The outlier in Brazil isn’t politics

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: CHUNT@EUROMONEY.COM

By:
Published on:

While growth forecasts for Brazil for 2018 are turning optimistic, a few – a surprisingly small number in fact – are warning about a growing downside risk for next year: a negative hit from a persistent drought.

While the two leading domestic banks are predicting growth of around 3% for next year, their chief economists’ presentations to the Felaban conference in Miami in mid November disregarded the risk to growth from drought.

Sylvio-Castro-2017-160x186
Sylvio Castro, Credit
Suisse Hedging-Griffo

However, according to Sylvio Castro, CIO at Credit Suisse Hedging-Griffo Private Banking, investors on Brazil “shouldn’t ignore the energy and lack-of-water risk in 2018, which is being over-looked. The truth is we are very much reliant on the hydroelectrical power for growth.”

Rainfall in Brazil’s latest rainy season ending in April was below average and the country is entering the dry season with much less water than in 2016. Reservoir levels in the southern/mid-west region, which represent 60% to 70% of the country’s hydropower generation, stood at 42% of capacity as of March in contrast to 62% in March 2016. In the northeast, reservoir levels – at 30% – are the lowest for the past four years.

Research from Moody’s points to the impact on power generation.

“To preserve reservoir levels, more expensive oil-fired thermal power plants will have to be fired up, causing spot prices to jump. At the same time, Brazil’s economy is emerging from a deep recession,” says the ratings agency. “That will fuel electricity demand, albeit at a slow pace, and add to upward pressure on spot prices as the additional supply comes from thermal plants under a scenario of poor hydrology conditions.”

Profits

Overall energy consumption in February 2017 reached an average of 66,186 megawatts in the month, the highest since February 2014. The volume registered in March 2017, at the end of the summer, was also the highest for the month of March since 2014.

However, as the cost of electricity rises, large industrial users begin to take profits from selling back energy allocations to the grid and scaling back production. This would impact GDP growth in the key recovery year, as well as exacerbating the other key risk for 2018 – the presidential election.

“You still have a very open elections landscape for 2018 in Brazil, and we should all hope for the best when it comes to the geopolitical risks,” says Castro.

With assets priced for perfection in Brazil, if either politics or drought risks came true, the potential downside would be bad.

If both came to pass, it could be painful for those with Brazilian exposure.

You have been warned.