Recovery from recession has been anemic

Brazil is struggling to prove that it’s cleaning up corruption and fixing its economy.

Latin America’s largest country had its debt downgraded deeper into junk territory on Friday by Fitch Ratings.

Ratings are important. A high rating can draw foreign investment, which can create jobs and boost growth. A low rating deters mainstream investors and attracts high-risk buyers, generally not the type governments want to recruit.

Political uncertainty, failure to reform the pension system, and large fiscal deficits triggered the decline, Fitch said in a statement. Standard & Poor’s, another debt rating agency, downgraded Brazil in January. It entered junk territory in 2015.

It’s a setback for Brazil, which just last year came out of the longest recession in its history. Its recovery has been anemic. And its presidential election this fall has been dogged by fears of a return to populism and complicated by a front-runner facing possible jail time.

Unemployment remains high at 11.8%. Before the corruption-fueled recession, unemployment was near 6%.

A longstanding push to reform Brazil’s pension system failed in the legislature earlier this month. That all but confirmed that any such reform will have to wait until a new president takes office in 2019.

More bad news arrived Wednesday when a nonprofit, Transparency International, severely lowered Brazil in its annual corruption rankings. Brazil ranked 96th out of 180 countries. It ranked 69th in 2014 and 79th in 2016.

Source: Channel 3000

Inflation in Brazil came in close to analyst expectations in mid-February, holding below the bottom end of the official targeted range, and sustaining bets on an interest rate cut next  month.

Consumer prices tracked by the benchmark IPCA index rose 2.86 percent in the twelve months through mid-February, government statistics agency IBGE said on Friday, in line with a forecast of economists polled by Reuters.

Lower energy tariffs kept a lid on price hikes after unexpectedly strong rains boosted hydropower generation, offseting a big jump in education and transport costs.

Underlying inflation trends remained muted due to double-digit  unemployment rates and widespread idle capacity among companies.

The IPCA index rose 0.38 percent in mid-February from the month before, slightly below the consensus analyst estimate of 0.42 percent.

The reading shows how the central bank is struggling to lift inflation back to its targeted range, of 4.5 percent plus or minus 1.5 percentage points, as the economy recovers from its deepest recession in decades.

This month, the bank cut interest rates to an all-time low of 6.75 percent and said it would keep them there if the economy evolved as expected.

But two straight downward inflationary surprises have spurred trader speculation that the bank could cut rates by an additional 25 basis points in March. This was made more likely after the minutes of the bank’s last policy meeting showed policymakers were divided over how strongly to signal the end of monetary easing.

Source: Reuters

In 2017 global emerging markets stocks and currencies posted their best return since 2009. And even after this robust performance emerging markets continue to offer attractive investment opportunities as economic growth outpaces the developed world in 2018 (4.9% vs 3.3% forecast growth this year (Shroders)), current account deficits improve, political volatility moderates and structural reforms get back on the agenda in many key markets. This supportive macro milieu should allow for further gains in corporate earnings (margins are currently below historical levels), return on equity and upside pressure in stock markets.

Emerging markets equity valuations, although not as cheap as before last year’s bull market, are broadly competitive versus developed markets and their historical levels. The rally has reduced the valuation discount for emerging markets relative to developed markets from 35% to 25% further gains could reduce this to around 20% in 2018 (Bulltick).

This emerging market thesis neatly sums up the Brazilian equity environment as well, as the country continues its recovery from one of its largest ever recessions. (With a 9% fall in GDP, that’s close to depression level economics.)

Brazil seems to have gotten back on a positive trajectory in 2017. According to Angela Bouzanis Senior Economist at FocusEconomics, recently released data “indicates that GDP grew for the first time in over three years in Q2, confirming that the [Brazilian] economy has turned a corner”, led by falling inflation and export growth. Indeed these factors, together with historic lows in the benchmark SELIC interest rate (currently at 7%), emerging discourse over political and fiscal reform and positive economic growth, have fuelled investor optimism and capital flows into Brazilian equities.

