As volatility batters even the strongest economies of emerging markets, one nation is turning into a haven of calm and investors’ choice to hide out the US Federal Reserve’s tightening spree: Brazil.
Developing nation stocks, bonds and currencies are witnessing their worst meltdown in decades, but one would not know that by looking at the Latin American country’s assets. Traders are raking in double-digit carry returns from its currency, making the most bullish bond bets in 13 years, sparing its local-currency debt from a high-yield sell-off and calling its stocks “the hottest trade in town.”
The outperformance is providing much-needed relief for emerging market investors who have been stung in: China, where growth is slumping; India, where high oil prices are crippling the currency; Africa, where debt crises are brewing; and eastern Europe, which has been whipsawed by the plunge in the euro.
Brazil is seen by many as the only major developing nation with an economic formula — double-digit benchmark interest rates coupled with a giant commodity exporting industry — that can withstand the financial pressure created by soaring global yields. There is also Sunday’s presidential election. Optimism is growing that regardless of who wins, the next government would pursue market-friendly policies.
“Brazil really is kind of a safe haven which one would not have expected in the run-up to the elections,” said Viktor Szabo, an investment director at London-based abrdn. “This is quite a difficult year for emerging markets overall, with inflation, a war in Ukraine and central bank tightening. But Brazil stands out, and is a solid investment story both in the financial markets and in the real economy.”
At the heart of this story is Brazil’s dogged pursuit of monetary tightening to contain inflation. While many emerging market central banks proactively raised interest rates to prepare for the US Fed tightening, few were as aggressive as Brazil’s central bank. Its benchmark rate is about seven times what it was 19 months ago.
The ploy worked. Brazil has become the first developing nation to herald a peak in inflation, seeing consumer price growth ease for three successive months — with some added help from tax cuts on fuels and other products. The country’s real policy rate has soared to a world-beating 6.58 percent. That is shifting the debate on interest rates from hikes to a potential cut next year.
That is a position to be envied by other emerging markets. Average inflation in the group is at a decade high, with double-digit price growth and negative real yields battering most countries.
The benchmark for emerging market local-currency bonds is heading for the worst annual losses since at least 2009, and that for US dollar bonds toward the biggest decline since 1994. Stocks are witnessing the sharpest sell-off since the 2008 financial crisis.
In contrast, Brazil is handing investors the best local-currency bond returns this month and is also the only high-yield nation to post a gain. In US dollar bonds, the sovereign risk premium over US Treasuries has tumbled 100 basis points since July, taking it to the lowest level since the financial crisis relative to other emerging markets. Its stocks are generating the fifth-best US dollar returns globally.
Carry returns on the Brazilian real have risen this month by the most since May, taking year-to-date returns to 16 percent. Given that other emerging markets have produced carry losses of 6 percent, traders who switched to Brazil are 22 percentage points better off this year.
“There isn’t really anywhere else in the world that looks like that,” Thornburg Investment Management money manager Ayman Ahmed said, referring to Brazil’s monetary tightening that led to this carry. “They’re so ahead of the curve, the country has become a darling for investors.”
Brazil’s presidential elections are arguably the most watched political event in emerging markets. The battle between Brazilian President Jair Bolsonaro and former Brazilian president Luiz Inacio Lula da Silva proved to be closer than expected, moving into a runoff at the end of this month. While Lula is still the poll favorite, Bolsonaro is gaining on him.
Investors believe either the market-friendly Bolsonaro would win, or Lula prevail in a close race that could encourage him to pursue more fiscally responsible policies. Both outcomes are seen as positive for risk in the immediate aftermath of elections, even though political compulsions to boost social spending could return in the medium term. The only scenario that could ruin the markets’ party is a contested result.
“The final vote remains a key test of Brazilian institutional strength,” said Robert Hoodless, head of foreign exchange and macro analysis for Europe and the Americas at InTouch Capital Markets. “So long as we do not get to such an ugly outcome, Brazil looks set to remain a must-have for most emerging market players.”
Foreign investors have reduced their bearish bets on the Brazilian real by about US$5 billion after the first round of the election, B3 local exchange data compiled by Bloomberg showed. Last week, the nation attracted the biggest inflow among emerging market exchange-traded funds.
The specter of an ugly outcome — not just in the elections, but in long-term fiscal discipline and political stability — always hangs in the air when money managers talk about Brazil. Therein lies the rub. A lot of things could quickly go wrong in this volatile emerging nation, which is stopping investors from turning bullish beyond a few months’ horizon.
“Regardless of a Lula or Bolsonaro victory, fiscal policy is likely to turn expansionary,” Wells Fargo strategist Brendan McKenna said. “Brazil already has limited fiscal space; so if public finances deteriorate further in the coming years and spending limitations are ignored, Brazilian assets could reverse course.”
However, investors’ immediate priority is to survive shrinking liquidity and the Fed’s relentless path toward higher rates. Most foresee at least six months of volatility, and they need a refuge to park and preserve their capital. Brazil answers that need.
“The country is in pretty good shape,” said Daniel Tenengauzer, the chief market strategist at Bank of New York Mellon Corp. “So that is basically the bias that I have: to be long almost regardless of the result.”
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