With the Olympic Games underway, many eyes are on Rio. Coincidentally, investors this year are similarly directing more attention to Brazil, although it is developments in the capitol, Brasilia, that are likely of greater importance.
Brazil has had one of the best-performing stock markets in the world this year. This may come as a surprise given the headlines we've seen this year coming from the country on everything from a presidential impeachment to the Zika virus. But according to Bloomberg data, the MSCI Brazil 25/50 Index is up more than 50% this year, while the MSCI Brazil Small Cap Index has risen over 60%.
The question now is, can the rally continue? My take is that it could potentially, but investors need to be willing to accept significant risk.
Some economic bright spots
First the good news: After two years of a deep recession, the economic fundamentals of Brazil are showing signs of bottoming out. Industrial production has started to turn, and so have sentiment indicators, with business confidence indexes leading the way (Source: Bloomberg).
Particularly encouraging are the improvements in the inflation trend. Prices have been easing since early 2016 (Source: Bloomberg), and the new central bank committee's focus on bringing down inflation has also helped lower inflation expectations for the year ahead. This ongoing adjustment has raised expectations of monetary policy easing, namely interest rate cuts in the fourth quarter, which will be supportive of a recovery in economic activity.
Political vulnerability and stalling reforms
That said, Brazil remains in a fragile situation. Economic imbalances such as weak fiscal accounts, high levels of debt and unemployment need to be addressed. The reforms needed to fix the Brazilian economy are complex and, in many instances, very unpopular with the public, making this a significant challenge for any government.
But it is political developments that continue to be the main variable in assessing the outlook for Brazil. Most important of these is the pending final vote on President Dilma Rousseff's impeachment, which will likely happen in late August or early September.
In May, Interim President Michel Temer took office after Rousseff stepped down to face an impeachment trial. Since then, Temer has had a few successes. In particular, his cabinet appointments were well received by both investors and politicians, which helped strengthen the relationship with Congress. This relationship has been, and will be, key for the cabinet ability to pass policy measures.
A vote to impeach Rousseff is likely to prompt an acceleration of much-needed reforms, such as cutting fiscal spending and revamping the pension system. Progress on policy changes, in turn, may go a long way towards restoring confidence of both consumers and investors. Nevertheless, while many believe the Senate would follow through with Rousseff's impeachment, we cannot rule out the opposite outcome, which would likely be adverse for risk assets, especially given high market expectations. Adding to the already high political uncertainty: the ongoing corruption and money laundering investigations surrounding the country's largest oil & gas company.
And there's the rub: Given the sharp rise in the markets this year it seems that investors are making a bet on the best-case scenario. Should that fall through, markets are likely to correct, perhaps sharply.
Things to look for
In short, investors in Brazil have already won a gold medal of sorts this year. Winning another medal will likely require a more prosaic path: a recovery of earnings on the back of the economic turnaround and effective execution on the reform front.
This post originally appeared on the BlackRock Blog.