Coronavirus is particularly cruel to Brazil
It might be too much to say the country was bouncing back before Covid-19 struck, but it was beginning to look a bit better. Not now though.
It is human nature, when self-isolating at a kitchen bench amid the sound of young children’s squabbles and Netflix programmes, to consider what comes next as coronavirus Covid-19 hits Latin America.
What will be the short-term effects, and what will change our lives in the longer term?
There will of course be many impacts. There is already speculation about increases in the state’s monitoring of citizens; perhaps there will be a more permanent shift to home working and video conferencing, meaning a fall-off in business travel and physical meetings.
But I’ll stay in my lane.
There are going to be wide and deep ramifications from Covid-19 across Latin America, and they will vary depending on the effectiveness of each government’s management of the crisis and the health of the economy.
Brazil is a particularly interesting example. Before the outbreak arrived, the economy was far from healthy – GDP growth was probably only going to be around 1.5% this year before the pandemic black swan – but it had been changing radically.
A train in Rio de Janeiro is disinfected on Thursday
Arguably it was becoming a ‘normal’ economy for the first time since the introduction of the stability plan, the Plano Real, in 1994.
Low and controlled inflation and low real interest rates had – finally – created a stable base.
More reforms were needed to encourage the investment that will improve productivity, but the framework was there.
Perception of control
While there is never a good time to be hit by a global pandemic, the timing does seem to be particularly cruel to Brazil.
The introduction of the fiscal spending law in 2016 had created the perception of control that led to a radical reduction in the price of Brazil risk. That has now reversed: the five-year credit default swap spread has risen by 259% over the month to March 22, to 334.5.
Now all bets are off.
Policymakers will have to respond with a fiscal impulse that – while lesser in scale than developed markets are adopting (and therefore leading to a slower recovery in terms of unemployment and growth generally) – will blow right through pre-Covid plans.
A negative feedback loop could quickly occur without strong fiscal action that (in the face of a shattered economy) is unlikely
Of course, this is going to become a national emergency and a fiscal response will be needed. But, at some point, Brazil will emerge with debt-to-GDP ratios at levels higher than they already are today (around 80% of GDP).
It is a stock problem that will quickly become a flow problem too: the record low interest rates seen in the market will rise, and sustaining that debt will become prohibitively expensive.
A negative feedback loop could quickly occur without strong fiscal action that (in the face of a shattered economy) is unlikely.
Given the fall in yields in sovereign bonds, investors have begun to develop an appetite for corporate bond risk.
Until very recently local investors only bought triple-A. That has been changing as investors reach for yield: first through reduced sensitivity to tenor and liquidity risk, and then through credit risk.
Rise in defaults
The Brazilian central bank won’t be able to stand behind the local bond market like the Fed has, and – depending on the length and severity of the coming recession – defaults will come at a pace that will defy the banks’ abilities to provide short-term funding without impairing their own chances of surviving the crisis.
The timing of the equities crash could be devastating.
That same driver of risk appetite has seen a huge shift into equities among all types of investor – retail growth alone saw the number of individual accounts at the B3 stock exchange rise to 1.9 million in February from 813,300 at the start of 2018.
It is impossible to untangle the Ibovespa’s run into individual drivers, but this positioning factor has arguably been larger than the lower-rate environment.
The index hit 118,000 in January, up from 38,000 in 2016 – and all that growth has been led by domestic demand. Famously, there have been net outflows from onshore Brazilian equities in the last 12 months.
Domestic demand had also begun to drive equity issuance – both primary and secondary.
Local banks with retail brokerages were at a competitive advantage; XP Inc’s mandate as global coordinator for BMG Bank was the first time a new bank had won such a role from a Brazilian company in 16 years.
There is surely more downside to come.
If we see falls comparable with when former president Dilma Rousseff was impeached – and it is certainly possible that we will – that would be equivalent to a two-thirds loss.
The behavioural impact of this stock rout on so many first-time equities investors will be fascinating.
International investors, having largely sat out the recent rally, may be ready to buy again once the country is in its trough (and the FX devaluations adds an interesting potential multiplier when its momentum turns).
This could give the equity capital markets teams at international banks the advantage in deal mandates once again.