Cyclical stocks have led the pack with consumer discretionary stocks up nearly 60% since December 2016. The benchmark Ibovespa index of leading Brazilian listed companies was up by 26.8% over 2017 in local currency, outperforming both developed markets and broader emerging indexes. The index has more than doubled since hitting a seven-year low in early 2016.

According to Bulltick, the Latin America focused Asset Manager, valuations may be slightly extended but “earnings will pick up amid stronger growth, justifying current multiples. It should also be noted that the current P/E ratio for the Bovespa is 14% higher than the trailing 60 month average, which is still less than in US markets, where the S&P 500 multiple is trading 19% above its 60 month historical average.”

A “Major upside trigger”

Since the impeachment of President Dilma Rousseff in August 2016, political stress – closely related to corruption investigations – has been a constant theme. One of the biggest discussion points for the markets has been the potential candidacy of Lula, Dilma’s predecessor and a central figure in the Car Wash corruption scandal that has captivated the nation. Fears over the return of the left-wing Workers’ Party in October’s presidential election have kept markets on egg shells over the last few months.

This uncertainty however, which was potentially holding back further upside pressure both in financial markets and the real economy, was cleared up in an appeals courtroom on 24th January, where Lula was condemned to 12 years in prison on corruption and money laundering related charges, therefore ruling him out as a presidential candidate. This eventuality, although widely expected, was greeted warmly by the markets. The Bovespa rose to a record high (almost 4% on the day the decision was announced), pushing year-to-date gains to more than 9% and taking the index to a historic high.

The trial will be a “major upside trigger” for Brazilian assets, said James Gulbrandsen, a Rio de Janeiro-based money manager at NCH Capital, which oversees $3.5 billion. “The Brazilian economy is already in major recovery mode. The first movement will be flows into Bovespa futures, but domestic economy-related companies will roar past the market once dedicated small and mid-cap flows overtake large cap flows.”

XP Investimentos, the largest security broker in the country, projects the index to reach close to 90,000 points by year end 2018 (and 95,000 points in the upside scenario), a positive but less impressive uptick than that seen last year. Furthermore, on the operational side, XP expect to see “consistent revenue growth, which with the dilution of fixed costs and controlled inflation will result in higher operating margins, further intensified on the bottom line because of lower financial expenses.

Bulltick expect GDP growth to be 2.2% this year with investment mood set to risk-on. They recommend long positions that would benefit from a not-priced-in collapse in the SELIC rate such as Discretionary, Materials and Financials. Looking at GDP to total market cap –  one of Warren Buffett’s favourite metrics – also suggests upside potential. The current ratio is 47%. The historical high is 106%, the historical low is 26% and the average is 53%.

The extent of secular upside in Brazil depends on GDP and other metrics continuing to strengthen, the progress of economic reforms and a market friendly “win” in the presidential elections later in the year. Domestic politics has always loomed large in Brazil’s market performance, even by emerging market standards. “The campaign looks set to bring bouts of increased market volatility”, according to Marcelo Carvalho, head of emerging market research at BNP Paribas. Jeffrey Lamoureux, senior country risk analyst with BMI Research adds that “it is far from clear that a strong, pro-reform candidate capable of building a broad electoral coalition will emerge”. Investors will therefore keep elections in the spotlight.

A “festa” in Brazilian equities

There is the possibility that a virtuous cycle on the economic front could result in higher growth, low inflation, low interest rate and debt sustainability et al. But equally, harmful economic policy post-elections could have a binary outcome. Recent history suggests Brazilian assets are either suffering acute downside or upside swings.

In any case, good earnings growth and an above average (but correcting) valuation discount compared to developed world equities should continue to support Brazilian equities. The Brazilian central bank’s aggressive rate cuts have not only supported aggregate demand but also anticipated expected monetary policy normalisation from developed market central banks. The Car Wash corruption investigations are also having a positive impact on corporate governance and compliance.

As a result of the improved outlook, country risk (as measured by JPM EMBI Brazil) is also seeing downward pressure. The relative bond spread of a basket of emerging market sovereigns is down 30% year-on-year, positively impacting equity valuations and supporting the consensus bullish view on Brazilian assets. There is a significant relationship between Brazil risk and Bovespa strength (historic R2 of 0.68 between 2015 and 2017).

