Structural reforms are crucial in the perspective of the stabilization of the Brazilian economy, but the ongoing political crisis in Brazil adds uncertainty about their progress. We discuss here, with our investment professionals, the causes of the political turmoil, the possible consequences and its investment implications.
On Wednesday, May 17, the newspaper O Globo published an article about a secret recording of Brazil’s President, Michel Temer, allegedly negotiating the payment of a bribe to silence one of his former allies, the ex-president of the Lower House, Eduardo Cunha, in connection with a corruption scandal which involves a large number of businessmen and politicians.
President Temer took office less than one year ago after the impeachment of Dilma Rousseff; his popularity rating is very low, as he has been trying to push through some unpopular reforms in order to rein in the nation’s depleted public finances that have been badly damaged by two years of recession.
It is not clear yet if what is contained in the tape could overthrow the President, or if it inconclusive, but the political support for Mr Temer is declining and the situation remains very opaque.
For a country where pensions and other benefits represent nearly half of federal spending (outside of interest payments), reforming the social security system is crucial in order to control the public deficit.
High inflation has also been a problem for Brazil, but has declined significantly over the past year and is now comfortably within the targeted range. The Central Bank has adopted an easing stance since September 2016 and, looking at the current and projected inflation and output gap, there is still significant room to continue this easing. But currency depreciation is putting our benign inflation outlook at risk and could be further undermined by a continuation of the political turmoil. The FX interventions to defend the Real will likely “preserve” reserves but at a painful fiscal cost, worsening the already poor fiscal conditions with higher interest rate costs.
The vote for the pension reform was supposed to happen in a few weeks. Recent events, however, look set to delay the process and the unpopularity of these reforms are unlikely to encourage the political parties – eager to win future elections – to push for it now. Moreover, the current political turmoil could shift the focus from reforms to elections, with an outcome of no pension reform being implemented. If the allegations are proven true, political transition and signs of a commitment to pension reform by the new leadership, together with currency dynamics will be the key focuses.
Unsurprisingly, the Brazilian assets sold off on the day this news story broke. While we have been constructive on the prospects for fixed income, perceiving potential opportunities from the implementation of structural reforms, recent events have prompted us to be more cautious and we have adopted a wait and see stance given the lack of visibility on future developments. In a situation where the allegations against President Termer are proven to be true and the current government is removed from power, we are assessing the probability that an interim transitional administration would be able to continue to push the pension reform agenda. On a broader perspective, we expect the crisis to be contained domestically and continue to hold positive attitude towards emerging market assets, on a selective basis, thanks to the more robust global growth momentum, a weaker case for US dollar strengthening, improved earnings for emerging market corporates.