S&P Downgrades Brazil: What Next?


S&P Downgrades Brazil: What Next?

On 9 September, S&P downgraded Brazil to BB+, a speculative rating, leaving the country on negative watch. Fitch (BBB, Outlook negative) and Moody’s (Baa3) maintain investment grade recommendations for Brazilian hard currency government debt; expectations now shift to the timing of further downgrades. Moody’s reaffirmed investment grade status on 11 August, leaving its outlook stable, while Fitch has not changed its rating since April 2011. Fitch’s negative outlook makes it the most likely candidate to downgrade in the near term.

S&P’s move is only a surprise for its timing, as Brazil’s alarming fiscal deterioration had reflected in widening spreads since May.  Consensus had expected Brazil to lose its investment grade rating. At close on 9 September, Brazilian spreads were 378 over Treasuries, a level consistent with speculative sovereign markets. Pre-downgrade, Brazilian spreads were the widest of any major investment grade emerging country.

The catalyst for the move appears to be President Dilma’s proposed 2016 budget, which includes a 1% of GDP primary deficit target. S&P had said in their 28 July release that their rating was influenced by Brazil’s credible response to fiscal challenge, a view shared by investors. Caught between its electoral mandate and fiscal reality, Brazil’s leadership has hesitated to introduce clear policy direction. The resulting muddle has generated both uncertainty and increasing sovereign debt levels, with Brazil’s total fiscal debt to GDP now approaching 70%. Brazil’s proposed budget suggests a lower commitment to credible response, which may have triggered S&P’s subsequent move.

The rating agency may have been looking for progress on the revenue side of the budget, with proposals to raise income tax on financial institutions (from 15% to 20%), an amnesty program for individuals with undeclared overseas assets, and suggested end to the income on capital benefit all recently debated. Further change may be required; Brazil could reintroduce CPMF, a tax on financial transactions. At 0.38%, we note local estimates of potential revenues of R$80 billion, roughly 2.5 times the total proposed increase detailed above.

Contagion Risks

Turkey and South Africa are both markets that present cases for potential future rating agency scrutiny.  As a whole, emerging market sovereign risk is below crisis levels, though the direction of change is not positive. Emerging markets now present investors with a balance of risk that is roughly mid-cycle. One challenge that may be faced by investors: the last cycle (2002-2009) saw rating agencies generally more pessimistic on emerging markets risk, while the current cycle has seen them generally more forgiving. Downgrade risk could surprise the market more severely as a result.

A Sovereign rating considers a wide range of inputs; because emerging markets are diverse, causes of rating downgrades may vary. In Turkey’s case, increasing leverage and external debt appear to have been increasing pressure on the national balance sheet. In South Africa, the government’s fiscal indiscipline has caused concern. As with Brazil, investors seem to worry that the government lacks the political capital to address the issue.

What does this mean for investors?

Historical experience suggests that a loss of investment grade status may lead to a decline in capital inflows, which will pressure both the current account and currency. The decline in flows may result in rising risk premiums, which tend to hurt valuation. A sovereign downgrade therefore presents a challenge to domestically focused, long-term investment cases. There is an exception: businesses that generate hard currency revenues against local currency costs should see profits (and valuation) rise in these situations.

Investors sometimes look through a de-rating, but with Brazil’s current fiscal deficit tracking at 4% of GDP, this feels unlikely in the present case. If another rating agency cut to a speculative rating would challenge Brazil’s membership in certain investment grade indexes. This could lead to forced institutional selling if the country’s average rating drops below investment grade. Brazil’s policymakers know that capital outflow hurts the country and makes their position more complex, so we may see efforts to protect the rating in the near future.

The situation remains fluid and we remain vigilant.

For more information, please visit our Emerging Markets dedicated site 

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Global Market Volatility Keeps Investor Expectations in Check

ThinkstockPhotos-185953030Volatility continued to dominate global financial markets during September 3-10, 2015. Constant concerns about global growth and growing worries about a prospective Federal Reserve (Fed) rate hike are weighing on global equity markets. Commodity prices came under renewed pressure with crude oil prices sinking 6% on a surprisingly large inventory build. There was a divergence in global fixed income markets with the prospect of a Fed hike putting upward pressure on 10-year yields, while the prospect of more European Central Bank (ECB) and Bank of Japan (BoJ) quantitative easting (QE) helped drive European and Japanese 10-year yields lower.