In a recent FT article on the current “festa” in Brazilian equities, Geoff Dennis, head of global emerging markets equity strategy at UBS, argues that “Brazil is still a market that investors love to love. When markets move, they tend to buy Brazil.” How long the rally can last, and the acuteness of future gains is harder to quantify though. For now, valuations are more attractive than India, China and broad Latin American markets based on forward PEs.

Looking at the EM universe as a whole, analysts at TM Rowe believe that the future path for EM equities is likely to be less homogenous and more divergent than it was in an era when commodity prices were rising, global trade was strong, and China’s economy was growing at over 10% annually. “This suggests that rigorous analysis of company fundamentals will be more important than ever in 2018. Being proactive will be essential to identify and invest in the most attractive opportunities within these highly diversified markets.”  As always, fundamentals are key to long term valuations.

Source: Master Investor

The Temer administration admitted for the first time that it did not have the votes for the pension reform bill, which would be off the agenda at least until the presidential election, and announced a plan B, consisting of a series of measures that also depend on Congress’ approval.

Among the proposals are the PIS/Confins tax reforms, an autonomous Central Bank, the approval of a general regulatory agency law, the revisiting of tax breaks, modifying the “Cadastro Positivo” – a financial history database – not to mention other proposals that were suggested by four ministers and three parliamentary leaders on the night of Monday the 19th, during a meeting at the Planalto Palace.

Earlier in the day, Secretary of Government Carlos Marun stated that the pension reform bill had been put on hold and that it would only be reintroduced in November at the earliest. Unofficially, the administration considers that the next administration will have to tackle the issue.

According to Mr. Marun, the administration arrived at the conclusion that there were no legal grounds to revoke the decree establishing a federal intervention in Rio – the decree rules out the possibility of amending the constitution, which pension reform would require.

“The issue of public safety became so explosive that it became necessary to implement a measure whose side effect means that pension reform will have to be suspended”, he said.

Finance Minister Henrique Meirelles said that pension reform is fundamental and a priority. “It is the most important fiscal reform and it will be submitted to Congress as soon as this is constitutionally possible.”

Source: Folha de S. Paulo.

Analysts are growing upbeat about Brazil’s inflation prospects this year as the nation’s currency, often a source of pressure on prices, is forecast to remain little changed in 2018.

Another reason for the local optimism is the outlook for global inflation, which is expected to remain subdued as synchronized growth in developed economies should keep the U.S. dollar from strengthening, which mitigates another risk for the Brazilian currency, says XP Investimentos Chief Economist Zeina Latif. And even in a worst-case scenario of an external shock in the coming months, it would take time for currency swings to have an impact on prices, leaving 2018 inflation in Brazil unscathed, Santander economist Mirella Hirakawa says.

The real has traded in the 3.12-3.31 per dollar this year, and is expected to close 2018 at 3.30, according to median estimate from economists surveyed by Bloomberg.

Source: Bloomberg

Economic activity in Brazil expanded at faster than expected in December, the central bank said on Monday, suggesting the economic recovery maintained momentum at the end of the year.

The central bank’s economic activity index rose 1.41 percent from November, surpassing a 1.1 percent median forecast in a Reuters poll of economists.

Source: Reuters

The federal government has been borrowing money in order to pay off ordinary expenditures, such as the payroll of civilian and military servants and social security pensions.

Such maneuvers are prohibited by the so-called ‘golden rule’, which forbids the government from borrowing money in order to pay off ordinary expenditures.

The norm stipulates that money borrowed from the financial market must be used either for investments or for managing the public deficit.

The only reason the government isn’t violating the golden rule is that, from 2016 onward, the federal government has been using funds from the Brazilian Development Bank (BNDES) in order to make up for the money being borrowed to pay for recurring expenditures – the government borrowed R$ 100 billion in 2016 (US$ 30.4 billion), R$ 50 billion (US$ 15.2 billion) in 2017 and is expected to borrow another R$ 130 billion (US$ 39.5 billion) in 2018.

