Was Brazil’s crash an opportunity or the end of a bull run?

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By:
Rob Dwyer
Published on:

Sharp crash in bank shares was followed by marked recovery; risk of political stagnation could lead to larger, longer-term falls in sector.

Michel-Temer-2017-R-600
President Michel Temer's refusal to resign risks more political paralysis in Brazil

Bargain hunters came into the market for shares in the Brazilian banks at the end of last week as investors bought the crash that immediately followed a scandal that threatens to end Michel Temer’s presidency.

However, while the subsequent recovery appeared to put a floor on the sector’s equities, there are some analysts who caution that Temer’s desire to cling on to power could see a slow reversal in what has been one of the world’s best performing asset classes in 2017 – for dollar-denominated investors.

On Wednesday evening, Brazilian newspaper O Globo reported that Joesley Batista, the co-owner of meatpacker JBS, had secretly recorded conversations with politicians as part of the Lava Jato investigation.

The newspaper said it had heard recordings of Temer agreeing a plan to pay the jailed ex-speaker of congress, Eduardo Cunha, to maintain his silence and not cooperate with the ongoing investigations.

The news story led to cabinet resignations and some of the smaller parties in his coalition announced they would be leaving the government. Impeachment proceedings were also filed by opposition congressmen.

Circuit-breaker

The next morning the markets crashed and the so-called circuit-breaker was enforced when the Bovespa fell by 10%. By the end of the day, the Bovespa was down 9% and the financial sector performed significantly below that dismal benchmark – at an average of a 14% fall – non-bank financials fell by an average of 5%.

The worst performer was Banco do Brasil, which fell by 19%. Furthermore, Brazil’s currency depreciated 8% to R$3.38 to the US dollar and CDS spreads widened almost 10 basis points to just over 300bp.

However, after the markets closed on Thursday, a visibly angry Temer addressed the country and vowed that he would never resign.

Later that evening, the audio was released and proved to be less definitive than O Globo had reported – though it was still damning and appears to show that Temer was at least aware of monthly bribes being paid to Cunha.

The next day bids returned for Brazilian bank equities and, while the previous session’s falls were far from erased, there were significant increases: Banco do Brasil rose 9.7% from its lowest point on Thursday by the market’s close on Friday; Bradesco by 7.2%, Itaú by 11.2% and Santander Brasil by 11.1%

A positive view of the outlook for Brazilian bank shares is based on the view that this scandal might not blow the country’s economic recovery completely off course.

This, from a UBS report, encapsulates this outlook: “We believe the macro fundamentals, BCB [Brazil’s central bank] credibility and tools like the FX swaps, as well as lower positioning from foreigners could attenuate the impact of the shock this time around compared to late 2015.

“Inflation is en route to the lowest level in a decade below the mid-level of the target range, the current account deficit is low and more than financed with (as of now) booming FDI.

“It is also not clear at all that pension reform is completely dead even if the current government is compromised. A lot of the work would in any case have fallen in the lap of the next government post-elections in 2018.”

However, UBS acknowledges this is an optimistic view and the more consensus view within Brazil is that pension reform is almost certainly dead if Temer doesn’t resign. Even if he does, Brazilian politics might still be too volatile in the run up to 2018 for significant reform.

Deutsche Bank is one of the many banks that see more downside risk than upside. The rally in the credit markets has been based on the assumption of a reasonable fiscal reform. With that reform agenda significantly delayed – at best – or halted due to political uncertainty, Deutsche says “the support for Brazil credit could dissipate rather quickly”.

Pensions

According to the bank’s Brazil economist José Faria, the original pensions reform would have eliminated the fiscal deficit by only 2025 – and these proposals had already been diluted by about 40%. Without reform, the national debt is projected to hit 100% of GDP around 2024.

Another risk stems from the fact Brazil has been in vogue in recent months and an overweight position from investors could exacerbate a sell-off.

“As of the end of March, EM dedicated funds were significantly overweight based on data derived from EPFR country weight report,” says Deutsche’s EM credit strategist Hongtao Jiang, who downgraded his sovereign recommendation to underweight because he believes the initial price action doesn’t reflect the risk of renewed downgrades.

“Meanwhile, inflows into Brazil fixed income assets have stayed strong over the past months, likely suggesting investors have not reduced their exposure to Brazil before Thursday. The heavy positioning could exacerbate the sell-off – absent a dramatic turnaround, we foresee continued reduction in Brazil risk by real money investors in the coming days.”

Should the credit markets continue to sell off, the share price rally for the banks, which was initially sparked and strongly maintained by the impact from the improving cost of risk to the sector, would reverse.

Bank valuations had begun to reflect the turnaround in non-performing loans and provisions in the sector – a return to recession would negatively impact these factors and if the currency sells off it would also complicate the downward path of interest rates.

As long as the political risks remain so elevated, it is a brave investor who sees the short-term price correction as an opportunity to build a profitable longer-term position.