Will ‘Operation Car Wash’ clean-up the investment landscape in Brazil?

With Brazilian president Michel Temer formally charged with corruption last month, the country has entered a new period of political instability which could pose a threat to the recent economic rebound. Delays to crucial reforms would make the country’s recovery more difficult in the short term, but Brazil is undergoing a democratic revolution in transparency that we believe investors can be optimistic about.

From 2004 to 2013, the Brazilian economy experienced a period of meaningful economic growth. On average, GDP grew 4.5 per cent during each year of the period and – as unemployment halved and financial conditions improved – Brazil became an attractive emerging market for investors.

By 2015, the country had undertaken an economic u-turn that saw GDP contract by 3.8 and 3.6 per cent in 2015 and 2016, respectively. Inflation doubled during the same period and, in July 2015, the central bank increased rates to a decade-high of 14.25 per cent.

Low commodity prices had a severe effect on the economy and the Brazilian real dropped more than 40 per cent against the US dollar between January 2014 and September 2015. This brutal economic recession has since been exacerbated by ongoing political turmoil.

In August 2016, Temer was elected president after the impeachment of Dilma Rousseff on bribery charges. As the political landscape stabilised, the country began to emerge from the worst recession in its history. A priority of the new Temer administration was to restore fiscal credibility and enhance business confidence through a series of proposed structural reforms.

While the vicious cycle of high inflation and policy rates, alongside falling economic growth, finally seemed to be over, the country remained under a political cloud as a national corruption investigation (dubbed Lava Jato or Car Wash) entered its third year.

It is, in terms of resources and accusations, one of the largest anti-corruption operations of the history of Latin America. The whole political system is being called into question with few of the country’s key politicians untouched by the saga – this includes the president himself.

Facing low public approval ratings and lacking support in Congress, Temer may struggle to stay in office and the probability of structural reforms is decreasing in the short term. The fragility of his leadership means that reforms proposed by his administration are unlikely to pass in their present form – this particularly applies to the pension and labour reforms essential to stabilise Brazil's economy.

The political crisis is threatening the economic landscape and posing serious obstacles to the recovery in the form of rising inflation, interest rates, unemployment and low wage growth.

Surprisingly, in contrast to the strong correction in May 2017 (when the scandal started), the market reaction to Temer’s indictment has been relatively tame. Investors may assume that existing political uncertainties are already priced by the market.

The Brazilian real and the country's benchmark Bovespa stock index have not declined substantially. Ultimately, Brazil is undergoing a democratic revolution – driven by a transparency shock – and, in the long run, we believe investors can be optimistic about the political paradigm shift that is clearly underway.

Investment outlook

We are positive on the economic fundamentals and think that Brazil is undoubtedly recovering. On the equity side, the current valuation of the Brazilian market is in line with other emerging countries with a price/earnings ratio of 12.

Even if political uncertainties remain, economic reforms are in progress. Inflation fell to 4 per cent and the central bank will probably continue to cut rates. The Brazilian real should stabilise, even if investors need to monitor the evolution of the political crisis. We believe that opportunities exist, but investors should remain selective.

After several months of investigations, trials are getting underway across the country. A political regime shift is clearly needed in Brazil but, in the meantime, ex-President Luiz Inacio Lula da Silva’s Workers’ Party – itself involved in several scandals – is currently leading polls for the 2018 elections.

We are closely watching the progress of the election campaign and, of course, the result because the new leadership that emerges will play a key role in Brazil’s economic future. On the one hand, investors will be forgiven for worrying about the current situation, but on the other hand, the evolution of the political system could be a necessary and positive step towards are more efficient economy.

Many scenarios are possible, with two main concerns. The more important one is whether Brazil will secure much-needed fiscal sustainability. The second, less relevant, concern is for Temer’s political future. A snap presidential election before the end of Temer’s mandate in 2018 seems the most plausible scenario – but, ultimately, any renewed political order will bring progress in the economy. The national motto of positivism “Ordem e Progresso” or Order and Progress seems more appropriate than ever.

Stephane Monier is head of investments at Lombard Odier

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