A survey carried out by Folha into federal expenditures revealed that, in 2016, the government turned to the financial market to cover social security pensions through debt issues.

The data, which the government started compiling from 2000 onward, demonstrates that 2016 was the first time that money was borrowed in order to pay social security pensions.

The government reached this low point after several years of high budget deficits, beginning in 2011. In other words, the government’s expenses are greater than its revenues and that the government needs to borrow money in order to cover the difference.

Failing to comply with the golden rule means that administrators, ministers and even the president may be held accountable. In the latter case, impeachment proceedings may ultimately ensue.

Source: Folha de S. Paulo

Members of Brazil’s central bank policy board diverged last week over how strongly to hint at the end of interest rate, though all agreed that reductions should cease if the economic outlook evolves as expected, the bank said on Thursday.

In the minutes of the central bank’s Feb. 7 monetary policy meeting, the bank repeated its message that the deepest easing cycle in a decade is close to an end. Still, it could pursue a final rate cut next month if inflation continues to underwhelm, the bank said.

“Some members expressed a preference for a high level of flexibility, favoring more symmetric communication about the next step, while others proposed to signal more strongly the possible interruption of the monetary easing cycle and to maintain freedom of action, but to a lesser extent,” the minutes said.

Last week, the central bank cut the benchmark Selic interest rate by 25 basis points, as widely expected, to an all-time low of 6.75 percent, and it strongly hinted at the end of the easing cycle.

The cut came despite a selloff in global stock markets as a jump in U.S. wages raised questions about the pace of rate hikes there, sending shock waves through developed and emerging markets alike.

Still, consumer price figures released since then came in sharply below economist forecasts, raising doubt over the bank’s plans as inflation remains stubbornly below the bottom-end of the official target.

Yields on interest rate futures suggested a sizeable minority of traders expected a final rate cut at the bank’s March meeting, though bets on the bank standing pat remained dominant.

The minutes stressed that the central bank has the leeway to adjust policy both to slower-than-expected inflation and to a worsening of global financial conditions.

Economists agree, however, that keeping interest rates at low levels will hinge on policymakers’ ability to curb government spending, a task that looks increasingly difficult as this year’s presidential elections approach.

Source: Reuters

Brazilian retail sales rose in 2017 for the first time in three years as low interest rates helped to lift the economy from its deepest recession in decades.

Retail sales rose 2 percent in 2017 from 2016, government statistics agency IBGE said on Friday, the largest increase since 2014.

With interest rates at all-time lows, consumers took out loans and purchased furniture and electrical appliances, driving a 9.5 percent increase in sales of these products.

Free-falling food prices in the wake of a strong agricultural harvest, as well as lower unemployment, bumped up sales of supermarkets, hypermarkets, foods and beverages.

But the recovery of Brazil’s services sector has been notably slower than that of the industrial sector, which has benefited from strong foreign demand.

Last week, data showed industrial output rose in 2017 at the fastest pace since 2010. December’s reading surpassed even the top estimate in a Reuters poll, suggesting manufacturers kicked off the new year on a strong footing.

In comparison, retail sales fell 1.5 percent in December from the previous month, a much larger decline than the 0.4 percent contraction median estimate among economists polled by Reuters.

The result highlights the two-track economic recovery of corporate Brazil, which for years suffered from bloated debt loads, high costs weak demand.

Nevertheless, economists expect the economy to turn that page in 2018, expanding at the fastest pace in four years.

Source: Reuters

Brazil submitted an extensive draft proposal for a potential agreement on investment facilitation to the WTO’s General Council last week, in a bid to jumpstart more “structured discussions” on the subject.

The proposal, which was circulated on 1 February, serves as a response to the call made by 70 WTO members in a “Joint Ministerial Statement on Investment Facilitation for Development,” which was released on 13 December on the margins of the WTO’s Eleventh Ministerial Conference (MC11).

