What’s the investment outlook for Brazil in 2018?

The Brazilian stock market has been on a tear for the past two years as the economy has returned to growth, and the real has also rallied strongly. But what’s the investment outlook for Brazil in 2018?

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results

Ibovespa, Brazil’s benchmark stock index, has been surging over the last two years, with the iShares MSCI Brazil ETF climbing 64% in 2016 and 24% in 2017 in US dollar terms. While Brazil’s economy returned to growth at the start of 2017 after contracting for eight consecutive quarters - the longest recession in the country’s history - continued reform of the public sector and an extension to the commodity price rally are key to further stock market gains.

The rise of the real

The story of a return to economic growth in South America’s largest economy starts with its currency, the Brazilian real. Since the beginning of 2016, the real has rallied after a period of instability, amid the downfall of disgraced former President Dilma Rousseff, impeached for manipulating government accounts. The real has appreciated 18% against the dollar over this period, leading to cheaper imports which in turn has reduced inflation. The annual rate of consumer price inflation was just 2.7% in November, down from a high of 10.7% in January 2016.

Low and stable inflation has helped kick-start consumer spending, while business confidence has also improved. This has led to an increase in domestic production, while the number of people unemployed has fallen for nine consecutive months.

What’s more, low inflation has also allowed the central bank to more than halve interest rates over the previous 17 months, taking the Selic target rate (a target interest rate set by the central bank in an effort to influence short-term interest rates) down to 7.0% from 14.25%. Since interest rates have fallen faster than inflation, the real interest has dropped significantly, reducing the cost of borrowing for Brazil’s heavily indebted households. This should help boost consumer spending since more cash will be available for purchasing goods and services instead of paying down debt.

Altogether, the economy seems to be recovering well after contracting by 8.2% during the last two-year recession with gross domestic product (GDP) in the third quarter rising, 1.4% against a year earlier. Looking forward, economists are forecasting the economy to grow by 2.5% in both 2018 and 2019.

But what lies ahead that could possibly trip up a recovery that appears to be based on a virtuous circle? The failure to deliver much needed fiscal reforms before October’s presidential election could disappoint investors, while a negative shock to commodity prices could also derail the recovery.

Temer the Reformer

The current president, Michel Temer, who took the reins from Dilma Rousseff last September, has faced an uphill battle to squeeze through much needed austerity measures, whilst simultaneously fighting off corruption allegations. The stock market rally has been partially built on hopes that Temer will be able to get public spending under control. In order to reign in the ballooning budget deficit, his government have drawn up a list of 57 public assets ripe for privatisation, including the state-controlled power company Eletrobras, and major airports such as Congonhas in São Paulo.

While markets have welcomed efforts to reduce the budget deficit, Mr Temer’s approval rating at home has plunged. Austerity measures have weighed heavily on the middle and lower classes and many Brazilians are not keen on the prospect of flogging prized assets to foreigners. According to a recent poll, the Temer government was considered 'Great / Good' by just 6% of respondents.

And with the presidential election just ten months away, the clock is ticking for Temer to implement what economists believe to be the golden goose of reforms – an overhaul of the country’s pension system. According to the World Bank, Brazil spends a reported 4% of GDP on public sector pensions, an even higher proportion than Greece. However, earlier in January, Temer’s plans were dealt a major blow as Congress failed to approve a series of pension reforms that are expected to save around $125 billion over the next decade. The cost: a credit rating downgrade by Standard & Poor’s to BB-, three notches below investment grade, putting the world’s eighth largest economy in the same bracket as Vietnam (48th), Costa Rica (77th) and Georgia (119th).

With such low levels of political capital it seems Temer’s plans to reform the pension system are unlikely to materialise during his remaining time in office. This could signal potential weakness ahead for both Brazil’s stock market and currency.

Commodity rally aids stock market gains

The other major force behind Brazil’s stock market is commodity prices. Around a quarter of the Ibovespa’s constituents are in the mining and energy industries. During the last financial crisis, commodities plummeted and the Ibovespa shed around 65% of its market capitalisation. However, since 2016, the Bloomberg Commodity Total Return Index has gained 15%, helping boost the earnings of companies that produce and export Brazil’s abundant supply of natural resources. Rising prices for commodities such as soybean, iron ore and oil have been fundamental in leading the stock market higher, since these three commodities make up 10%, 7.2% and 5.4% of all Brazilian exports, respectively.

Looking at iron ore specifically, which has doubled in price since 2016, investors who are looking to take a view on the metal may be interested in miner Vale (VALE.A). While the price of iron ore doubled in the past two years, the world’s largest iron ore company has returned more than 300%. The outlook for the company depends heavily on the price of iron ore, which is primarily driven by demand from China and the US.

Credit downgrade may provide support for reforms

While the credit rating downgrade is negative for the government, it could actually play into the hands of Temer, who may use this to convince Congress to vote in favour of his proposed pension reforms. However, if he is unable to gain support for the plan before October’s election, the market will be welcoming of a new president that is equally pro-reform. The likelihood of which will depend on whether inflation can remain at current levels, and unemployment continues to fall. And if commodity prices continue their upward trajectory, the more likely it is that the stock market will remain elevated.

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