Brazil has been the hottest emerging market for the past year.
In that time the equity market has risen 39 per cent, according to MSCI — by far the strongest performance of any country in the EM universe. Meanwhile, EPFR data show that it has attracted easily the greatest inflows of cash from foreign investors, in comparison to assets.
This follows a political crisis last year which saw the impeachment of President Dilma Rousseff and her replacement by her more technocratic vice-president, Michel Temer, and Brazil’s worst ever economic recession. Mr Temer is now trying to push through a radical package of structural reforms.
What is intriguing about the market rally is that it has been achieved even though the economic data continue to deteriorate, while political uncertainty remains acute. Unemployment is still rising and has just topped 13 per cent, and GDP is still declining. In both cases the rate of decline has lessened, which is important, but the economy is not expected to show growth until the end of the year.
As for politics, there is a wide-open presidential election coming up in October 2018. Meanwhile, Mr Temer’s approval ratings are terrible, at 10 per cent. And a wide-ranging corruption scandal known as “car wash” is picking up ever more politicians and corporate leaders.
Is the market ahead of itself? The bull case, made to me this week by the finance minister Henrique Meirelles, is as follows. First, the single most important reform has already been achieved. Brazil’s constitution has been amended to require the government to reduce spending from 20 to 15 per cent of GDP over the next decade. The political establishment is now committed to cutting the level of government expenditure which, he says, has been crowding out the private sector.
The next reform, being argued over at present, is to change the pension system and institute a new universal retirement age of 65. This is in line with much of the developed world, and would replace a current system where many are able to retire on full benefits in their early 50s. Naturally it is unpopular and there is much political horse-trading at present.
Following that, Mr Meirelles says there is enough time left before the next presidential election to overhaul Brazil’s ridiculously over-complicated tax code. Also on the agenda are labour reforms, moves to spur infrastructure and a host of micro measures to lower the cost of doing business in Brazil. For example, he wants to reduce the average time to open a business from 100 working days to three.
Mr Meirelles describes the entire package as a “revolution”, which seems reasonable. The question is whether it can happen under an unpopular president and with new elections fast approaching. He makes two points. The first is that the unpopularity makes it far easier for the government to try to do something ambitious for the long term. They have nothing to lose. This should actually appeal to the markets.
Second, this administration was largely installed by Congress as a result of the impeachment process, and so this presidential team aligns with the groups in Congress more closely than any in decades.
Finally, reflexivity is already at work. Market optimism has brought down interest rates on bonds and unfrozen the bond market. For a period of 11 months starting in mid-2015, Brazil saw no corporate bond issuance at all. Now, the deals are back, making it easier for companies to build. Equity capital is once more available.
Meaningful pension reform would be the single most meaningful step towards putting Brazil’s finances on a sustainable basis
The opportunity in Brazil remains evident. Its natural advantages in terms of scale and resources have not gone away. But so are the risks. On what basis might investors buy at this point?
Thankfully, a litmus test is in the offing. Pension reform negotiations are coming to a head. No reforms are more important. Reaching the federally mandated cuts in spending will be impossible without drastically shifting pension entitlements. The last attempt at pension reform, almost 20 years ago, failed by one vote; if this effort fails it could be a while before there is another. And failure now would also damage the government’s political momentum for other reforms.
The reverse is also true. Meaningful pension reform would be the single most meaningful step towards putting Brazil’s finances on a sustainable basis. The negotiations in Congress are due to come to a head in the next few weeks.
This looks like a binary issue for markets. Investors interested in Brazil should monitor the headlines on pension reform. With success, Brazilian assets should continue their rally. With failure, and with messy elections looming, it could be time to cut back once more.
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