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Brazil Bargains Beckon After S&P Downgrades to 'Junk'

09/18/2015 - 10h20



When Dilma Rousseff went out for her morning ride around her official residence on Wednesday, she and her security came across another cyclist who had run into a dog and fallen off his bike.

The Brazilian president duly stuck around until medics arrived. She would be forgiven for wishing that restoring market sentiment in Latin America's largest economy was easy as calling an ambulance.

By backpedalling on its budget promises during the past month, the government has cost Brazil its prized investment-grade credit rating and sent its currency, the real, plummeting against the dollar as bond spreads soar.

Analysts are competing with forecasts of further weakening for the real, but some market observers wonder whether the moment has come for bargain-hunting among Brazilian assets.

"I'm not calling the bottom necessarily," says Fernando Honorato, chief economist of Bradesco Asset Management, referring to the Brazilian market. "What I'm saying is that we see prices at stressed levels.

"We told clients that if you have a budget for Brazil and want to be exposed, maybe it's a good time to deploy 25 per cent of this budget right now."

But Brazil's political and economic woes have placed it in the vanguard of emerging market turmoil as concerns over a slowing China force investors to reassess riskier assets.

A year ago the real was trading at about R$2.3516 to the dollar. On Thursday it was close to lows following the downgrade by Standard & Poor's at R$3.9002, a depreciation of nearly 70 per cent in 12 months and just shy of 2002's R$3.9790 nadir.

The benchmark stock index, the Ibovespa, has fallen nearly 18 per cent in 12 months and sovereign spreads have widened more than 100 basis points to more than 400bp - worse than Russia.

Brazil's five-year credit default swaps are on par with Russia at more than 350bp.

For investors eyeing Brazil the problem is that the situation is hard to predict. The government has fiddled with its goals for the fiscal deficit four times, leading to concern that it is losing the ability to stabilise its finances.

The fiscal situation is made worse by an economy sinking into recession. Credit Suisse has revised lower its forecast for the economy and expects a higher rate of unemployment, while calling for the real to weaken towards R$4.25 this year and R$4.50 in 2016.

"Although the real is one of the currencies that has devalued the most against the US dollar in 2015, we expect additional depreciation in the next few quarters due to the deterioration in fundamentals," say the bank's analysts.

Others think the real has weakened too much. Andrés Garcia-Amaya, research analyst with JPMorgan Asset Management, says that on some measures the real is trading at 29 per cent below fair value.

"Could it continue to sell off in the short term?" he says. "Of course. But in my mind it now has more upside than downside if you are looking 12 months out."

Equities look less compelling, he adds. Stocks have been trading at below 10 times forward prices-to-earnings, but with the earnings outlook poor given the recession, analysts see equity market valuations as having further to fall.

Many see a possible buying opportunity in Brazil's woes. Interest in mergers and acquisitions have continued throughout the downturn, according to Jean-Marc Etlin, chief executive officer of Itaú BBA, the investment bank.

"Have we bottomed out or not? I don't know. What I can tell you is, we have been very active on the M&A front throughout this period. I think it is partly because valuations have become more reasonable and the exchange rate has moved quite dramatically. There seems to be value at this level, if one has a longer perspective," he says.

The deteriorating economy is adding to concerns about Ms Rousseff's political future. The most unpopular president in Brazil's modern democratic history, according to opinion polls, is facing nascent moves in Congress to impeach her, which raises uncertainty for investors.

After S&P's move to "junk" this month, Brazil could face downgrades from the other credit rating agencies, Moody's and Fitch, but such a move would be unlikely to cause a market shock.

"The reaction to the downgrade has been somewhat muted, which suggests it was mostly priced in," says Mr Etlin.

Copyright The Financial Times Limited 2015

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