Global risk-on trumps Brazilian risk as investors eye fresh equity deals

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By:
Rob Dwyer
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Carrefour subsidiary shows demand for Brazilian IPO; carry trade boosting equity as well as bond performance in Latin America.

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The pricing of the IPO of Carrefour Group’s Brazilian subsidiary Atacadão on Wednesday and Grupo Biotoscana on Friday show that the market is open despite the political uncertainty in the country.

Itaú BBA led the deal, with Bank of America Merrill Lynch, Bradesco BBI, Goldman Sachs, JPMorgan and Santander participating, which priced at the bottom of its R$15 to R$19 range.

The deal raised $1.6 billion and is significant as it is the first IPO in the country since airline Azul in April.

The Azul deal, which was led by Citi, Deutsche Bank and Itaú BBA, had been seen as heralding the start of a strong flow of primary issuance during the rest of 2017, only for a new political scandal to engulf president Michel Temer and throw investment banks’ pipeline plans into fresh doubt.

Atacadão was swiftly followed two days later by biotech firm Biotoscana – which priced at the midpoint of its range – and banks report a good pipeline with other companies close to issuing, including Omega Energia and reinsurer IRB.

Strong recent investment flows into emerging market (EM) equity – and Brazil in particular – have led to a strong performance in the asset class, and bankers are reporting keen interest from international investors for new Brazilian investment stories.

The performance of Latin American equities has been strong in recent months as part of the general search for returns in EMs as central banks continue their accommodative stance.

The Brazilian MSCI equity index returned 6.5% in the past 30 days, with Chile, Mexico and Peru all returning between 4% and 4.5%, and Colombia some way back with a positive 1% return.

A lot of this positive performance for international investors comes from the strong performance of the Brazilian real, which has risen by 6.7% in the past 30 days.

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Sonja Gibbs, IIF

Sonja Gibbs, the Institute of International Finance’s (IIF) senior director for global capital markets in Washington, argues that positive factors favouring the carry trade are also benefiting EM equities.

“When you think about carry, we are primarily thinking about fixed-income securities or the short-term money market, but equity is another great way to go,” she says.

“Equity can be a great carry trade as well because flows into equities are traditionally driven by expectation of real appreciation – that’s another way to profit from [today’s positive carry momentum].”

Gibbs says Brazil has traditionally been a favourite destination for carry-trade investors as it has historically attractive carry fundamentals – a combination of yield differentials and FX volatility. Additionally, the country’s depth and liquidity is also another positive factor for investors as “Brazil stacks up very well” relative to other EM markets.

Despite the falling yields in the country – and expectations of further falls to come – the relative differential even on a relative basis is still attractive; inflation turned negative in Brazil in June on a monthly basis for the first time in 11 years.

Gibbs thinks the outlook is set for more inflows in EM and Brazilian fixed income and equities in particular as investors continue to enter an appealing risk-adjusted return.

That will in turn offer Brazilian investment bankers the international appetite needed to conduct equity IPOs and follow-ons, as well as boosting liquidity in the local fixed-income markets.

'All about the Fed'

“The caveat here is that one of the biggest overall drivers of EM flows is changes in expectation for Fed rates,” says Gibbs. “To some extent the European Central Bank and the Bank of Japan enter the equation, but really it is pretty much still all about the Fed.”

Gibbs says the main three selling points of the EM trade – EM’s growth premium, positive rate differentials and the ‘central bank put’ from developed market central banks; effectively meaning that investors see reduced downside risk in risk assets as global monetary policy remains loose – rest on the assumption that the Fed’s increase in rates will be gradual and well communicated.

The market is pricing in two more rate hikes of 25 basis points in the coming 12 months – a rate of increase that shouldn’t threaten the dynamics driving EM flows.

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David Woo, BAML

However, while David Woo, head of global rates and currencies research at Bank of America Merrill Lynch (BAML), broadly agrees with the market, he has an interesting theory that could threaten this positive outlook for EM. 

Woo believes that the chances of rate rises is bimodal, by which he agrees that with the market predicting 50bp of rate increases on average,but believes it will transpire as either zero increases or 100bp.

Woo’s belief comes down to his reading of the Trump administration’s tax reform strategy. He believes the US government has shifted the attempt to pass tax reform to September and October to include that legislation as part of an overall agreement to avoid a government shutdown.

If Woo is correct, he believes successful tax reform will be positive for the US dollar and US inflation, and will likely lead to a 100bp increase in US rates – enough to lead to a negative impact on EM investments as investors pull money out of these markets.

However, in Woo’s theory, if this “game of chicken” with Congress fails, the result will be zero rate rises and the EM carry trade will strengthen on the back of a weakening dollar.