The MC11 statement followed the work done by the “Friends of Investment Facilitation for Development” (FIFD) group, which had led to informal discussions on the subject last year. The FIFD group had also helped convene a high-level investment facilitation meeting in Abuja, Nigeria, with the support of regional partners last November.

That same MC11 document had confirmed that this group of members would begin holding “structured discussions with the aim of developing a multilateral framework on investment facilitation,” along with welcoming any other interested members to join the initiative.

This framework, they said, would be “flexible” and “responsive” given members’ respective priorities, while also preserving the right to regulate “in order to meet their policy objectives.”

The group had also confirmed plans to meet early in the new year “to discuss how to organise outreach activities and structured discussions on this important topic,” without setting a concrete date for doing so. The Brazilian proposal is the first formal document to emerge on investment facilitation and the WTO since MC11 drew to a close in mid-December.

Illustrative example of a future deal

In its submission, the Brazilian delegation clarifies that the draft proposal is not intended to serve as a negotiating text, but rather is meant to serve as a “concrete illustration” of what an agreement on investment facilitation could look like. The submission, they say, could help serve as a starting point for a “more focused and text-based discussion” on the subject, along with supporting outreach efforts towards bringing more WTO members on board.

The Brazilian text is more extensive and detailed compared to earlier proposals submitted by various delegations in 2017. The scope and the main elements, however, remain the same. These include articles that aim to improve the transparency, predictability, and efficiency of regulatory and administrative frameworks related to investment policies and measures. Proponents of these measures say that these would then provide a more stable and secure enabling environment for investors to undertake sustainable investments in host economies, thus promoting trade and economic growth.

The Brazilian proposal includes examples of articles that would strengthen institutional or “electronic” governance, such as by setting up a “single electronic window” that would publish relevant documents and help streamline the application and admission procedures for incoming investments.

The proposal also includes an article that would establish a national focal point, in other words a delegated authority which would mediate and facilitate investor concerns with public authorities and would also operate the above-mentioned single electronic window.

In line with previous proposals submitted last year by other delegations, the Brazilian text emphasises that issues such as investment protection, dispute settlement “not foreseen” under current WTO dispute rules, and market access, as well as government procurement, are outside the ambit of an investment facilitation accord.

Brazil has also included a range of other illustrative articles, such as “voluntary principles and standards of corporate social responsibility” for investors to undertake in other countries, along with suggested provisions for special and differential treatment (S&DT) for developing country and least developed country (LDC) members. These provisions include technical assistance, additional time for implementing certain articles, and the exclusion of LDCs from meeting some requirements.

The South American country has also outlined how a potential “WTO Committee on Investment Facilitation” could work, including reviews on implementation, cooperation with other international agencies, and the potential establishment of subsidiary bodies.

Questions remaining

Going forward, it remains to be seen how the proposal will be received among both current participants in the investment facilitation joint statement, as well as the WTO’s wider membership. Earlier attempts to discuss investment facilitation-related issues at the General Council last year and in minister-facilitated meetings during MC11 were strongly opposed by a coalition of countries, which included India and South Africa.

Some sceptics of the investment facilitation initiative have suggested that the subject falls outside the organisation’s mandate, while some have said the issue of investment facilitation is no different than the original “Singapore” issue of investment that had been considered for inclusion in the Doha Round of trade talks, only to be dropped from consideration.

Along with trade and investment, the other “Singapore” issues, so named for the location of the 1996 WTO ministerial which set up working groups to discuss certain subject areas, were trade facilitation, trade and competition policy, and transparency in government procurement. Only trade facilitation advanced to formal WTO negotiations from this working group process.

Another open question is whether and how the process for more “structured discussions” on new issues, such as investment facilitation, would be integrated within the WTO’s structures and formal processes.

The investment facilitation talks are not the only new initiative being pursued by WTO member groups in the wake of MC11. Joint ministerial statements were also released on e-commerce and on micro, small, and medium-sized enterprises (MSMEs), along with a declaration on trade and women’s economic empowerment. All of these drew the backing of several WTO members, who urged others to consider signing on.

Source: ICTSD