Congratulations, Brasilia, you have shot the country in the foot with a double barrel shotgun. The political crisis, now well into its first year and with no end in sight, stripped the country of its coveted investment grade (IG) rating by Standard & Poor's this month. Fitch and Moody's still consider Brazil IG. But guess what? The political drama still unfolding in the capital promises to see at least one more credit watchdog push Brazilian sovereign debt to junk before the year is out.
"Our rating judgments will have to take into account the political environment," says Shelly Shetty, head of Latin American sovereigns at Fitch Ratings. Shetty took part in a round table discussion on Brazil in New York on Sept. 10 when she made those comments. "There are three issues that make Brazil different than other investment grade countries. One is loss of popularity of the president (Dilma Rousseff) very early in the term. The second is not a very cooperative congress. And the third is the contamination that is coming from the Petrobras investigation, and the expanding nature of those investigations, and how that’s clouding the overall environment and hampering the legislative success of this government.”
The political crisis in Brazil may have started with the ruling Workers' Party and state controlled energy firm Petrobras. But since the Federal Police's historic busting of Brazil's untouchable oligarchs, and the court's charging ruling coalition politicians like house leader Eduardo Cunha with corruption, the country's entire political apparatus is in disarray. Brasilia is now one-part Greek tragedy, one part Keystone Cops...shaken, stirred and on the rocks.
Brazil is becoming as ungovernable as Greece. President Dilma Rousseff has lost support of her own vice president, Michel Temer. Earlier this year, Temer said his party would consider running a presidential candidate against the Workers' Party in 2018.
His party, the Democratic Movement, or PMDB, is being disruptive in Congress. Dilma is essentially a lame duck president. Whatever she proposes, the congress rejects. And vice-versa.
Her Finance Minister, Joaquim Levy, is running the business. Austerity is the nature of the beast. The opposition party, meanwhile, the Social Democrats, or PSDB, is unsure whether or not they, not the country, will be better off with Dilma impeached, or severely weakened over the course of her last term in office. A severely weakened Dilma means the Workers' Party is finished for the time being. As it is, its star and founding father, ex-President Luiz Inacio Lula da Silva, is being scrutinized for possible influence peddling in the Petrobras scandal. He has not been found of any wrong-doings at this time.
With both of the Workers' Party's top dogs being tarred and feathered, it is unlikely that the Party will survive unless Brazil's economy can grow and grow fast. Current policies assure us that will not be the case.
As it is, there is not a single Brazilian bank that has GDP growth in the forecast for 2016. A recession is guaranteed for this year.
“Gone are the days that we should expect that Brazil will go back to the 3-4% growth platform that we had seen," says Shetty. "It’s likely that the potential growth in Brazil is somewhere around the 2% mark. So when we talk about a recovery, we’re talking still about a very muted recovery," she says.
For Shetty, Brazil is getting worse.
"We are seeing the economic contraction actually deeper than what we had anticipated. The fiscal deterioration is now faster than our baseline scenario and the political risks remain challenging,” Shetty says.
The Brazilian real at 4.05 to the dollar versus the spread between AAA and BBB investment grade... [+]
Worse Than Political Crisis
The global headwind in all of this is deflation. Brazil is being asked to do Greek shock therapy at a bad time because all commodity-based emerging markets are being crushed by a strong dollar. Chart watchers that track technicals in emerging markets will point out that falling gold prices have led to weaker commodity currencies like the Russian ruble, and the Brazilian real is now part of that process irrespective of what the Brazilian Central Bank (BCB) does with interest rates.
Brazil's interest rates are over 14% and inflation is currently 9.5%. There is a chance monetary policy will be more accommodating next year, but if commodities are still in the gutter, so too shall Brazil.
The deflationary process can take months if not years to play out. Unless the dollar weakens, then Brazilian assets are going lower, investor phoned survey sources say. Sustained declines in commodities, as tracked by gold futures below $1,100 an ounce, is bad news for Brazilian securities. Gold is currently priced at $1,123.
It's getting scary.
The last time the sovereign debt spread between AAA and BBB investment grade was around 1.5 on the index was 2012. Back then, bond lords were speculating on a euro zone crack up. It wasn't until Mario Draghi, the head of the European Central Bank, told investors that he would do whatever it took to save the euro that the spread tightened.
Now, China and a declining commodity market -- particularly in the metals and energy space -- are pulling those spreads apart again. It's not about the euro anymore. It's about a strong dollar and weak commodities.
"What is Brazil's backstop? Is it the BCB?" asks Vladimir Signorelli, head of macro research firm Bretton Woods Research out of New Jersey. "You have growth slowing down and you have more tax hikes coming. What we are seeing is the government pushing Brazil into the IMF's arms again," he says.
Lula effectively kicked the IMF out of the country in his first term, making Brazil a net creditor nation for the first time in its history. Thanks to Brasilia's Keystone cops, that legacy is in jeopardy.
"I don't think Dilma has any concept of what is at stake. I don't think anyone sees that down there," Signorelli says.
As Brazil's leadership on both sides of the aisle dig the country's grave, what's at stake is "shock doctrine" economics -- led by Brazil's own political class. The result? A more divisive society and a weak economy that delivers nothing but cheap assets for the IMF's pilot fish.
Boa sorte, Brasil.
