Brazilian Real (BRL) - November 2016

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The UK’s shock Brexit vote in June and a relatively weak US labour report in August has now ensured we’re unlikely to see multiple interest rate increases in the US in 2016. We now expect just one hike from the Federal Reserve in December followed by further increases on a quarterly basis thereafter. Meanwhile, almost every other G10 central bank remains overwhelmingly in easing mode.

In the UK, the Bank of England cut interest rates for the first time in nine years in August, with the European Central Bank looking likely to expand its quantitative easing measures later in 2016. Further, the Bank of Japan announced a modest expansion of its monetary stimulus program, while the Japanese Government will significantly expand stimulus spending.

We think that the backdrop of extraordinarily stimulative policy from the main central banks, with the notable exception of the Federal Reserve, and a clear shift towards more accommodative policies in the laggard economies (e.g. Japan) is generally positive for risk assets and emerging market currencies in particular.

In line with our forecasts, the volatile Brazilian Real (BRL) has recovered so far this year following a violent sell-off in 2015 that resulted in one of the sharpest depreciations of any emerging market currency. The Real lost around a third of its value against the US Dollar amid a weak economic performance and political uncertainty which weighed heavily on investor sentiment towards the currency.

However, the fortunes of the Real have changed dramatically so far this year, with the currency experiencing a remarkable recovery in the first nine months of the year. The Real has now appreciated in excess of 20%, making it one of the best performing currencies in the world (Figure 1).

Figure 1: USD/BRL (2011 - 2016)

Source: Thomson Reuters Datastream Date: 01/11/2016

Political turmoil in Brazil weighed heavily on sentiment towards the currency in 2015 with deeply unpopular President Dilma Rousseff plagued with allegations that she manipulated government accounts in 2014. However, the Real has strengthened since April with both the lower house of Congress and the Senate voting in favour of proceeding with an impeachment vote. Rousseff was subsequently thrown out of office at the end of August following a crushing 61-20 vote in the upper house, ending 13 years of the Worker’s Party’s rule. Interim President Michel Temer will now permanently replace Rousseff for the remaining two years of her term.

The Real’s depreciation can also be attributed to the country’s economic woes. Brazil’s economy has experienced a torrid couple of years, contracting in each of the past nine quarters and suffering from its worst recession in decades. The economy contracted by 3.8% in the second quarter of 2016 (Figure 2) with a crisis in consumer and investor confidence, high interest rates and soaring inflation causing consumer spending to plunge. Industrial and mining production have been particularly hard hit, with both suffering from double digit contraction this year following the recent plunge in global commodity prices.

Figure 2: Brazil’s Annual GDP Growth (2006 – 2016)

Source: Thomson Reuters Datastream Date: 27/09/2016

Growth forecasts for Brazil this year are among the worst in the world, with the IMF suggesting the economy will contract by 3.3% in 2016, which would mark its worst recession in more than a century.
The country’s budget deficit has ballooned under the leadership of Dilma Rousseff, soaring to a record high in 2015 and equivalent to 10.5% of overall GDP. The labour market has also deteriorated markedly this year, with unemployment now at a sky-high 11.6% according to the benchmark jobless rate. Moody’s also became the third major credit rating agency to downgrade Brazil’s status to junk in February, with the negative outlook suggesting that more downgrades may be coming.

On a slightly more positive note, inflation has begun to slow again, having surged to a thirteen year high of 10.7% at the beginning of the year. Headline consumer price growth fell to 8.7% in July, its lowest level in fourteen months, albeit still well above the 4.5% +/-2.0% target.

The Central Bank of Brazil has also accumulated a vast hoard of foreign exchange reserves during the years of Real strength, now equivalent to over 30 months’ worth of import cover (Figure 3). This chest gives Brazilian authorities considerable room to intervene in the currency markets in order to stabilise the Real and prevent another excessive sell-off.

Figure 3: Brazil Foreign Exchange Reserves (2000 – 2016)

Source: Thomson Reuters Datastream Date: 27/09/2016

While the macroeconomic and political backgrounds are poor, in our view there are three main factors supporting the Real:

  • Interest rates remain high and well above the level of inflation, meaning real rates are comfortably positive at around 5.5% (Figure 4). In a world of very low interest rates, the Real now offers a very attractive proposition to investors.
  • The valuation of the Real continues to be very cheap even after the recent stabilisation. This, together with the drop in imports, has helped cut Brazil’s current account deficit almost in half within just one year.
  • Commodity prices appear to have stabilised and even initiated a modest rebound.

Figure 4: Brazil Interest Rate vs. Inflation (2006 - 2016)

Source: Thomson Reuters Datastream Date: 01/11/2016

Our view that last year’s depreciation of the Real was excessive has been validated so far in 2016, with the Real being one of the best performing currencies in the world in the first half of the year. Barring any further political shocks, the significant supportive factors for the Real should prevent another dramatic depreciation in the currency.

We therefore expect BRL to hold its own against the US Dollar and Sterling, while gradually appreciating against the Euro amid the large scale easing measures announced by the European Central Bank in the Eurozone.































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