As emerging market currency kerfuffles go, Brazil’s “Caipirinha Crisis”, where the real fell to a 20-year low, certainly sounded sweeter than Mexico’s 1994 “Tequila Crisis”, even if the reality for investors was distinctly bitter. In September last year, the real fell to the lowest level against the dollar since it was created in 1994 and rating agencies cut Brazil’s government debt to junk status.
It is not hard to see why many believed the country was heading for its worst crisis in more than a decade. In 2015, a mounting political corruption scandal, combined with tumbling commodities prices, concerns about government spending and an economic slowdown made Brazil the worst-performing local-currency debt market of the year, according to JPMorgan.
President Dilma Rousseff, once loved by voters and financial markets alike, has suffered a rapid fall from grace amid convulsive street protests, and now appears likely to be impeached on corruption charges.
And Brazil, which recorded 7.5 per cent GDP growth in 2010, has now entered its worst recession for a century. Growth fell 3.8 per cent in 2015.
Yet in spite of this barrage of bad news, investor sentiment appears to be turning once again in favour of Brazil, at least for those brave enough to wear the risks. “I don’t think the end of the world is coming, which is what some people thought,” says Guillermo Ossés, head of emerging market debt at the hedge fund Man GLG. “Most of the capital that was going to leave many emerging markets has already left.”
Brazilian debt has offered the best returns of all emerging markets since the turn of the year: weighted returns from Brazilian real bonds stand at 21 per cent, according to the JPMorgan GBI EM Global Diversified Index — far outpacing rivals Russia and Indonesia.
Some investment managers who are paid to pick emerging market currencies and debt continue to believe that Brazil could represent the best trade of its sort for 2016, even given the hefty rebound.
“We have built up an overweight position in Brazil despite all the problems we have seen there. We thought what had been priced into the market was starting to compensate us to those risks,” says Denise Prime, an emerging markets investment manager at the Swiss asset manager GAM. Ms Prime argued in January that Brazil could be the fixed income “trade of the year”.
Optimists point to a rapid improvement in Brazil’s current account, which roughly measures the balance between how much a country imports and exports. Over 2015 Brazil’s current account deficit narrowed by almost half as its slowing economy and increasing joblessness weakened demand for imported goods.
“At the end of 2015 it became clear to me that the dynamic of the currency account in Brazil was changing,” says Mr Ossés of Man GLG. “The news has been very negative and there was a large concentration of short positions in the currency. People were pricing in the very worst outcome, and it is fair to say things look like they will be less severe. Now, you are being paid enough to take on the volatility.”
The “payment” or “compensation” Ms Prime and Mr Ossés refer to is the attractive yield that is now offered by Brazilian government debt, with investors being paid 14 per cent a year to lend to the Brazilian state in its local currency.
As it stands, for investors denominated in US dollars, the Brazilian real would then have to fall by a further 14 per cent this year against the US currency for them to not at least break even. If, these fund managers argue, the case for Brazil begins to look rosier over the year, then they could make many times their money.
Yet while sentiment among some towards Brazil has certainly improved, others argue that the country is more likely to have been the beneficiary of factors outside its own control, namely the level of US interest rates. Last year markets expected the US Federal Reserve to tighten its monetary policy quickly, which would have strengthened the dollar against emerging market currencies, but it took a more dovish turn.
“On the currency side I think 70 per cent is global factors and 30 per cent is local factors,” says Dirk Willer, head of emerging market strategy at Citigroup.
“Part of the strong rally we have seen in Brazil we have seen to a lesser extent elsewhere. And that has been driven by a more dovish Fed. In a vacuum Brazil would not have performed as well.”
Investors must be careful what they wish for. To temper the real’s strengthening, Brazil’s central bank took action which led to a 2.1 per cent one-day fall in the currency in late March. Finding the right balance may yet prove elusive.