Emerging markets (EM) and debt markets were hit with a string of negative news. First, JP Morgan removed Nigeria from its Government Bond EM indices, which could potentially lead to $1.5bn in outflows over the next two months. Second, Brazil became the second BRIC (Brazil, Russia, India, China) nation to lose its investment grade credit rating, after Russia. These actions sent Nigerian 10-year bonds sharply lower, falling 3.7% while Brazilian long-term bonds plunged 4.3%. The U.S. dollar (USD) rallied across the board, aided by higher U.S. interest rates and continued worries about global growth, with the exception of the euro (EUR).

Overall, the choppy price action in global financial markets reminds us that we have entered an uncertain and volatile period where concerns about the health of global growth, disinflationary pressures, and U.S. rate normalization will dominate global asset prices.

Click here for The Weekly Compass – a more complete discussion of the week’s capital markets activity.

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3 Things the European Investment-Grade Fixed Income Team Talked About Last Week

187927625Catalonia Goes to the Polls (Again) 

Last week marked the start of campaigning for a regional election in Catalonia, traditionally Spain’s industrial and economic powerhouse. Although formally a regional election, it has become a kind of unofficial second vote on independence for the region. In November 2014, Catalans voted in an unofficial referendum on the same topic – the Catalans wanted the vote to be an official referendum but the central government in Madrid refused to allow the election to have official status. But the Catalans sent a clear message back to Madrid – over 80% of those who voted declared themselves in favour of independence. Catalans have a long history of being fiercely independent, and believe that they subsidise the rest of Spain – in 2010 Catalans contributed almost €62bn in taxes and revenues to the central government in Madrid, but only received back €45bn. The depth of feeling runs deep – even the former Barcelona FC manager Pep Guardiola is standing for one of the pro-independence parties. Should these parties have a majority after the election, they could make moves to declare formal independence within 18 months. This political uncertainty has seen a marked under-performance of Spanish government bonds versus other European countries, and especially Italian government bonds.

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3 Things the European Investment-Grade Fixed Income Team Talked About Last Week

Business People Discussing Around The Conference Table

  1. 50 Shades of QE

The ECB’s September introductory statement reads “We emphasise our willingness and ability to act, if warranted, by using all the instruments available within our mandate”. It goes on to repeat what was said in the July statement – that Quantitative Easing (QE) “is intended to last until the end of September 2016”. But then, it adds an additional 4 words, which completely change the complexion of the statement – “…or beyond if necessary”. With those 4 words, ECB President Mario Draghi has, once again, demonstrated to markets his ability to continually fulfil market expectations. Pre-meeting, all the chat was about how the ECB would react to a stronger Euro and falling oil and commodity prices. The ECB responded by lowering their growth and inflation forecasts. Importantly, the ECB now sees inflation at 1.7% in Q4 2017, whereas in June it had forecast a level of 1.9% for Q4 2017. They also noted that “inflation will rise more slowly towards the close to but below 2% target than previously anticipated” and “risks to the inflation outlook are tilted to the downside”. Even more dovishly, Draghi noted that the forecasts were made on August 12th and “since then financial conditions have tightened”. So, we now have a bias to easing monetary policy from the ECB, and the burden of proof lies on why they should not increase QE. However, the current programme has a year to run, and as we have seen recently, a lot can change in a short time. Continue reading

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European Equities – Where Next?

Finding the solutionView from the European Equities desk

2015 was to be the year of European Equities. After five years of trailing the U.S. market, all eyes turned to Europe, as the power of Quantitative Easing (QE) and an expectation of greater growth (in terms of both GDP and corporate earnings) saw investors almost unanimously bullish on the asset class. Fast forward nine months and the asset class has given back all the gains from Q1. So, what now?

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