The silhouette of Christ Redeemer in Rio de Janeiro.
The 2014 World Cup and preparations for the 2016 Rio De Janeiro Olympic Games should have given a boost to Brazil’s (EWZ) economic health, but the country is facing its toughest times in decades. Once lauded for its tremendous economic growth prospects thanks to a rising middle class and a commodity boom, Brazil is now reeling from public discontent related to inflation, corruption, complicated regulations, and a burdensome debt load. The corruption scandal at state-run Petrobras (PBR) may only be the tip of the iceberg, and it has sent shockwaves within political circles going all the way to the top. Protests in the country have been recurring.
Brazil, the world’s seventh-largest economy and the largest one in Latin America, is facing declines in private consumption and fixed investment, while export growth has slowed considerably as a result of China’s slowdown. With Brazil’s GDP falling 1.9% in the second quarter of 2015, marking the second consecutive quarter of falling economic activity, the Latin American economy has entered into the definition of a technical recession–but the pace of contraction may even get worse in coming periods. Economists are targeting a 2%+ decline in economic activity in 2015, the biggest fall in over two decades, and next year’s economic performance isn’t looking much better, at least from our perspective. The Brazilian real has dropped to the lowest level against the US dollar since 2002 as asset flight out of the country continues.
In the face of declining tax revenue due to economic pressures, Brazil’s government plans to run a sizable budget deficit in 2016, and the credit rating agencies, including Fitch and Moody’s, have recently raised concerns about the country’s deteriorating financial health. Inflation in Brazil is running rampant at twice the government target, and the country’s largest importer, China, is reeling from its own stock market crash and commodity bust. At last check, Brazilian President Dilma Rousseff’s approval ratings are at ~8% (not a typo) with 60% of Brazilians favoring impeachment, and such a political crisis is only adding complexity to the current economic one. Just last week, police asked prosecutors to file charges against Brazil’s former presidential chief of staff, Jose Dirceu, the most senior member of the existing Workers’ party administration, for involvement in the Petrobras scheme.
Brazil may not be able to escape the current political and economic crisis unscathed. The country’s ~$230 billion US dollar-denominated debt is only growing more expensive in relative terms as its currency weakens, and public debt amounts to nearly two thirds of the country’s economy. Moody’s recently showed that, when indirect debt (pensions, guarantees, etc.) is considered, Brazil’s government debt is equivalent to all of its GDP, making the country one of the most indebted nations in the world. It gets worse though. Where 10-year yields on US Treasuries are under 3%, Brazil’s government 10-year local yield is over 13%. That makes the implied debt to GDP level in Brazil much more burdensome than even more leveraged countries where public debt yields (interest costs) are but a fraction of Brazil’s. Interest payments are expected to exceed “20% of government revenues in 2015 and 2016 compared with 16% in 2013,” according to Moody’s.
Brazilian corporates are feeling the pain.
In early August, embattled Petrobras reported a profit decline of nearly 90% as falling oil prices and a tax settlement took their toll. With the corruption scandal still hurting the oil giant’s perception and fueling share-price uncertainty, Brazil’s largest oil workers’ union is making matters worse and fighting the company’s capex cuts and cash-raising efforts (asset sales) required for the state-run energy company to survive. What’s more, the credit rating of Brazil’s largest utility, by revenue, Electrobras (EBR) was recently cut to junk by Moody’s, citing the need for “a major reduction in its capital expenditure program or some sort of capital injection.” Even the former CEO of Electrobras’ subsidiary Electronuclear is under investigation on alleged bribes. Brazil’s largest iron-ore producer, Vale (VALE) has seen its shares fall from nearly $40 at the beginning of 2011 to ~$5 at present, as the glut of oversupply in iron ore (and corresponding price weakness) shows no signs of alleviating. Brazilian jet maker, Embraer (ERJ) lowered its revenue guidance in late July to reflect the “recent devaluation of the Brazilian real versus the US dollar.”
With the country’s unemployment on the rise, hitting a five-year high last month at 7.5%, and the Brazilian government pushing for austerity measures, the makings of a financial catastrophe are all in place, from our experience. “Middle-class households are starting to miss car payments and the poor are eating less meat,” signals of deteriorating consumer wealth, and the lending bust is probably best portrayed in the country’s World Cup stadiums that currently “sit unused.” On hopes of an ever-increasing commodity boom, “Brazil’s national development bank, BNDES, lent so much that its loan portfolio became bigger than the World Bank’s,” according to the Wall Street Journal, and we doubt the entity will be made whole. Brazil’s banks—Itau Unibanco (ITUB), Banco Bradesco (BBD) and Banco Santander (BSBR)—appear to be on the cusp of a financial crisis as over-expansion has now turned into bust. The market capitalizations of these three banks have been cut in half during the past 12 months.
Brazil is in a deepening recession, which may grow into depression, as unemployment continues to rise and corporate credit quality deteriorates. Those that made a bundle investing in Brazil’s commodity-driven export boom have been looking to cash out, if they haven’t already, and the real continues to weaken on deteriorating sovereign credit and rampant inflation. Any interest rate hike by the US could have the unintended effect of sending Brazil’s local yields to the mid-teens to account for incremental currency risk and credit deterioration, which would only exacerbate debt service costs as a percentage of the country’s shrinking GDP. This, in turn, could be the catalyst for even more asset flight out of the country, and a full-blown currency crisis. What’s worse is that all of this could happen if the Workers’ Party is not overthrown.
It is not lost on us that the Latin American debt crisis in the early 1980s was a direct result of US interest rate increases and a strengthening US dollar relative to other currencies, a combination that made foreign-issued debt near-impossible to service for emerging market countries. Those same two dynamics are happening again today, but that commodity-based economies are swooning has made the current scenario incrementally worse, in our view. Brazil may look to throw its international reserve buffers to stem any sovereign crisis, but even if the country doesn’t experience financial catastrophe, the coming decade may not be much better than “La Decada Perdida” (“The Lost Decade”) that plagued Latin America during the 1980s.
With Brazil looking to a battered China for help, the world may be in for a whole lot of financial pain. China may eventually be in need of a bailout itself. Will the US or EU come to the world’s rescue? And if so, at what cost?
Related Stocks: ELP, CIG, CPL, SBS
Related ETFs: BRF, BRZU, EWZS, BRXX, BRAQ, BZQ, BRAZ, BRAF, UBR, DBBR, FBZ
Image Source: Christian Haugen