Is there anything left for fixed-income investors in Brazil?

The Rio Olympics are over; President Dilma Rousseff has been impeached. Despite widespread concerns about both events, they went off more-or-less according to plan. Brazil's fixed-income markets have already rallied strongly this year, significantly outperforming other emerging markets: the real has strengthened by 25 percent against the U.S. dollar and local bond yields have fallen by one-third, resulting in total returns for foreign investors of around 60 percent.

What's left for Brazil?

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Brazil's economy has adjusted: A crippling recession – the economy has contracted by nearly 10 percent in the past three years – and a slump in the real led to a collapse in import demand, resulting in a sharp improvement in the country's trade balance. Historically, sharp trade balance adjustments have presaged currency gains of 60 percent to 70 percent over the following year. With Brazil's trade balance turning only in April, there is potential for further upside – or, at the very least, limited downside risk – from the real.

Meanwhile, local bonds still yield 11 percent . The Brazilian central bank -- faced with double-digit inflation due to currency weakness, long-overdue adjustments to regulated prices and widespread indexation-- doggedly raised interest rates to 14.25 percent, despite collapsing growth. It has just cut rates, by a conservative 0.25 percent, for the first time since 2012. Though conditional on medium-term inflation expectations converging to its 4.5 percent target, as well as external factors such as the Federal Reserve's own rate cycle, the likelihood is that the central bank will be able to cut interest rates substantially over the next year or two.

Financial markets are pricing in 350 basis points of cuts, all by the end of 2017. Brazil's real yields have always been high, a legacy of the country's hyperinflationary past, but 6 percent or 7 percent would be notable given the severity of economic contraction, and in an international context where developed market yields are so low. With US real yields at zero, the 6 percent spread is as wide as it has ever been prior to 2016. Yields also look excessive when compared to Brazil's emerging market peers: even Argentina, with a similar history of hyperinflation, is attracting hoards of investors to its domestic debt markets with real yields of just 2 percent. Brazil's central bank could cut more aggressively, further supporting bonds.

Brazil still faces considerable challenges – not least the ability of Rousseff's successor, Michel Temer, to slash a primary fiscal deficit of over 2 percent of GDP. Pushing through much-needed structural reforms and revamping the notoriously convoluted tax system will be complicated in a highly-fragmented congress. Though immensely disruptive today, the resulting institutional strengthening could be a major long-term benefit for Brazil.

The central bank highlighted fiscal consolidation as a critical factor enabling it to cut interest rates, so setbacks on the political front could extend to monetary policy.

Though Temer's popularity levels are as low as his predecessor's, he is expected to be more adept at marshaling support. He may eventually benefit from early signs the economic contraction may finally have bottomed.

Business sentiment, which is strongly correlated with economic activity, has improved markedly, while investment picked up in the second quarter after nine consecutive quarters of decline. Inflation should ease further, helped by the real's rally and declining food prices. The unemployment rate, however, remains stuck at nearly 12 percent , the highest level in a dozen years.

The very fact that domestic factors are likely to be the key drivers of performance is another reason why we think Brazil remains attractive: it is an idiosyncratic opportunity in a universe of highly correlated assets. It is ambitious to hope to replicate the extraordinary gains of early 2016, but attractive total returns might still be possible over the coming year.

Denise Prime is an investment manager at GAM.You can follow her @GAMInsights.

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