Brazilian Real (BRL) - December 2016

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Donald Trump’s election and the prospects for added fiscal stimulus in the US has brought about a significant increase in interest rate hike expectations and a strong rally in the US Dollar. We expect the Federal Reserve to hike interest rates in December followed by further increases on a quarterly basis thereafter. Meanwhile, almost every other G10 central bank remains overwhelmingly in easing mode.

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. However, Trump’s victory introduces an element of uncertainty. The prospects for each particular emerging market currency will be highly dependent on two factors:

  • The country’s position as a commodity exporter or importer, as exporters will benefit from our expectations for worldwide reflation.
  • The impact of potential restrictions on trade passed by the Trump administration on trade flows.

In line with our forecasts, the Brazilian Real (BRL) has rebounded strongly so far this year following a violent sell-off in 2015 that resulted in one of the sharpest depreciations of any emerging market currency. However, following the surprise US election victory of Donald Trump in November, the Real sold off sharply, sinking by around 6% against the US Dollar and slumping to its lowest level since June (Figure 1). With the exception of the Mexican Peso and South African Rand, the Real was the worst performing major emerging market currency in the world in the aftermath of the election.


Figure 1: USD/BRL (2011 - 2016)

Source: Thomson Reuters Datastream Date: 06/12/2016


Even after the post-election sell-off, the Real has so far been the best performing emerging market currency against the US Dollar in 2016 and is currently trading around 15% higher for the year. Political uncertainty has subsided. Deeply unpopular former President Dilma Rousseff, who was dogged by allegations that she manipulated government accounts in 2014, was thrown out of office at the end of August following a 61-20 impeachment vote in the upper house, ending the 13 year rule of the Workers’ Party.

Former vice-President Michel Temer was sworn in at the end of August, having served as interim President since May. The new President is trying to implement new fiscal reforms in order to plug the gaping budget deficit and end Brazil’s prolonged recession.
Brazil’s economy has continued to perform poorly. The economy has contracted in each of the past nine quarters and in the process suffering from its worst recession in decades. Brazil’s GDP contracted by 2.9% in the third quarter of 2016 (Figure 2). A downturn in consumer and investor confidence, high interest rates and soaring inflation caused 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: 06/12/2016


Growth is expected to remain negative in 2016. The IMF has suggested that 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 also 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 at a 12-year-high of 11.8%. All three major credit rating agencies have recently downgraded Brazil’s status to junk.

On a more positive note, inflation has moderated rather significantly so far this year, after surging to a thirteen year high of 10.7% at the beginning of the year. Headline consumer price growth fell to a far more manageable 7.9% in October, 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. The central bank intervened in the days following the US election and should have plenty of room to continue to do so in the future 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: 06/12/2016


While the macroeconomic and political backgrounds in Brazil remain relatively poor, in our view there are four main factors supporting the Real:

● Interest rates remain high despite two 25 basis point rate cuts in October and November and well above the level of inflation, meaning real rates are comfortably positive at around 6% (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 rebound. 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.
● Markets have priced very negative forecasts for the Brazilian economy in the coming quarters.

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

Source: Thomson Reuters Datastream Date: 06/12/2016


Our forecasts for a recovery in the Real have been validated so far this year, with the currency being one of the best performing currencies in the world in the first half of 2016. We think the raft of supportive factors for the Real should alleviate much of the post-US election sell-off.
We therefore expect BRL to hold its own against the US Dollar and Sterling, while experiencing a gradual appreciation against the Euro amid the large scale easing measures announced by the European Central Bank in the Eurozone.

 

USD/BRL

EUR/BRL

GBP/BRL

E-2016

3.40

3.55

4.25

Q1-2017

3.40

3.35

4.30

Q2-2017

3.40

3.30

4.35

Q3-2017

3.40

3.25

4.35

E-2017

3.40

3.25

4.35

E-2018

3.40

3.25

4.35

 

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