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Brazilian stocks rebound as political turmoil rumbles on

Brazilian President Michel Temer
Evaristo Sa | AFP | Getty Images
Brazilian President Michel Temer

Brazilian stocks showed slight signs of recovery at their open on Friday, after a new wave of political turmoil saw major indices post their worst day since the start of the 2008 global financial crisis.

The Brazilian benchmark was 1.7 percent higher, recovering from a previous session where stocks dropped amid allegations that President Michel Temer agreed to pay hush money to a witness in the country's biggest-ever corruption probe.

Meanwhile, the iShares MSCI Emerging Markets ETF (EEM), which features a 7.65 percent exposure to Brazil, was up by 1.7 percent Friday after closing the previous day down 1.66 percent.

The uptick will provide slight relief to investors, who continue to battle against a tide of volatility within the embattled economy.

However, turmoil is par for the course in emerging markets.

The Brazil Bovespa index, which also logged its worst day since October 2008, fell 10 percent in Thursday trading and has suffered a tumultuous journey before now. Nevertheless, the Brazilian stock exchange has been on a largely upwards trajectory since early 2016 and is up almost 20 percent over the past decade.

So, just how concerned should investors be by the latest development to shake the Latin American powerhouse?

Game changing events

Though regional markets cannot be compared on a like-for-like basis, it is worth looking at the impact of recent political upheaval in other emerging economies, which may give some indication of the direction of travel for markets.

In South Africa, a fellow BRICS economy, for example, stocks suffered a sudden sell-off after President Jacob Zuma abruptly dismissed his finance minister Pravin Gordhan in late March. However, after enjoying a fairly speedy recovery, the impact has since been muted.

"The initial market reaction may be more violent than the eventual range," UBS said in a research note released Thursday.

However, it added that the news "has the potential to be a game changer for Brazil duration."

How are fund managers responding?

As such, the Swiss bank has removed its overweight recommendation on Brazilian equities, citing "material downside risk."

The shifts come after research from Bloomberg revealed that U.S. hedge funds reduced equity holdings tied to Brazil by about $800 million in the first quarter of this year. This followed a 69 percent surge in the country's benchmark stock index last year.

View of with Christ the Redeemer and Sugar Loaf at background
Buda Mendes | Getty Images
View of with Christ the Redeemer and Sugar Loaf at background

Of the ten U.S. hedge funds who held a combined almost $2 billion in Brazilian assets and ETFs (Exchange Traded Funds), as of March 2017, the largest allocations were in publicly quoted bank Itau Unibanco, state-run energy company Petroleo Brasil and iShares MSCI Brazil Capped ETF, according to Bloomberg data.

However, Ross Teverson, head of emerging market strategy, said that the recent shake up would likely dissipate, creating value in the long-term.

"Questionable governance has held Brazil back for a number of years and, while the ongoing corruption investigations create short-term uncertainty, there is a much greater longer-term payoff for Brazil if the new reality is that politicians and companies can no longer break the law with impunity," Teverson told CNBC in an email.

Going forward, UBS said it recommends sticking to "high quality names", preferably exporters with U.S. dollar earnings and strong balance sheets. Such names include Brazilian brewery business AmBev, telecommunications company Telefonica Brasil, paper exporter Klabin and food conglomerate BRF.

What next for Brazilian politics?

President Temer has forcefully denied allegations that he approved an illicit payment to a former coalition ally, Eduardo Cunha, to cover up a corruption scandal and has vowed that he will not resign from his two-year-old government.

The president, who was appointed to replace impeached former president Dilma Rousseff, was once seen as a symbol of economic confidence for Brazil but is now seen as one of the most unpopular presidents in the country's history.

He will now face a criminal inquiry by the Supreme Court over the corruption allegations.

Former Brazilian President Dilma Rousseff speaks during a media conference at Uruguay's Frente Amplio party's headquarters in Montevideo, November 4, 2016.
Andres Stapff | Reuters
Former Brazilian President Dilma Rousseff speaks during a media conference at Uruguay's Frente Amplio party's headquarters in Montevideo, November 4, 2016.

If found innocent, Temer can be expected to remain in office until the next general election, due in October 2018.

If found guilty, he too will face impeachment and will be removed from office. In this instance, head of congress, Rodrigo Maia of the Democratic party, would take office on an interim basis of 30 days before a new president is appointed via indirect elections.

UBS said the latter would likely spur an economic scenario akin to late 2015, when the country was imbued by a period of protests and social unrest following the emergence of allegations against the then-President Rousseff.

Already, an 'occupy' protest is scheduled to take place in Brasilia on 24 May against the government's reform plans.

Central Bank policy

Brazil's central bank said following Thursday's reports that it will "monitor the impact of the information" and "act to maintain the full functionality of markets."

J.P. Morgan Asset Management's senior client portfolio manager in Emerging Markets suggested that this could include continue efforts to contain local currency (BRL) depreciation, possibly by selling further U.S. dollar through swaps if the Brazilian Real depreciates.

Demonstrators shouts slogans during a protest against austerity measures in front of the Legislative Palace in Rio de Janeiro, Brazil, on Monday, Dec. 12, 2016.
Dado Galdieri | Bloomberg | Getty Images
Demonstrators shouts slogans during a protest against austerity measures in front of the Legislative Palace in Rio de Janeiro, Brazil, on Monday, Dec. 12, 2016.

"This will be perceived as a key thermometer of market stress," Zsolt Papp told CNBC via email.

"The National Treasury can also join the effort to calm markets and buy back bonds (as was done in 2015)," she added.

"While these moves may be supportive in the very near term, if the political environment remains unsettled for longer (and no signal of eventual improvement in fiscal accounts) we may see further depreciation of Brazilian assets."

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