Well, bad news is still good news in Brazil, apparently.
Despite the fact that a complete political meltdown is less than two months away, the market is excited about what’s being viewed as a possible turning point for the country’s economic fortunes.
Of course the notion that things are about to get better isn’t based on the data or on anything that even approximates an upturn in the fundamentals. Indeed it was just yesterday when the country reported its largest primary budget deficit in history, underscoring just how silly it was when officials suggested late last summer that the government would somehow manage to report a 0.5% surplus.
Just this morning we got still more bad news when Copom released its quarterly inflation outlook. “In the policy-passive reference scenario (Selic constant at 14.25% and BRL/USD constant at 3.70), projected inflation for end-2016 deteriorated by 40bp to 6.6% and is now above the 6.5% inflation target upper limit,” Goldman writes, summarizing the central bank’s forecasts on the way to explaining why the BCB is effectively incapacitated having found itself stuck between high inflation and abysmal growth. “Given the atypical inflation-activity backdrop (very high inflation amidst extremely weak real activity), and the fact that monetary policy and overall financial conditions facing the Brazilian economy are already quite restrictive, we expect the central bank to keep the Selic policy rate unchanged at the current 14.25% for a while longer. However, given the uncommon depth, breadth, and duration of the economic recession we expect the central bank to likely act on the first window of opportunity to ease policy.”
In other words, things are really, really bad on all fronts and the central bank is powerless to do anything to boost the economy because cutting rates risks exacerbating already high inflation.
Make no mistake, nothing about this situation screams: “buy.” But that’s not stopping the market from going all-in on the whole “the night is darkest just before the dawn” theory of trading.
As Bloomberg notes, “bearish bets by foreign investors against the real are at the lowest level since November 2013 [with] bearish wagers [sitting] at $16.5 billion as of March 29, down 57.4 percent from a record high of $38.7 billion on May 29.”
Ironically, the stronger the BRL, the harder it will be for the Brazilian economy to adjust, which means those betting on BRL strength as a play on an economic turnaround are inadvertently undercutting their own cause. The BCB is doing its best to counter the FX rally by selling reverse swaps, but that effort fell flat on Thursday as the bank was only able to place 2,900 of the 17,000 contracts offered. That, combined with the hot inflation report, drove the currency still higher.
It’s against this backdrop that one investor sees an opportunity in Brazilian equities (which have staged a furious rally this year). “We try to buy when blood is running on the street,” Monty Guild Jr., chief investment officer at a boutique investment firm with $190 million in global equity funds tells Bloomberg. “This is a lot like Watergate, and after Watergate what happened? Where there’s a crisis in confidence, costs go down and there’s a huge opportunity.”
The best way to capitalize on this “huge opportunity” is through Brazilian stocks Guild says. Have a look at the chart below which compares the S&P during the Watergate era to the Bovespa so far during the Carwash probe.
“While some 40 years apart, there appear to be several similarities between the episodes,” Bloomberg goes on to write. “Just like the investigation into the break-in at the Watergate hotel, Brazil’s probe into kickbacks at the state oil company escalated over two years of deepening economic turmoil, eventually implicating President Dilma Rousseff [and] like the infamous tapes that led Nixon to resign, a recording of Rousseff’s conversation with her predecessor now has brought her one step closer to being impeached.”
This is all fine and good but we would advise caution here for two reasons.
First, Brazil is not America. Yes, corruption is rampant inside the Beltway and $19 trillion in debt makes the US look more and more like a banana republic with each passing day. But in Brazil, a quarter of Congress face active criminal proceedings. 1/4 of Rousseff's impeachment committee are themselves the subjects of Supreme Court probes. Brazilians are protesting in the streets by the millions. Allow us to reiterate: by the millions. This is a country that is rapidly backsliding into "failed state" status and that isn't where you necessarily want to invest.
Second, it's not clear that those who have a front row seat for Brazil's descent into chaos are feeling too good about the prospects for Brazilian risk assets. To illustrate that point, we'll simply close with one last chart from Bloomberg.
