The Brazilian market yesterday fell by nearly 9%. The currency also tumbled 7.0% versus the dollar. The stock exchange used a ‘circuit breaker’ to halt trading for 30 minutes following corruption allegations against President Temer. The Robeco Emerging Markets Equities strategies remain underweight in Brazil.
A local newspaper in Brazil came out with the news that the chairman of JBS, a major meat processor in Brazil, had taped President Michel Temer on 7 March. On the tape President Temer is said to give his encouragement to a plan to pay ex-Head of Congress Eduardo Cunha to keep silent and not cooperate with the ongoing ‘Car Wash”’corruption investigations. The taping was done as part of an agreement that the chairman of JBS had with the Federal Police. President Temer later confirmed that the meeting with the chairman of JBS did happen, but denied all allegations.
What is on the tapes was apparently strong enough for the Supreme Court to start an investigation. This development could potentially mean the end of the Presidency of Michel Temer.
The best scenario for the stock market is that the ‘evidence’ on the tapes turns out to be less strong than what is currently being feared. This would likely bring back stability and is probably the most positive scenario. However, in this case the question remains whether Temer will be able to keep a strong enough coalition to continue the reform process that he had started. Investors will anyhow have been made re-aware of the existing political risk in Brazil and will demand a higher premium for holding Brazilian assets.
The worst scenario would be one in which political uncertainty continues to drag on for a long time and halt reforms that Brazil urgently needs. For example, an impeachment process could be started, President Temer wants to hold on to his post and does not resign, social tensions rise and Brazil basically is back to where it was in 2015.
The third scenario, which is the one we think is the most probable if the allegations are true, is that the President leaves his post. This could happen because he resigns or even because he is arrested. The most important thing is that he leaves. In this case the Constitution determines that the next in the line of succession is the now speaker in the Lower House, Deputy Rodrigo Maia. He would take over as a caretaker president and call an indirect election in 30 days. Indirect election means that Congress elects a new President, which serves out the current term ending in 2018. If Congress is able to find a candidate that is independent and acceptable to all parties, the new President could keep the existing economic team and try to restart the reform process.
Although in this case Brazil remains on the right long-term path, quite some damage has still been done and precious time will be lost. The most important issue is the delay in passing the Pension Reform, which was planned to happen in the coming weeks. Passing the Pension Reform is critical in regaining fiscal stability. The longer it takes to pass this reform or the more the current proposals are being diluted, the more difficult it will become for Brazil to control its fiscal situation.
The second setback could be that the Central Bank will not be able to strongly cut interest rates because the high political risk leads to a weaker currency, which has a negative impact on inflation. This is obviously negative for both investments and credit driven consumption.
The third impact is on economic sentiment. The economy of Brazil is slowly getting out of recession and it needs political stability in order for companies to start investing and increase employment, which is needed to kick-start the economy.
The Robeco CGF Emerging Markets Equities has a 1.5% underweight position in Brazil. Robeco Emerging Stars Equities has a position of 6.6%. Brazil makes up 7.7% of the MSCI Emerging Markets index.
Political risk has been one of the reasons for Robeco to be underweight Brazil. We viewed the reform process that was started by President Temer as a necessary step in the right direction. The current political crisis can significantly complicate this process and the potential delay of the reforms also increases the country’s economic vulnerability .
Besides that, valuations in Brazil are not that attractive compared with other emerging markets, particularly in the light of the weak underlying improvement of the economy and the political risk. We therefore have so far not been using this weakness in the market to add to our positions. We will continue to closely monitor developments and if necessary adjust the portfolios.