Brazilian real likely to strengthen further

investment insights

Brazilian real likely to strengthen further

Vasileios Gkionakis, PhD - Global Head of FX Strategy

Vasileios Gkionakis, PhD

Global Head of FX Strategy
  • Despite the BRL rally these past few months, we argue that reform implementation has not been priced in the currency so far, in sharp contrast to the equity market
  • February’s congressional elections are likely to see the pro-reform speaker of the lower House re-elected
  • This should facilitate progress in structural reforms, especially in the social security system
  • Such an outcome would be market friendly and trigger inflows into Brazilian assets, supporting the BRL and setting the stage for its outperformance vs emerging market peer currencies

Brazil is going through some historic shifts since voters elected Jair Bolsonaro to lead Latin America’s biggest country for the next four years. After choosing to turn the page on years of recession and corruption scandals, hopes have been revived for structural reforms to address chronic issues of mounting deficits and a loss-making pension system.

Although opposition to reforms remains a big challenge, investors (mainly locals – see below) are giving the government the benefit of the doubt. The probability of a Bolsonaro victory started rising in September 2018, a month before the elections, and the IBOVESPA index (the main equity index and a gauge of sentiment towards domestic economic and political dynamics) has risen 28% since then, outperforming the MSCI EM Equity index by a staggering 29%. During the same period, the BRL has appreciated by more than 10% against the USD. In a way, Mr Bolsonaro has helped by showing a willingness to deliver on promises. Two-thirds of his administration’s cabinet, for example, consist of members with no party political affiliations.

In what follows, we argue that the Brazilian equity market has been propelled higher by pricing-in idiosyncratic (Brazil) related issues, such as hopes of reform implementation, while the BRL is yet to meaningfully reflect such expectations. The currency’s rise has been mostly due to its high-beta relationship1 to global emerging market currencies, which have strengthened over the same period. Consequently, positive developments on reform implementation should be seen as positive for the BRL and would likely lead to outperformance versus EM peers.

Chart 1 shows the relative performance of the IBOVESPA index against the MSCI EM Equity index (capturing global EM factors) and the MSCI LatAm Equity index (capturing regional factors). In both cases, Brazilian equities have outperformed global and regional returns since September 2018 by a wide margin. In fact, since the beginning of 2018, Brazilian stocks have outperformed global EM peers by 35% and LatAm peers by 15%. We interpret this as evidence that the domestic stock market has been pricing in positive domestic developments, most likely increasing probabilities of structural reform implementation alongside a gradual rebound in growth

We interpret this as evidence that the domestic stock market has been pricing in positive domestic developments, most likely increasing probabilities of structural reform implementation alongside a gradual rebound in growth.

Why has the BRL appreciated and what’s the role of foreign investors?

The appreciation of the BRL over this period comes against a backdrop of positive EM FX returns. In other words, different types of investors reallocated towards BRL within a broader process of reallocation towards EM currencies. From a historical perspective, a 6% gain in the EM FX index (the spot return achieved between mid-September and now) translates to about 8.5% gain in BRL against the US dollar, fairly close to the actual appreciation of the real vs the USD during the period. Put differently, BRL gains reflect, by and large, a general rotation towards emerging market currencies (broad market forces) rather than Brazil-specific factors. This is also evident by the fact that “fast/hot” money inflows have been absent during this period, despite the improved domestic sentiment.

Indeed, when we look at the monthly data of portfolio flows (see chart 3), we see that foreign investors have not been buyers of Brazilian assets for quite some time. We interpret this as showing that ‘fast’ international money has been cautious and in a wait-and-see mode, in contrast to local investors who have been bidding domestic stocks higher.

We think that there are more-than-even odds that the next few weeks will provide a catalyst for gradually reviving foreign investors’ interest in Brazilian assets, pushing the currency higher.

The next crucial step involves the elections of the speaker of the lower House and the president of the Senate on 1 February. Virtually nothing gets passed in Brazilian legislature if there is strong opposition from both of these congressional leaders.

In the lower House the incumbent Rodrigo Maia looks set for re-election and apparently he has secured the backing of the Social Democratic party, the Social Liberal party (Bolsonaro’s newly elected government) and the Democrats (Maia’s own party). Together with the fact that Mr Maia has liberal economic inclinations and is pro-reform, this is likely to be seen positive by the market as it increases the chances of structural reforms passing the lower House.

The election of the Senate president is slightly more complicated. Here, the leading candidate is Renan Calheiros, an ever-present figure in Brazilian politics. He is largely seen as representing the “old school”, which in principle distances him from Bolsonaro. However, Mr Calheiro is not someone to make an enemy of, and we suspect that his reputation, skill, experience and influence should act as a catalyst for President Bolsonaro to work hard at forging an alliance.

In all, given Brazil’s system of governance which relies on “coalition presidentialism” where alliances matter, we expect that the Bolsonaro administration will make progress on the passing of structural reforms - especially in what concerns changes to the loss-making social security system - sometime in Q2/Q3 of this year.

This is likely to play out against a backdrop of ongoing BRL undervaluation. Both our long-term (based on terms of trade) and short-term (based on Brazilian CDS and Brazilian yields) models suggest a USDBRL overvaluation of around 20% (see charts 4 and 5).

On balance, we think there is an increasing probability that BRL would come under further upside pressure in the following months and should start outperforming a number of other EM currencies. We believe investors should expect downside in USDBRL and, in relative terms, outperformance versus the CLP where growth has peaked – while in Brazil the recovery is still young.

We believe investors should expect downside in USDBRL and, in relative terms, outperformance versus the CLP where growth has peaked – while in Brazil the recovery is still young.

That said, market participants need to manage exposure prudently as risks remain and are not negligible. The first risk is global and relates to the possibility that the recent economic slowdown manifests itself as something deeper and more sinister, weighing on EM assets and high beta EM currencies. The second risk relates to the possibility that reform opposition grows to the point that Mr Bolsonaro is unable to proceed with meaningful changes. If the current administration delivers nothing or too little, then the BRL would come under pressure in the same way as the South African rand (ZAR) in early 2018 when the market was disappointed by the stalled reforms promised by the newly-elected South African President Cyril Ramaphosa.

Wichtige Hinweise.

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