Brazil’s market rally has been driven by politics rather than fundamentals, says Will Ballard.

 

In Brasilia, Dilma Rousseff and her Workers Party (PT) are under siege. Yet while the final impeachment of the president looks inevitable, questions remain over how long she can withstand the onslaught and the nature of her defence. Given this uncertainty, not to mention the country’s deteriorating economic state, the exuberant market reaction to Dilma’s travails appears premature.  

The Bovespa, Brazil’s domestic equity market index, has recovered nearly 40% from its January lows; over 60% in US dollar terms. According to Bloomberg’s BEST estimates, the Bovespa now trades on 13.5x forecast earnings. In the context of developed market indices - such as the S&P 500, which trades on 17x forecast earnings - it may not look expensive. However, Brazil is now trading at a 15% premium to emerging markets and a 25% premium to its five-year average.

Brazil’s political system has always required the creation of a coalition government, achieved through a patchwork of negotiations and alliances with other parties. In the country’s 513-seat Congress, the PT controls only 58 seats directly. In the face of growing public discontent, it was no surprise that the PT coalition crumbled and that the vote on the 17th April to start the impeachment process faced few obstacles.

Contrary to current perceptions, the vote does not mark the immediate removal of Dilma. The next step is for the Senate to vote to accept the impeachment motion for trial. This requires a simple majority of the 81 senators. Dilma will then need to stand down and prepare her defence before the final stage, which could be up to six months later and need a further vote from the Senate, this time with a two-thirds majority.

Unlike the impeachment of Fernando Collor in 1992, the situation surrounding Dilma’s impeachment is far from clear. The perception that it is related to the Petrobras money laundering and corruption investigation is wrong: it is in fact due to a nuance in the sourcing of funding for the budget deficit. This adds additional complexity and provides some context to Dilma’s claims that this is an orchestrated coup.

The impeachment process was set in motion by Eduardo Cunha, president of the Chamber of Deputies (Congress). Muddying the waters further, Cunha is also under-investigation by the Congressional Ethics Committee and prosecutors for alleged perjury, money laundering and receipt of at least $5 million in bribes. Meanwhile, Michel Temer, the vice-president who would be set to take power if the Senate forces Dilma to step aside, is accused of appointing lobbyists to pay bribes and manipulate appointments at Petrobras; allowing his allies to control the flow of campaign donations. He was also vice-president during the period in which Dilma is alleged to have misdirected funds.

The allegations do not stop there. Renan Calheiros, head of the Senate – which has to rule on Dilma’s position - is also under investigation by the Supreme Court for alleged crimes related to Petrobras, ranging from bribery to obstruction of justice.

The political and legal ambiguity surrounding this impeachment and its key protagonists is one clear impediment to the quick solution expected and hoped for by markets. A leaked recording showed Temer outlining some of the key aims of his potential administration, backing the further involvement of the private sector in the economy, but also pledging to maintain welfare benefits. In November, he launched a new liberal economic policy platform, proposing the liberalisation of industrial relations and reforms of pensions and government spending.

Having the right policy is one thing; getting approval for and then implementing reforms is more problematic. Congress is made up of over 20 different political parties. The ruling PT block held 295 seats, including Temer’s PMDB party among others. Recent events have broken up any semblance of a coalition, making it nigh-on impossible to vote anything through. The 81-member Senate is equally fragmented.

It is not as if political risk is the only issue facing investors. The country remains in the grips of the worst recession in decades. Gross domestic product is in its second year of contraction, with recent estimates suggesting a year-on-year decline of nearly six per cent. Industrial production has fallen a further 10 per cent, while capital spending, a good indicator of how companies view future growth prospects, has contracted dramatically. Unemployment has reversed an 11-year contractionary trend by rising to 7.4 per cent, while retail sales have fallen a further 4% year-on-year.

One indicator moving in the right direction is the current account balance. The Brazilian economy has benefitted from a terms of trade shock as a result of the 40% devaluation of the real since 2013. Imports have contracted dramatically, both in value and volume, while more recently exports have sputtered back to life, benefitting from China’s recent credit stimulus.

Equity investors should draw little comfort from this, however, with Brazil’s economic fortunes so dependent on resurgent demand from China, the US Federal Reserve refraining from hiking rates too quickly and a speedy resolution to the political crisis. Any prospect of pushing meaningful reforms and structural change to lift the economy out of recession during this political process looks slim. In this context, it is hard to see how the Bovespa rally can continue for much longer, especially given it is already trading at high valuations compared to its history and other emerging markets. There is little margin for error in what is an unpredictable, drawn out and incredibly complex situation.

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