Standard & Poor’s surprised the market with its downgrade of Brazil’s sovereign rating to BB+, a speculative grade-rating, late on Wednesday, confirming foreign-investors’ love-affair with the country is firmly over.
As one macro trader observes: “Brazil downgrade been hanging over the market like a Sword of Damocles. Slowest guys in the room finally acknowledged what everyone knows.”
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Indeed. In July, Euromoney Country Risk reported Brazil was on the brink of losing its investment-grade status, after the sovereign’s risk score fell by 2.5 points to 56.5 out of a maximum 100 points, culminating in a seven-place drop in the global rankings, to 50th out of 186 countries surveyed.
This move pushed Brazil deeper into tier-three category – the middle of ECR’s five categories commensurate with a credit rating towards the lower end of the BB+ to A- range.
Brazil is presently ranking on a similar scale to Botswana (47th in the survey), Italy (49th) and Uruguay (52nd) in terms of its total risk score. Despite the fall in Brazil’s creditworthiness in the eyes of markets, most had expected rating agencies would respond in kind early 2016.
Although Brazilian assets tumbled following the news, especially since S&P also slapped a negative-outlook on the junk rating, the immediate market impact for fixed-income investors might be contained in the near-term.
BNP Paribas, for example, reckons the downgrade is well-justified, but the news was already priced in, especially in the CDS market. “The downgrade itself was not a major surprise, although the speed was [Brazil was only placed on negative outlook less than two months ago],” states BNP Paribas analysts.
A litany of fiscal errors and the end of the commodity boom have handicapped Brazil’s creditworthiness since 2012, with debt-to-GDP likely to hit 65% of GDP end-2015 compared with 53% this year, while the deficit is expected to hit 8% of GDP this year.
The government has persistently missed its fiscal targets while the central bank has typically overshot its 2.5% to 6.5% inflation target range for the past three years, savaging real wages and consumption and foreign-investor confidence.
Fitch and Moody’s rate the sovereign BBB and Baa2, respectively, and both with negative outlooks. Brazil joins junk-rating peers that include Russia, Bulgaria, Indonesia, Hungary, Guatemala and Paraguay. The IMF forecasts the economy will contract 1.5% and 0.7% in 2015 and 2016, respectively.
BNP analysts add: “The agency correctly argues the government's 2016 budget proposal envisions yet another change to the primary fiscal target less than six weeks after the previous downward revision, which would mean three consecutive years of a primary deficit and net general debt continuing to rise if subsequent revenue or expenditure measures are not taken.”
Typically, fixed-income investors’ investment-grade portfolios require a sovereign to be downgraded to junk by at least two agencies before they are forced to divest their exposures. Despite market perception to the contrary, at the index-level, such as the GBI-Emerging Market Global Diversified Index, rating restrictions don’t apply, while liquidity and accessibility are big factors that determine a given sovereign’s inclusion.
Exclusion
However, Brazil could eventually be excluded from the investment-grade sub-component of the index, though BNP analysts are largely sanguine.
They state: “In the investment grade sub-component, Brazil accounts for 15% of the index, with an estimated $9 billion in total assets under management. Therefore, the exclusion would imply only $1.35 billion of potential outflows from LTN/NTNF [domestic] bonds, which is insignificant compared to a total foreign participation of $150 billion at the end of June 2015 (2% of the current foreign ownership).”
While the Brazil downgrade will inevitably hike borrowing costs for companies and the sovereign, debt capital market bankers counter that all-in issuance costs will, in part, be capped by stubbornly low US Treasury yields.
The key question for equity investors is should they buy the news?
Research by UBS, published on August 18, suggests courageous investors could profit from buying a country’s equities at the point of downgrade from investment grade. UBS analyzed the six instances when a MSCI GEM country was cut to sub-IG since 1996:
“[We] find that the downgrade of a country below IG tends to be preceded by falling equity markets ahead of the downgrade, which is then a 'buy on the news’ event: Indonesia, Korea, Thailand (1997), Colombia (1999), Hungary (2011) and Russia (2015).”
The research confirmed the lagging nature of rating-agency actions: in all six cases, equity-markets losses preceded the loss of IG status in the three, six and 12 months leading up to the event, with the average market fall in the three and six months before was 42% and 48% respectively ($), with average relative performance v MSCI GEMs of -34% and -41%.
The research found that in the three months after the loss of IG, five of the six markets rose – the exception being Indonesia – with an average gain of 23% (33% ex-Indonesia) and a gain relative to GEMs of 11% (20% ex-Indonesia).
However, the report also found that the buy-on-the-news trend in the first three months after a downgrade tended to fade over six and 12 months.
The case for debt is similar, although less clear cut.
“There is less EMBI+ debt data for these episodes,” states the report’s authors, macro strategists Geoff Dennis and Howard Park. “However, equity market performance around the loss of IG has generally been backed up by the debt markets. For Hungary and Russia, debt spreads rose by an average of 221 basis points and 302bp respectively in the three and six months before the loss of IG, with both underperforming overall EMBI+ spreads during the periods.
"Including also the available post-downgrade data for Colombia, the average spread narrowing after the loss of IG status was 137bp, although nearly all of this was due to Colombia and Russia.”
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Nevertheless, most investors at present are bearish when asked whether Brazilian assets will bottom-out anytime soon, citing the fiscal and political funk, with president Dilma Rousseff’s ratings at historic lows and the next elections not until 2018.
The hope is the downgrade will be the jolt respected finance minister Joaquim Levy, installed in January, needs to implement politically sensitive spending cuts and structural reforms.
In any case, the Brics grouping – originally marketed as a dynamic growing asset class with sovereign creditworthiness on the up – is unravelling.
Analysts at Standard Bank are concerned, stating: “South Africa is often compared to Brazil when it comes to sovereign credit ratings. We therefore have a particular interest in the development of Brazil’s sovereign credit ratings as it may impact SAGBs [South African government bonds] and the rand.
"South Africa’s foreign currency rating is on BBB- (stable) at S&P. While we are of the opinion that S&P won’t change South Africa’s rating in December, the events in Brazil will put Minister [Nhlanhla] Nene’s MTBPS [medium-term budget policy statement] next month firmly on the radar of local and international investors."
They add: "Furthermore, the events in Brazil may make markets even more nervous about the outlook for EMs in general and is likely to impact the rand negatively.”