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Bonus: "The Collapse of Dilma Rousseff; The Richard Nixon Of Brazil," by Nicholas Lemann as originally published in The New Yorker
Richard Nixon was reëlected overwhelmingly in November, 1972, and resigned in August, 1974. Dilma Rousseff, the President of Brazil, looks to be on about the same schedule: reëlected (not overwhelmingly) in October, 2014, and in such deep peril a year and a half later that it seems unlikely that she will finish her term. This week, the largest party in her governing coalition, the Partido do Movimento Democrático Brasileiro, or Democratic Movement Party, voted to leave the government, which is the most severe in what must seem to her a never-ending series of blows.
The obvious cause of Nixon’s downfall was Watergate, and the obvious cause of Rousseff’s is the Lava Jato scandal. In both cases, the name may be mysterious to outsiders. Lava jato means car wash and refers to a penny-ante roadside money-laundering operation in Brasília that, when exposed, provided the first peek at what turned out to be an almost all-encompassing system of corruption. The chief government prosecutor, a youngish judge named Sérgio Moro, from a provincial city in southern Brazil, is now investigating such economic behemoths as Petrobras, the state oil company, and the construction industry, which has been especially busy in the run-up to the 2016 Summer Olympics, in Rio de Janeiro. Every day seems to bring news of another high official under investigation, another corrupt arrangement uncovered, another grant of immunity in exchange for information.
Corruption scandals are a constant feature of Brazilian politics. Government plays a far larger role in the economy than it does in most of the developed world: there are many state-owned businesses, subsidized businesses, and businesses legally protected from competition. And an especially complex and chaotic parliamentary system—at the moment, more than two dozen parties hold seats in the national legislature—means the only way to create a governing coalition is to dole out patronage to parties, often in the form of control over government ministries, in exchange for their support. The reason that Rousseff, a career bureaucrat who had never run for office before, was elected President in 2010 is that the people who were in line for the job ahead of her were felled during a previous scandal. One of her few remaining talking points in her campaign to avoid being impeached is that almost no Brazilian politician can feel entirely safe if Moro’s investigation is permitted to play out indefinitely.
Even by Brazilian standards, though, things seem to have gotten out of hand over the last few years. For example, the prosecutors recently charged João Santana, one of Rousseff’s political consultants and therefore only a second-order political figure, with receiving $7.5 million in funds siphoned from bribes that big companies paid the government in exchange for contracts. There are now almost two dozen separate investigations under way under the broad rubric of the Lava Jato scandal.
It seems unlikely that the driving force in the mega-corruption was personal greed on the part of the rather austere President. Instead, it was probably a combination of the party-time atmosphere produced by the economic boom of the aughts—in particular, high oil prices and the prospect of the Olympics—and Rousseff’s political ineptitude. Lacking the charm and cunning of her predecessor and mentor, Luiz Inácio Lula da Silva, Rousseff seems to have been more reliant on unsubtle means of maintaining a hold on power. In particular, as a far more intellectually consistent leftist than Lula, Rousseff lacks his uncanny instinct for finding a mix of policies that at once reassure economic élites and deliver for an overwhelmingly poor political base. Rousseff’s attempt to bring Lula back into politics as her chief of staff seems to have had two purposes: to immunize him from prosecution, and to enlist him as anti-impeachment lobbyist-in-chief, a role to which he is naturally suited. As of now, a judicial injunction prevents Lula’s appointment from going forward, and that only increases the likelihood of Rousseff’s government collapsing.
The revolt against Rousseff is a middle-class one, in a country that is not yet essentially middle class in the manner of the United States. Like everything that happens in politics, it’s about power and policy, as well as corruption. Brazil’s abrupt shift from prosperity to recession, caused in part by the dramatic fall in oil prices, has made it impossible for investors and politicians to continue to get simultaneous spectacular economic returns. Now they are competitors, and the unlikely consensus over which Lula presided, in which former revolutionaries and bankers appeared to coexist happily within a government ruled by an organization called the Workers’ Party, is gone.
The real losers in the reshaping of Brazilian politics that is to come won’t only be corrupt politicians. The tens of millions of beneficiaries of the generously funded core social programs of the Lula-Rousseff years, Bolsa Família (cash grants to families) and Minha Casa Minha Vida (public housing), are at risk, too. These programs are the heart of the social compact in Brazil, in the way that Social Security and Medicare are here. It will be a tragedy if, in the mad scramble to assemble a new ruling coalition that will almost certainly be more business-friendly, their constituency gets left behind.