PMC Weekly Review - April 29, 2016

A Macro View – No Gold Medal for the Brazilian Economy

Political corruption has long been a part of life in Brazil. There’s even a saying dating back to colonial times “Jeitinho Brasileiro”, which means the Brazilian way of doing things, implying a creative ability to solve problems even if it involves cutting corners or breaking laws. The most recent series of scandals has culminated in Brazil’s lower house of Congress voting on April 17th to initiate impeachment proceedings against President Dilma Rousseff of the Workers’ Party. The vote now moves to the Senate, which is expected to confirm the vote, resulting in Ms. Rousseff’s suspension from office and formal trial. Rousseff, who was re-elected for a second term in October 2014 after a contentious campaign, has come under fire in recent months amid allegations of manipulating government accounts during her re-election campaign to paper over a ballooning deficit, alleged affiliation with the recent Petrobras scandal, and implementing ineffective policy to combat a devastating recession.

Rousseff, who served as head of the board at the state-run oil company Petroleo Brasileiro SA or Petrobras from 2003 to 2010, is alleged to have had knowledge of the recent corporate scandal dubbed “Operation Car Wash”, in which Brazil’s largest construction firms overcharged the company for building contracts. The excess profits were then doled out to Petrobras executives, politicians of various parties, and corrupt officials who took bribes to secure large Petrobras contracts. Making matters worse for Rousseff, she recently nominated her mentor, former President Luiz Inacio Lula da Silva, who was briefly detained in March for alleged involvement in Operation Car Wash, as chief of staff. Many suspect the move was intended to provide him with legal protection from the Petrobras investigation.

Concurrently, after roughly a decade of prosperity and functioning as the posterchild for developing nations, Brazil’s economy has fallen on extremely hard times. The slowdown in China has devastated the commodity-rich nation’s exports of iron ore, oil, soy beans, and beef. As commodity prices have tumbled over the last 18 plus months, unemployment has surged, inflation has soared into the double digits, and the country’s currency, the real, has lost roughly one third of its value against the U.S. dollar. Rousseff’s government funded the initial slowdown with an expensive stimulus package to guide the country through what was initially expected to be a short-term slowdown. However, as signs began pointing to a prolonged recession, Rousseff maintained her policy, refusing to make reforms, such as budget cuts and higher taxes for the wealthy. In 2015, GDP shrunk by 3.8%, the worst contraction of any major economy in the world.

Complicating matters further, the country is hosting the 2016 Summer Olympic Games in less than 100 days, at which point the government may be in complete gridlock. Much of the infrastructure for the Games remains incomplete, including several key venues, as many of the financing and construction firms have been entangled in Operation Car Wash. Political turmoil and the ongoing recession have also led to funding shortfalls for the construction of a metro line extension to the Olympic hub and the pollution cleanup effort in Guanabara Bay (home to several water sports), which has drawn the contempt of many participating nations and athletes. Furthermore, the recent outbreak of the Zika virus has dampened ticket sales, with only 60% of Olympic and 22% of Paralympic tickets sold as of mid-April. Many speculate that the government may be forced to buy up the remaining unsold tickets.

So how do these events impact U.S. investors going forward? Well, markets have generally reacted favorably to the pending impeachment news, as Vice President Michel Temer, of the Brazilian Democracy Movement Party (PMDB), is generally seen as better for business. Many EM equity managers are cautiously optimistic, and have recently begun dipping their toes back into Brazilian markets after fleeing on news of the Petrobras scandal. On the fixed income side, despite the fact that Brazil’s sovereign debt was downgraded to below-investment grade in 2015, the bonds have been viewed by many global and EM mandates as an attractive play, offering one of the highest yields in the world in both nominal and real terms. While opportunities exist in Brazilian markets, they undoubtedly involve a certain degree of speculation and volatility. The fact that each of the top three officials in line to succeed Rousseff is also accused of corruption demonstrates just how deep-rooted these problems are and it’s clear the world’s eighth largest economy has a long way to go to achieve its full potential.

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