Currency Of The Month – An Uphill Marathon Awaits For The Brazilian Real

With less than a year before Brazil becomes the first South American country to host one of the world’s foremost sporting events, preparations for the 2016 Olympics are still feverishly underway in the country’s symbolic city, Rio de Janeiro. Unfortunately, this intense activity may ultimately be overshadowed by ongoing economic challenges that Brazil has been facing since being awarded this major global event.

When the IOC (International Olympic Committee) selected Rio de Janeiro over the likes of Chicago, Tokyo, and Madrid in October 2009,1 the choice appeared to be a logical selection for a global community that had benefited from the emergence of important developing market economies. Not only had South America’s largest economy been riding a strong wave of growth prior to the 2008 global recession, Brazil had weathered the first year of the credit crisis better than most economies, with Brazilian gross domestic product (GDP) of -0.2% in 2009 outpacing U.S., European Union, and Japan’s GDP growth of -2.4%, -4.2%, and -5.0%, respectively.2

Already known throughout the world as exceptionally passionate for World Cup soccer and Carnival celebrations, surrounded by the world renowned beaches of Ipanema and Copacabana, and having the backdrop of the iconic Christ the Redeemer statue set atop Corcovado mountain with outstretched arms welcoming the world, the selection of Rio de Janeiro for the 2016 Olympics appeared to be yet another vote of confidence that Brazil was ready to join the global stage of influential economies previously dominated by countries in North America, Europe and Asia. As it stands today, Brazil may have more to worry about than simply completing the construction of Olympic venues on time.

Brazil Economic Overview
Only six short years after the IOC made its decision, Brazil’s economy has lost the gusto that it once exhibited, due to a combination of slumping global commodity prices, domestic economic challenges, and political instability. In the first half of this year, Brazil officially entered into an economic recession, posting a 0.7% contraction in GDP during the first quarter and a 1.9% contraction in GDP for the second quarter.3 The outlook for the full year 2015 is not much better, given expectations for a 2.6% contraction in GDP versus 2014. (Figure #1)

Fig. #1

Brazilian GDP Growth

Source: EverBank Research Team, based on analysis of publicly available data from Worldbank, Trading Economics.
(View a larger image here.) A good portion of Brazil’s economic pressures is due to exogenous global issues, primarily the fall in worldwide commodity prices and sluggish global growth, particularly from China. Brazil’s exporting activity represents 13% of total GDP, with a majority generated from the sale of raw materials, including minerals, agricultural products, and other primary products.4 Furthermore, 20% of Brazil’s exporting is between its largest trading partner, China,5 whose own economic struggles have placed further pressure on Brazil’s important commodity industry. Similarly, the precipitous fall in oil prices has left Brazil’s goal of becoming a top-5 global oil producer in jeopardy, as the state-owned oil company, Petrobras, relies on deep water drilling to extract offshore oil from pre-salt reserves at prices above break-even costs between $45 and $52 per barrel,6 and at present, above prevailing Brent crude oil prices (Figure #2).

Fig. #2

Brent Crude Oil Prices in U.S. Dollars

Source: EverBank Research Team, based on analysis of publicly available data from the U.S. Energy Information Administration.
(View a larger image here.) Brazil’s economic pressures are certainly not limited to issues outside the country’s borders, as the domestic economy faces challenges from a number of different areas. The most noteworthy of domestic issues were highlighted in the recent release of Q2 2015 GDP figures, which included household spending falling 2.1%, construction output down 8.4%, industrial production contracting 3.2%, and 12-month unemployment rates of 9% – twice the government’s internal target.7 Consumer confidence in August 2015 dropped to its lowest level in history with consumer inflation running at 9.6%,8 while business confidence fell to a record low in June 2015.9 In an effort to stem inflationary pressures, the Brazilian Central Bank has set interest rates at 14.25%,10 contracting the money supply even further, and restricting borrowing and investment.

Needless to say, present economic conditions in Brazil are not particularly conducive for attracting external investment or incenting domestic investment. Clearly, investment rating agencies have taken note, in light of Moody’s Investment Services’ recent downgrade of Brazil’s credit rating to Baa3, one step above junk status.11 Adding further insult to injury, Brazil is currently mired in political upheaval, as massive protests are calling for President Dilma Rousseff’s impeachment. President Rousseff’s approval ratings presently stand at just 8% due ostensibly to the country’s economic conditions and a widespread bribery scandal involving companies funneling an estimated $2 billion in kick-backs through Petrobras officials, including members of the president’s political party.12

Whether or not President Rousseff survives impeachment calls is difficult to gauge, but it is clear that the loss of confidence in the administration’s policies will make it difficult to implement any meaningful reforms to reverse Brazil’s downward trajectory. Any efforts to improve the country’s fiscal condition through austerity measures are further limited by constitutionally mandated spending on social benefit and entitlement spending, presently representing 90% of the country’s non-discretionary spending budget.13 The conclusions from these data points are unambiguous; Brazil’s economy will not be taking home many gold medals in 2016.

Outlook For The Brazilian Real
The Brazilian real has all the hallmarks for currencies that should be avoided: global economic challenges, domestic pressures, political instability, and deteriorating balance sheet quality. Moreover, silver linings appear to be in scarce supply in terms of investing in the real. Brazil’s recent positive balance of trade position could be in jeopardy based on further price declines in the commodity complex, and certainly notable in light of the government’s recent downward revisions to its key primary surplus target, underscoring the challenges of President Rousseff shoring up the country’s finances. As such, the persistent risk of further investment downgrades could have a material impact on the currency’s trading value.

For investors considering investment in the Brazilian real, enticed by the high interest rates the currency presently offers, caution is warranted given the aforementioned political instability, and internal and external economic conditions. Investors should keep in mind that benefits of high interest rates can easily be offset by any declines in the value of the currency, which is a material risk in the case of the Brazilian real considering that it has declined nearly 40% over the past 12 months.14 In addition, some investors may also be intrigued by the attention the Brazilian real will likely receive as we approach the 2016 Olympics as we have observed value appreciations in currencies of Olympic-host countries as far back as 1985; however, any periods of appreciation tend to be transient and short lived.

It appears as though the Brazilian economy and political environment will likely be in transition for the foreseeable future. For now, I would prefer to watch the action from the stands. For those traveling to attend next year’s Olympic festivities in Rio de Janeiro, the lower valued Brazilian real should certainly provide a boost to your purchasing power at the games, which will be one of many things to cheer for during the event.

Until the next Daily Pfennig® edition…

Chuck Butler
Managing Director
EverBank Global Markets Group