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Brazilian markets flying high over economic reality

The rebound in Brazil’s economy that many expected following last year’s change of government has failed to materialise. GDP will grow just 0.5 per cent this year according to a central bank survey. In per capita terms, that means another 12 months of contraction after headline negative growth of about 8 per cent over the past two years.

Not that investors are deterred. The Bovespa equities index is up more than 9 per cent this year, while the currency has gained about 3.5 per cent against the dollar. Last year, as the economy tanked, Brazilian stocks outperformed emerging markets as a whole by 55 per cent, according to MSCI, the index provider, as optimism surged on the impeachment of leftist president Dilma Rousseff and her replacement in August with pro-business, former vice-president Michel Temer.

But now, some fear, the rally is running on fumes.

Alberto Ramos, an economist at Goldman Sachs, said that to validate the rally Brazil would need a V-shaped recovery from its recession — but that isn’t going to happen.

“It will be slow and protracted,” he said. “This was a balance-sheet recession. All sectors are overstretched and need to delever.”

Companies had no reason to invest, he said, household income had fallen — and for the millions who had lost their jobs, collapsed — and the government had embarked on a long-term path of reform and fiscal contraction.

“An awful lot of good news is baked in the currency and equities”, particularly from the rapid progress the Temer administration has made on reforms to public spending and welfare, he said. “But the window for reform is not wide, no more than a year or two. When the election comes along in [October] 2018, it’s hard to see a candidate promising to continue and deepen the beautiful austerity programme of finance minister [Henrique] Meirelles.”

Much of the rally, too, has been driven by the recent recovery in commodities prices. Some 20 per cent of the Bovespa equities index is made up of shares in Petrobras, the state-owned oil company, and Vale, the miner.

This does not mean the optimists have got everything wrong. While the recovery may disappoint, inflation — the perennial scourge of Brazil’s economy — is coming down fast. For the first time in two years, annual consumer price inflation to December 31 last year fell within the central bank’s target range of 4.5 per cent plus or minus two percentage points. It is expected to hit the 4.5 per cent target this year. This has allowed the bank to embark on what many expect to be a deep easing cycle. It cut its policy rate by 75 basis points this month, to 13 per cent. Another 350bp of cuts are on the cards this year.

Luis Oganes, head of emerging market research at JPMorgan, notes that in the past, cutting cycles have gone hand in hand with equity rallies.

“History may not matter much these days given how unprecedented things are on so many fronts, but in every past easing cycle we have had an equity rally of at least 20 per cent,” he said. “That’s why equity markets are rallying despite the fact that growth is quite poor.”

Celson Plácido, chief strategist at XP Investimentos in São Paulo, expects a direct boost from falling rates. “For companies, just having much lower interest rates this year will mean higher profits,” he said.

The fact that Brazil’s economy is relatively closed and domestically oriented leaves it relatively well insulated from the “Trump factor”, said Alejo Czerwonko, emerging market strategist at UBS Wealth Management.

“If you are looking at the EM universe and looking to protect yourself from the next Trump tweet there are not many places you can hide,” he said. “[But] one of them is Brazil.”

While he still “likes” Brazil`s currency and bonds in local and dollar denominations, he believes the equities market has probably peaked for now. Trailing 12-month price to earning, for example, are running at 12 times. That is above the 10-year average of 10.3.

“We are not turning bearish Brazilian equities — we are simply taking profits and saying expected returns are going to be very different from 2016 realised returns,” he said.

Brazil still has a high level of idiosyncratic risk. Mr Plácido at XP Investimentos points to the possibility that Mr Temer’s mandate could be terminated as part of investigations into corruption at Petrobras.

But this remained a remote prospect, he said, and even if it happened, it would probably take up until almost the next election to pass through the courts.

In the meantime, investors were taking advantage of Brazil`s generous interest rates which, despite the central bank’s cutting cycle, remained very high.

Mr Ramos at Goldman Sachs agrees. “Real rates [after inflation] are above 6 per cent. Where can you get that on the planet? Only in Brazil.”

But he warned that the currency had now risen to a level “that doesn’t help the economy any more”, adding to the headwinds of political risk.

His big concern is that the government’s gradualist approach to reform will fail to deliver results.

“Look at Mexico,” he said. “They did it all at once. This is the time for Brazil to do the same — under a transition government, with an economy ravaged by a populist experiment. After that you get reform fatigue.”

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