Brazil: keep an eye on reforms

In the past few years, Brazil has suffered its worst recession on record, impeached a president, and discovered that an uncomfortably large proportion of its politicians have been implicated in a kickback scandal at state-owned oil giant Petrobras. This is hardly an auspicious backdrop for equities, yet the market has outperformed all its emerging-market counterparts in the past year. It has almost doubled to a six-year high since early 2016.

So is the rally justified, and can it endure? For starters, "the economy has definitely turned a corner and is moving in the right direction", as Walter Molano of BCP Securities points out. The economy is still shrinking, but the business cycle is clearly on the turn. A survey tracking manufacturing has risen to a two-year high.

The firmer global economy and recent falls in the currency, the real, are bolstering exports. Previous interest-rate hikes and the downturn have lowered inflation and provided scope for more rate cuts. But don't expect a rapid rebound in GDP. Households and companies "continue to pay down debt they accumulated during the financial orgy" of the 2000s.

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Most encouraging, however, are prospects for structural reform. A landmark change to combat chronic overspending has already occurred: Brazil has changed its constitution to require the government to reduce expenditure from 20% of GDP to 15% in the next decade. The next step is to reform the retirement system to bring it into line with the developed world. The retirement age will be set at 65 (many can currently retire on full benefits in their 50s) and various loopholes and distortions will be closed.

Next on the agenda is the Byzantine tax code, a boost for infrastructure, and a bonfire of red tape for businesses. Pension reform "would be the single most meaningful step towards putting Brazil's finances on a sustainable basis", says John Authers in the FT. Think of it as a "litmus test" for Brazilian stocks. If it passes, the rally should continue, but if it fails, momentum for further change would probably dwindle too, making stocks less appealing.

The government is unpopular, but that just means it has little to lose by making long-term changes, says Authers. What's more, it bodes well that it was installed by Congress after President Dilma Rousseff's impeachment. As a result, "this presidential team aligns with the groups in Congress more closely than any in decades". Goldman Sachs reckons the pension reform will gain approval by the end of the year. Brazil's still very reasonable cyclically adjusted price-earnings ratio of ten is a further reason for optimism.