Spotting the bottom in the Brazilian real

by Rob Dwyer

The continued slide of the Brazilian real below most investment banks’ assessment of its fair valuation against the dollar is leading to increased speculation among international investors about an entry point into the currency, the carry trade and asset purchases in the country.

Bank of America Merrill Lynch says the real’s deprecation is a key focus for investors. “The BRL deprecation is creating value in some Brazilian assets, so the investors we met wanted to know about the prospects for the currency and what to expect in terms of intervention,” the bank notes in a client report.

It assesses the currency’s fair value at $3:15 – and a lot of other investment banks support this estimate. RBC Capital Markets estimated fair value at $2.85-$2.95 last December, but high inflation should push this to around $3.15 within six months.

“The key risk appears to be the currency overshooting beyond the fair value. Some investors noted that the currency needs to stabilize before they add Brazilian assets to their portfolios,” says BAML.

Daniel Tenengauzer, head of EM and global FX strategy at RBC, says that despite the recent devaluation and the 13% base rate on offer in the country (with a real interest rate around 5%) investors are not looking at Brazil as a carry trade opportunity yet. “No one really cares about the carry anymore because intra-day currency volatility is so large that investors are really focused on valuation and where the currency will go from here rather than what kind of carry I can gain along the way.”

Tenengauzer says this volatility and the wide range of risks – from possible energy rationing, a technical Petrobras default if it is unable to publish audited accounts and political risks with the government trying to pass unpopular fiscal consolidation measures – means that the currency is likely to fall further.

“The question I am trying to answer is at what level does the pricing [of the real] make a difference in terms of Brazilian competitiveness and fundamentals? I really can’t see that happening below 15% to 20% away from equilibrium. And so the currency really needs to go to $3.50 to $3.60 before you see a significant impact for the economy and an improvement in the balance of payments.”

Claudio Irigoyen, LatAm FX Strategist, BAML, agrees that investors should expect further currency weakening before the real bottoms-out. “When you take the risk premium into account you can justify an overshooting of the exchange rate relative to the fair value level. That means you could easily see [the valuation at] $3.50 or $3.60 in the short-run, depending on the domestic shocks, as well as being influenced by the external dynamics.”

However, the view from Brazil is not universally pessimistic. Fernando Barbosa, chief economist at Bradesco Asset Management, says that the fall in the real is in line with other EM currencies when viewed over a 12 month period. He believes that 70% of the depreciation is due to global trends and 30% due to the “local story”. He also believes that risks such as energy rationing are priced in and he doesn’t see much room for further dollar strengthening.

“I think we have an upside for the currency by the end of the year,” says Barbosa, who forecasts the real to be at between $3.05 and $3.10 by the end of 2015.

He is not very bullish in the short term. “We have another three or four months of difficult global and local stories that need to be solved” but “the key question we need to answer in the next six to eight months is if Brazil is headed in the right direction,” he says. “We will be going through a recession and the markets will look at the valuations and prices and say they are getting cheap – they are already cheap in my opinion. There will be fiscal adjustment and inflation will start coming down and the recession will open up some spare capacity in the economy, so I can see growth resuming next year.”

Barbosa expects growth to rebound from a contraction of 0.5% this year to 1.5% next year: “And we definitely have an upward bias for 2016 growth.” 

Tenengauzer is more bearish. His central forecast now includes Brazil losing its investment grade status – and the impact that will have on economic, financial and FX volatility.

“Brazil is facing a very, very difficult situation. Given that Brazilian corporates now don’t have access to the international markets and the cost of financing in the local markets is so expensive, we don’t see any investment-led growth from the private sector,” he says.

“BNDES’s funding to the economy is declining because of fiscal issues and the interest rate differentials between the development bank and the rates of domestic sovereign bonds so we really don’t see how activity will pick up unless some sort of easing takes place.”

Given the contractionary stance of fiscal and monetary policy, Tenengauzer says the government may be forced to ease somewhere to try to break a vicious cycle of public sector contraction, falling growth and lower fiscal revenues. Any break in macroeconomic discipline – combined with low growth – would, Tenengauzer argues, lead to the sovereign downgrade and added pressure to an economy that could take much longer than a quarter or two to return to growth.