Analysing the bearish case for Brazil's stock market

Dubai - Country hit hard by capital flight, plunge in real, Bovespa and devastating trucker's strike

Charles de Gaulle once dissed brazil when he said the world's third largest emerging market after China and India was "a country of the future and always will be". Brazil is a land of fabulous opportunities and exquisite beauty but it is haunted by political and financial demons from its decades as a brutal military dictatorship. When I first visited Rio and Sao Paulo in the early-1990s, then-president Collor had just been impeached after allegations of cocaine binges, the currency was renamed three times after it lost public confidence, hyperinflation and a foreign debt crisis crippled Latin America's largest economy. In 2018, Brazil is still haunted by the Jato Lavo consumption scandal that led to the ouster of President Dilma Rousseff and the criminal conviction of populist Workers Party head of state Lula da Silva.
The unelected but pro-business government of President Michel Temer faces an election in October that he is not guaranteed to win. Temer, who ascended to the presidency in August 2016 after Dilma's removal from power, reformed restrictive labour laws, rolled back the credit subsidy regime from state banks, provided political space for the central bank to combat inflation, presented legislation to Congress on pension reform and courted Wall Street with the promises of structural reform. Unfortunately, Temer does not have the personal charisma of the trade union firebrand Lula and runs a caretaker, not an elected government. He could well be gone in the October election.
Brazil has been hit hard by capital flight, a plunge in the real, the Bovespa and a devastating trucker's strike that threatens a return to recession and a spike in the budget deficit. The established political parties have all been tainted by the Jato Lavo corruption scandal and Jair Bolsonaro, the populist front-runner, is known as the Trump of Brazil. The trucker's strike has meant huge losses for Brazil's chicken farmers and soybeans exporters. Petrobras' CEO has been forced to resign. Wall Street fund managers have slashed their exposure to Brazil's sovereign debt and the Bovespa. There is no real catalyst for a rally in Brazil unless Temer or a centre-right candidate with a credible economic blueprint (Senhor Jair has none). Brazil, which just recovered from its most vicious recession since the Great Depression, can well slip into double-digit recession because of the sheer scale of the damage done by the trucker's strike. It will be a pity if the next leader of Brazil's 200 million citizens is a populist with no economic agenda or reformist vision.
Petrobras' New York ADR rose 300 per cent since early-2016, when oil prices bottomed and the impeachment of Dilma Rousseff became certain. However, Petrobras has now fallen more than 40 per cent since its recent highs. While I cannot recommend trying to catch a falling knife when Brazil's macro, politics and fiscal outlook is so uncertain, Petrobras shares trade 18 per cent below its book value of $12 a share. Petrobras' 2021 domestic liquids production target of 2.77 million barrels a day is totally unrealistic. For now, I maintain Petrobras ADR as a short, down to a $8 target. I much prefer Banco Itau Unibanco, Brazil's preeminent commercial and investment bank, which benefits from Temer's state bank credit reforms.
The Brazilian real is at 3.90 as I write despite significant central bank intervention. The resignation of Petrobras CEO Pedro Parente, under pressure from trade unions and striking truck drivers, has amplified the loss of confidence in Brazil's macroeconomic future. The central bank in Brasilia also failed to restore investor confidence in the Real with its $1.5 billion swap offer. The rise in the Brazil credit default swaps is ominous as it is significant and it means investors are bracing for another sovereign credit downgrade. The central bank will need to engineer far higher interest rates to stabilise the real.
The real has dropped 15 per cent in 2018, joining the basket case currencies such as the Turkish lira and the Argentine peso. The truckers strike has not only paralyzed Brazil's economy but also increased worries in the capital markets that Michel Temer will be defeated by a populist in October and trigger a fiscal/external debt crisis of confidence. This means the optimal strategy is to stay short the Brazil index fund, which can well fall from its current 36 to 30 by October.
The writer is a global equities strategist and fund manager. He can be contacted at mateinkhalid09@gmail.com.