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For Emerging Market Investors, Brazil Has Become A Hot Mess

For Emerging Market Investors, Brazil Has Become A Hot Mess

Posted by Juan Gavasa on February 26, 2015

For those who like their macro trades to be alluring and exotic, but with an overdose of danger, then Brazil is the place for you. Like Rio de Janeiro itself, pretty but deadly, Brazil has become the hot mess of emerging markets.

Not even Russia, the wild east sanctioned geopolitical disaster zone that it is today, can compare to Brazil. Russia is, well, Russia. It’s always trading at a discount to better managed, diverse and transparent economies like Brazil.  But Russia is failing because of geopolitics and oil. Brazil, meanwhile, is shooting itself in the foot.

The most visible problem in Brazil today is the ongoing scandal involving Petrobras. Brazil’s state run oil firm was downgraded by Moody’s to junk bond status on Tuesday. More importantly, the corruption scandal has changed investor perception of Petrobras. It’s no longer trustworthy. Investor sentiment has soured to the point where Petrobras shares have lost 43.6% in the last 12  months.  Petrobras’ problems are Brazil’s problems. As the country’s most important company, when sentiment sours on Petrobras, it sours on the political leadership that’s in charge of it. When that happens, investors, like civil society in Brazil in general, lose confidence in government.

Brazil’s Triple Whammy

Barclays Capital economists led by Bruno Rovai in New York listed three things that will pull Brazil into a recession this year.

The risks of energy rationing remain high. Rovai expects a 15% rationing program could lower 2015 real GDP growth by 1.2 percentage points. The Petrobras investigation has led the company to reduce investments. New CEO Aldemir Bendine said Petrobras will keep its proposed expenditures on the production side but would cut new investments in exploration. So for now, Petrobras is stuck with the oil it has in the ground. That’s a lot, of course, but given the direct and indirect effects of those cuts down the Petrobras food chain, Barclays estimates another 0.5 percentage points scrapped from GDP.

Lastly, Brazil’s economy likely contracted in the fourth quarter, implying a negative statistical carryover for 2015 of 0.2 percentage points. Taken together, Brazil has already shaved at least 1.9% off this year’s GDP. Last year the economy grew an estimated 0.5%. This year, Brazil is already off to a poor start.

Market consensus is for negative GDP in 2015.

The iShares MSCI Brazil (EWZ) exchange traded fund, the most popular day trade into Brazil equities, is down 1.93% on Wednesday. The ETF is down 13.2% over the last 12 months. The MSCI Emerging Markets Index is up 4.7% over the same period.

Dilma, Her Central Bank, and Brazil’s Withering Currency

President Dilma Rousseff of the Workers’ Party was re-elected in November by a small margin. Her popularity has stabilized, but is tenuous. Within the business and investment community, Dilma is still a downer. Many blame the lack of dialogue between Dilma and Congress. Most of Dilma’s economic measures over the last four years were done between herself and Finance Minister Guido Mantega.

Mantega is gone. He’s been replaced by ex-Treasury Secretary Joaquim Levy. But that won’t change Congress’ perception of Dilma.  Many analysts are worried about a political deadlock in Brasilia, the nation’s capital. This will impede Dilma’s chances to help the economy long-term.

Despite the fact that Moody’s downgraded Petrobras to Ba2 on Tuesday, Dilma’s new economic team’s measures will be sufficient to keep Brazil’s sovereign investment grade rating, Barclays believes.

Meanwhile, Brazil’s central bank is in a precarious situation.

On Monday, a central bank survey showed inflation is expected to rise over 7% this year. That’s way above the high water market of 6.5% and far from the target of 4.5% set by the bank. Over the past four years, Brazil has shied away from tackling inflation with interest rate hikes. But Alexandre Tombini, still head of the bank, will unlikely follow that approach this time around. That means interest rates will stay higher for longer.

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