Brazil has been suffering from macroeconomic headwinds for quite some time. Strong capital outflows since mid-2013 triggered by the prospect of rising interest rates in the U.S. have resulted in a weakening currency which in turn fuels inflation via rising import prices. Against this backdrop, the central bank has been forced to raise interest rates to double digit levels – a reasonable measure to fight inflation, but hardly favourable for economic growth.
Any prospects of an imminent political turnaround?
In addition to the economic mess, the political outlook is hardly encouraging. Even if there is somewhat of a consensus that President Dilma Rousseff will win the elections in October, economic leaders would rather welcome an opposition candidate gaining popularity. At least, the once rather 'dogmatic' Mrs Rousseff has adopted a more 'pragmatic' posture since former president and fellow party member Lula da Silva has decided to campaign side by side with her. Rumour has it that Lula plans to candidate himself again in 5 years time, hence his effort to campaign next to her. Despite his potential involvement in corruption scandals, veteran leader Lula may still be able to benefit from his charisma and popularity among ordinary people. In general, the Brazilians are non-confrontational, even if the protests of summer 2013 may have left a different impression. Actually, an atmosphere of political opposition in the streets is virtually non-existent. As the oppositional forces are not aligned, they appear weak and may find it difficult to score against the ruling Worker’s Party. As Brazil gets closer to the election, state run cash-generating entities like Petrobras and Banco do Brasil will continue to finance social programs in order to keep voters happy. This will of course be much to the detriment of the fiscal accounts and add further to the fiscal pressure already existing.
What measures can be expected to fight inflation?
While official inflation figures in Brazil are around 5-6%, real inflation could easily be 8-9%. Actually, inflation is likely to be kept artificially low, as the government forces the state-owned oil company Petrobras to sell petrol below market levels. In order to further contain inflationary pressure, the Central Bank of Brazil has raised interest rates significantly in the past few months, resulting in an interest level of 10.5% p.a. The money market has priced in further rate hikes until the end of the year. However, despite the formal independency of Central Bank of Brazil, doubts remain regarding a further increase of the base rate, as this might harm the government’s popularity prior to election.
Is the Real likely to recover from his plunge?
Over the long-term, yes, but over the short-term, probably not. Political uncertainty, poor health of public finances and the ongoing recovery of the US economy are likely to put further pressure on the currency. There is broad consensus that the Brazilian Real will continue to depreciate in the near future. While current BRL levels are around 2.50 against the USD, 12 month futures are pricing in a further weakening of the BRL to levels above 2.75. Nevertheless, the Central Bank of Brazil is supposed to intervene if the depreciation threatens to get out of hand. As foreign reserves are at a comfortable level of approximately USD 300bn, the central bank has sufficient fire-power to oppose excessive speculation.
Any hope for a pick-up in growth?
Actually, the growth outlook does not look too bad after the Brazilian economy had almost stalled in 2012. The official forecast is a 2.5% growth for 2014, which appears achievable considering the positive effect of the currency devaluation on Brazil’s export prospects. Furthermore, the FIFA World Cup taking place this year might result in a positive surprise. While the immediate impact of the event on the real economy may be debatable, it will likely have a positive impact on the sentiment of consumers and entrepreneurs which could eventually result in a stronger recovery than expected. Such intangible effects on the overall dynamics of an economy should not be underrated.
So, what is the conclusion for investors?
While the short-term prospects of Brazil still appear dim, the current phase of uncertainty and lack of confidence among investors might prove a good entry point for contrarian buyers. As regards equity markets, carefully selected private investments in public equity as well as private equity investments made with a medium term view appear particularly promising. Regarding liquid assets, dollarized fixed income investments at the short end of the curve are highly appealing given current interest levels. Corporate credit may become at a later stage, as economic prospects brighten. Exposure to local currency bonds should still be avoided, for the time being. The downside risk of currency fluctuations is currently not compensated even with interest rates exceeding 10 % p.a. While a further recovery of the Brazilian economy appears probable, investors should not expect a resurrection of the currency any time soon.