The 2 Important Questions Facing Brazil

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Includes: BRZU, BZQ, DBBR, EWZ, FBZ, UBR
by: Manning & Napier

Headlines out of Brazil in recent months have been dominated by the political circus tied to the potential impeachment of President Dilma Rousseff. The last couple of weeks have been no different, but some new twists and turns have upped the chances that Rousseff will soon be out of a job. There are now two important questions to answer in regard to the investment impact of what has been happening: Who might be Rousseff's successor? And would that person be up to the task?

Rousseff is in hot water because of allegations that her 2014 campaign was financed with bribe money connected to corruption at the state-run oil company, Petrobras (NYSE:PBR). Two weeks ago, Rousseff appointed Luiz Inacio Lula da Silva - her predecessor as president - as chief of staff in her cabinet. The appointment followed charges tying da Silva to corruption and money laundering while he was in office. The new post would have helped provide da Silva with legal protection from prosecution, as only the supreme court can try government ministers.

However, widespread protests broke out in Brazil after a federal judge released transcripts of phone recordings that suggested Rousseff appointed da Silva to shield him from the criminal probe, an allegation she denied. A judge subsequently suspended da Silva's appointment, and the lower house of the Brazilian legislature approved a committee that could eventually bring Rousseff's impeachment to a vote.

This barrage of events pointing to an increased likelihood that Rousseff will be impeached has led to a surge in the Brazilian equity market. The São Paulo stock exchange is up about 15% in local currency terms and more than 20% in U.S. dollar terms year to date, with the majority of the gains resulting from March's performance. If Rousseff were impeached and her Workers' Party relinquished control of the country's political system, we believe there would be a further rally in Brazilian equities. However, we also believe that the durability of that rally would be determined by the market's perception of what a new administration would bring to the table.

Will Rousseff's Successor Be Up To The Task?

Brazil has severe fiscal and structural problems that are unlikely to be solved overnight. The Brazilian budget deficit is more than 10% of GDP, and the continued contraction of the economy has increased unemployment, tightened credit conditions, and hurt tax revenues. The government cannot easily cut its spending programs due to constitutional mandates, and real incomes are declining given high inflation.

Burdensome regulations negatively impact Brazil's competitiveness and business profitability and severely depress the country's potential growth and investment climate. In short, while a change of government would likely be met with fanfare in the near term, Brazil's next president will be in the unenviable position of inheriting an abundance of challenges that will require building political consensus and real sacrifice to solve.

Who Might Be Rousseff's Successor?

Right now, there is no clear answer to the question of who might succeed Rousseff. Brazilians don't have much to show for Rousseff's tenure, leading us to believe that the next administration would not continue the leftist, populist bent of Rousseff and the Workers' Party. That is a positive. Current Vice President Michel Temer is one possible successor, and although he is a member of a different party from Rousseff in the coalition government, it is not clear that he would immediately take strong action to tackle Brazil's problems. Temer might not want to risk his party's chances in the next round of Brazilian elections, which are scheduled for 2018. This means the fiscal and structural changes that Brazil needs could be delayed, resulting in more of the status quo.

Another possibility is a caretaker government for the next two years, if the various parties realize that change can no longer be postponed. We would look favorably on a caretaker administration scenario if it were led by someone with demonstrated reformist and free-market credentials, such as former Finance Minister Joaquim Levy. Such a government might be the best-case scenario in the short term.

Our View

For now, we maintain our investments in Brazil since our core portfolio holdings in the country are levered to secular, rather than cyclical, growth themes. As further clarity about the political situation emerges, we will continue to assess our positions. If we get a sense that there isn't a clear successor, or that the new administration would not be up to the task, then we would likely reduce our exposure. On the other hand, a new government run by Levy or an outsider not tainted by corruption and the ongoing scandal would be a signal to consider increasing our allocation. In the meantime, we are developing a list of quality companies with exposure to Brazil so that we are ready to invest our portfolios appropriately should we become more confident about the country's future political environment and economic path.