After Brazil’s Market Rout, Bargain Hunters Step In
Brazilian President Luiz Inácio Lula da Silva won a surprise victory on Oct. 25, securing a fourth term.
Following the election, Brazil’s real plunged 7% and yields on 10-year government bonds rose two percentage points.
Some strategists believe the market reaction was an overshoot, while others warn that Brazil’s budget deficit is approaching 10% of GDP.
A fourth term for the left-leaning Brazilian President Luiz Inácio Lula da Silva is bad news from markets’ point of view. But is it bad enough to justify a 7% plunge in the real and two percentage point leap in yields on 10-year government bonds following Lula’s surprise Oct. 25 victory?
No, thinks Graham Stock, senior sovereign strategist at RBC BlueBay Asset Management. “There’s been an overshoot relative to deterioration in the fundamentals,” he says.
Most of Stock’s competitors agree in the short term. “We are looking for a bottom and patiently scaling in,” says Christopher Hays, an emerging markets debt portfolio manager at TCW.
Longer-term prospects depend on reading the 81-year-old Lula’s mind, among other known unknowns.
Volatile Brazilian equities are a niche play for the strong-of-stomach. The near-$1 trillion bond market attracts investors far and wide for the highest “real yields” (return minus inflation) of any decently liquid market. Those same yields are threatening a crisis for Brazil’s perennially overspending government and increasingly indebted population alike.
The sovereign 10-year yield is around 15% annually, with inflation less than 5%. Bank loans average more than 60%. Credit cards frequently charge triple digits. “No country can function with real rates of 10%,” says Arthur Budaghyan, chief emerging markets strategist at BCA Research.
Hawkish paranoia is embedded in Brazil’s central bankers after a decade of runaway inflation in the 1980s and ’90s. Monetary loosening will depend on Lula shrinking a budget deficit, approaching 10% of gross domestic product, says Steven Schoenfeld, CEO of MarketVector Indexes. “The only way to lower interest rates is to see some positive signs on fiscal policy,” he says.
Lula generated few such signs in the third term he is just completing. More than 90% of Brazilian state spending is set automatically through a web of indexation schemes, making cuts doubly challenging for any government.
The good news is that Brazil is flush with cash, points out Thierry Larose, portfolio manager for emerging markets local debt at Vontobel Asset Management. The central bank is sitting on more than $360 billion in currency reserves as commodity exports boom. Foreigners hold just 10% or so of local-currency bonds, minimizing the risk of a “hot money” run. “Brazil is not facing a liquidity crisis, still less a solvency crisis,” Larose says.
Fourth-term Lula hardly needs shock therapy to stem the vicious cycle of mounting debt pushing mountainous interest rates, TCW’s Hays says. A primary budget surplus (not counting interest payments) of 1% of GDP would “be taken positively by markets,” he predicts.
Budaghyan’s BCA sees a less investor-friendly escape from the rate straitjacket: the central bank printing money to buy government debt, known in the developed world as quantitative easing. For Brazil’s more fragile economy, this policy will result in “massive” currency devaluation, unleashing inflation and crushing bondholders. “Basically, Brazil needs to do QE,” he says. “But then where does the currency go?”
Which path to expect depends considerably on armchair psychoanalysis of Lula, who was first elected president 24 years ago. RBC’s Stock sees a “social democrat” who has tightened the fiscal reins before when circumstances demanded it. Schoenfeld frets about new populist promises Lula unveiled in the weeks before his runoff triumph, from retiring small business debt to shortening the official workweek. “The government absolutely can’t afford these measures,” he says.
The smart money is buying the dip for now, though.