Market Strategy - Politics-Driven Sell Off Has Further To Run - JAN 2018

Brazilian assets are likely to see further downside over the coming months due to a poor political outlook that will weaken growth prospects. This will reflect a repricing of assets in light of the diminishing prospects for pension reform, uncertainty over the outcome of the 2018 election and weak near-term growth.

We hold a comparatively downbeat view on growth over the coming quarters. We forecast real GDP growth of 1.7% in 2018, versus Bloomberg consensus of 2.4%, as we expect fixed investment will remain on the sidelines ( see ' Political Uncertainty Will Constrain Recovery ' , September 29). Weak growth over the coming quarters will likely lead to downside for equities and the real. Meanwhile, CDS spreads will likely widen as pension reforms disappoint and concern over policy direction in 2019 and beyond undermines the potential for continued fiscal consolidation.

Sell Off Reflects Sentiment & FX Weakness
Brazil - MSCI Brazil Index (USD)
Source: Bloomberg, BMI

Additionally, conditions in external markets more broadly will keep downside pressure on Brazilian assets. We have turned neutral towards EM stocks over the past month due to a combination of a sharp rise in bullish sentiment and a marked deterioration in participation in the rally ( see 'Monthly Market Strategy: Shifting To Neutral On EM', November 16), and we are fundamentally bullish on the US dollar, suggesting downside for EM FX broadly in spot terms, although we are neutral in total return terms.

Rally Now A Memory

Across much of H217, Brazilian assets, in particular equities, were boosted by relatively buoyant sentiment regarding Brazil's economic rebound and the outlook for reforms that would support long-term growth. Anecdotal evidence suggests that investors have viewed corruption allegations against President Michel Temer as political noise that would not derail pension reforms, considered essential for lowering the fiscal deficit and reducing the structural causes of inflation, or threaten the potential for a pro-reform candidate in the 2018 general election.

Political Noise Becoming Signal
Brazil - IBOV Index (BRL)
Source: Bloomberg, BMI

However, the splintering of Temer's coalition is causing a reassessment among investors of the probability of pension reform, and we believe the associated repricing of Brazilian assets has further to run. Over the last month, ongoing corruption investigations have driven intra-coalition tensions. In recent days the second-largest party in Temer's coalition, Partido da Social Democracia Brasileira (PSDB), has signalled its intent to leave the government, which will force Temer to seek support from a number of smaller parties, using up political capital and delaying movement on pension reform. As of November 16, the MSCI Brazil Index has fallen 12.2% over the previous month, and intraday swings have been volatile. The decline reflects a sentiment-driven sell-off on the local bourse, compounded by a weakening exchange rate.

Strong USD & Weakening Sentiment Driving Downside
Brazil - Exchange Rate, BRL/USD
Source: Bloomberg, BMI

2018 Election Will Become A Concern

While we maintain our core view that a pension reform bill will likely pass Congress before the general election campaign begins in earnest in Q218, we acknowledge that downside risks continue to rise. We have long held that pension reforms, if enacted, would disappoint investors' expectations ( see 'Pension Reform Set To Challenge Next Administration', June 15), and we believe the probability of passage has steadily fallen over recent months ( see 'Fiscal Outlook Hangs In The Balance', September 26). Further, the reforms currently being considered will not be sufficient to curtail the growth of public pension obligations, which will force the next administration to revisit the issue.

CDS Spreads Likely To Rise On Weak Pension Reform
Brazil - 5-Year USD Credit Default Swaps
Source: Bloomberg, BMI

At the same time, we do not believe markets have begun to price in the probability of an anti-reform candidate winning the 2018 election. Anecdotal evidence suggests that the market remains optimistic that a pro-reform candidate will win and continue with the reform efforts initiated under Temer. However, we believe that the public's deep dissatisfaction with the political establishment will create space for anti-reform candidates to mount competitive campaigns ( see '2018 Election Initial Thoughts: Corruption Critical To Outlook', August 22), which will likely lead to volatile shifts in sentiment over the coming quarters.