Why we are underweight Brazilian equities

By Daniela Da Costa from the Emerging Markets team at Robeco

Brazil is in recession territory. The country’s fiscal consolidation plan had a major set-back in July as the finance minister Joaquim Levy announced a significant downward revision of the government’s primary fiscal surplus targets.

In August, S&P placed Brazil’s foreign currency rating, on negative outlook. Last month, after realising the deterioration in tax collection, neg-ative GDP output and the eminence of a political crisis, S&P anticipated the rating downgrade of Brazil, from Investment Grade to junk.

Since the change in S&P’s outlook and further rating downgrade, capital outflows intensified and the currency devaluated very rapidly.

Fiscal adjustment vs. political crisis

The country economic recession is being aggravated by a political crisis. Brazil has a growing nominal deficit that needs to be properly addressed. However, the Government is not finding support in the Congress to implement a fiscal adjustment plan.

The current government was elected in the end of 2014 promising to continue a benevolent social policy while there is no funding for it. They are trying to promote a soft fiscal adjustment via tax increases while the low tax collection and economic growth calls for more serious expenses cut.

Their posture is generating a big discomfort in the Congress and the first attempts to pass forward the fiscal package have failed.

The opposition is calling for an impeachment, claiming the Government broke the fiscal responsibility law, but there is not yet enough evidence or consensus to start a formal process in the Congress.

Therefore the opposition is deliberately voting against all fiscal measures proposed by the Government to make them weak and force a resignation.

The Government coalition is also broken as there is a wide perception the Government is not fulfilling the mandate for which they were elected for. The president’s last attempt to recover Congress support was a ministry reshuffle to please allies.

It is yet to be seen if this move is enough to buy Congress support. It all remains very fragile, especially when the President has less than 10% of population approval, the GDP is contracting more than 2.5% this year and it is likely to contract in 2016 as well, and unemployment is increasing very rapidly.

The recent S&P rating downgrade puts pressure on the government to deliver a realistic fiscal consolidation plan and we don’t think they are there yet.

It has also contributed to bring back discussions of necessary reforms in the fiscal and pension systems. However, how to push for reforms in this political scenario?

In the event there is neither a fiscal consolidation, nor approval of reforms that can improve the fiscal deficit picture in the long run, we can see other credit agencies downgrading Brazil to junk and ultimately further rating cuts and currency de-valuation in 2016.

Interest rates would be likely to remain at the current high levels in order to control inflation expectations. As a consequence we would continue to see low investments and poor economic activity numbers, extending the current recession throughout 2016.

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