Brazil: Markets underestimating political risks - BBH

Analysts from Brown Brother Harriman, believe that markets are underestimating political risk in Brazil ahead of the presidential elections to be held on October. They see the very dovish stance of the Central Bank of Brazil as a mistake taking into account growing local risks. 

Key Quotes: 

“Brazil’s central bank has unexpectedly turned more dovish.  This comes at a bad time, as political risk remains high even though the Supreme Court has cleared the way for the imprisonment of former President Lula.”
  
“Elections (presidential) will be held on October 7. At this point, it appears that no presidential candidate will win more than 50% of the first round vote.”

“The most important determinant for the election outlook is how Lula’s support is distributed amongst the leftist candidates. Expect to see new polls emerging soon that exclude Lula.  However, these polls will hold little meaning until Lula picks his successor for his PT.  Whoever it might be, we do not think markets would take kindly to another PT government (...) All in all, we believe markets are underestimating political risk in Brazil.” 

“The economy is recovering. GDP growth is forecast by the IMF at 1.9% in 2018 and 2.1% in 2019, up from 1.0% in 2017. GDP rose 2.1% y/y in Q4, the strongest since Q1 2014.  PMI readings remain firmly above 50.  With the central bank still easing, we see upside risks to the growth forecasts.”

“Price pressures remain low, with IPCA consumer inflation at 2.8% y/y in mid-March. This is down from a peak of 3.02% in mid-January, and remains near the bottom of the 2.5-6.5% target range (...) We believe caution is warranted with regards to monetary policy. Yet COPOM continues to cut rates.”

“The dovish tilt took most by surprise, as COPOM had hinted at its February meeting that easing had ended. We think it is a mistake for the central bank to be so dovish in this current environment where Brazil has many home-grown risks.”

“The fiscal outlook bears watching. We are seeing a cyclical improvement in the budget numbers as the economy recovers, but the structural outlook remains poor now that pension reforms are dead in the water.”

“Foreign reserves remain near record highs, at $380 bln in March.  They cover nearly 17 months of imports and are about 8 times the stock of short-term external debt.  As such, external vulnerabilities are extremely low.” 

“After a brief relief rally due to the Lula ruling, the real has since given up all its gains. We believe USD/BRL will move into a 3.35-3.40 range in the coming days, with an eventual target of the May 2017 high near 3.41.”

“With inflation likely to remain low and the central bank seen on hold this week, we think Brazilian can continue to outperform near-term. Longer-term, rising inflation will likely take a toll and lead to great underperformance.”