Brazil's Bovespa fairytale could well end in tears

dubai - Will the Bovespa rise to 100,000 in 2018 or plunge to 62,000 points

"Brazil is a country of the future and always will be". General Charles de Gaulle so dissed Latin America's largest economy, a vicious military dictatorship in his lifetime. The Rio and Sao Paulo I knew is the early 1990s were mired in hyperinflation, banking crises and upper class social decadence - then President Collor was impeached, among other things, for his fondness for cocaine. The decade of Luiz Inacio Lula da Silva and Workers Party rule spawned an epic commodities driven boom, averted a sovereign debt default, consolidated the Real Plan (drafted by my Wharton finance prof Arminio Fraga, governor of the Brasilia central bank) and promised pension reform. Yet Lula's sordid legacy was the Lavo Jato corruption scandal, Brazil's worst recession in a hundred years and the resignation of his handpicked successor Dilma Rousseff. Now Brazil faces an election in October that could well seal its political and economic fate.

Brazil's Bovespa stock market index was a licence to make money in 2017, thanks to the 11 per cent fall in King Dollar (the Brazil Real is the high beta anti green back), the frenzied inflows into emerging markets, the surge in commodities and the fall in Volatility Index (VIX). I have learnt the hard way that when things get too good to be true, the wicked witch of Wall Street casts her malign spell and, well, things fall apart, the centre does not hold, mere anarchy is loosened upon the world (Forgive me, W.B. Yeats). So will the Bovespa rise to 100,000 in 2018, as the bulls in the emerging market carnival insist or plunge to 62,000 points as I fear, given my crystal ball gazing on the ten-year US Treasury bond note, the Brazil Real exchange rate, sovereign debt risk premia, volatility curves and the Selic rate are remotely correct. After all, the Bovespa traded just above 60,000 a year ago.

I do not expect a bear market in Brazil, only a correction that is a classic "buy on dips" moment. After all, Brazil has emerged from its most brutal recession since the 1930s. Corporate earnings could well rise 20 per cent. Inflation plunged from 6 to 3 per cent in 2017. Interest rates are at a record low of 7 per cent. Petrobras is on a roll due to its US legal settlements and Brent crude's spectacular rise from $45 to $68. The Rio Carnival, Copacabana Beach, samba, Gisele and Roberto Carlos make Brazil the hottest emerging market culture I ever encountered in my life - and a lodestar of El Torro in 2017.

However, there are Sophoclean signs of hubris in Bovespa 80,000. One, President Temer has failed to implement pension reform and could well lose in October. Two, Congress is polarised and fiscal black holes could well gut the Bovespa bulls. Three, Congress may well not approve social security reform. Four, the external debt and sovereign risk, as always, is the Achilles heel of Brazil. Five, Lula's criminal conviction remains a political wound. If the Federal Appeals Court overturns his conviction, the populist Lula could well become the next President of Brazil.

My biggest fear is that US wage inflation ignites a bloodbath in the US Treasury bond market and the yield on Uncle Sam's ten-year note could well spike to 3.2 per cent. This mean the ten-year Brazil dollar bond could well rise from 4.5 per cent to as high as 6 per cent given the scale of leverage embedded in the debt market.

I am a nervous bull on Brazil as its exchange traded fund (EWZ) trades at 44.50 in New York. So how does the carnival on the Sao Paulo Borse end? Lula gets a reprieve from his criminal conviction and the bulls go ballistic on the prospect of a Lula II reign. A rise in the US dollar means the Brazil Real depreciates to 3.50. Foreign funds yank capital from Brazil equities as the yield on Uncle Sam debt spikes amid the Powell Fed's monetary tightening. The bloodbath in the Wall Street debt markets triggers an emerging market contagion panic at the speed of light. I survived (barely) Mexico 1994, Thailand 1997, Indonesia 1998, Turkey 1999, Argentina 2001, the Milky Way 2008. I know how these emerging market fairy tales bewitch the bulls and then kill them.

Political risks in 2018 include Trump/Nafta, elections in Mexico and Colombia. Brazilian equities are now expensive at 13.7 times earnings, above their historical 11.6X level. Yet higher oil prices makes Petrobras a no brainer, as is Vale in mining, Gerdau in steel and Itau Unibanco in banking - at least for now.


The writer is is a global equities strategist and fund manager. He can be contacted at: mateinkhalid09@gmail.com