Dutch disease and repeated corruption scandals. Obviously neither these woes nor the country's nagging political divisions will be overcome anytime soon, not even with Rousseff out of the way. Moreover no other political figure can claim massive backing for the time being.  


Besides, the impeachment of President Rousseff is not a foregone conclusion. While the easiest solution would be for her to resign, she has repeatedly stated that she would stay on the job. The last election, in 2014, could be annulled if allegations of irregularities in her campaign financing are proved, in which case an interim president would be appointed until the next vote, in 2018. The prospect of impeachment, the event that triggered the recent rally in Brazilian assets, will depend on a vote in the Senate. The decision of the president's main coalition ally, the Brazilian Democratic Movement, to join the opposition, has left her more isolated than ever. The opposition has to muster the votes of two-thirds of the country's senators by mid-April to initiate the impeachment process. One can well imagine that the next two weeks will see frantic horse-trading in the wings.


So, as we can see, dethroning Rousseff quickly will be no easy matter and, moreover, won't guarantee significant progress on the road to reform.


Part of the reason why investors scrambled to buy Russian stocks last year was the market's rock-bottom valuation, 40% below the historical average. Brazil does not boast the same buying argument. The local benchmark was trading at 10x earnings in January (about the same level as the emerging markets' in general), just 10% below its historical average (see chart below).


In view of these developments we wonder how sustainable the present rally, largely driven by uncertain political hopes, can be.


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