Emerging Markets

Brazil a 'cornucopia of possibilities' in spite of political upheaval, rate cuts

President of Brazil Michel Temer
Ricardo Botelho | BrazilPhotoPress | LatinContent | Getty Images

Political crisis? Where?

Brazil's turbulent 2016 — in which the country played host to a troubled Olympics as corruption scandals swirled around impeached President Dilma Rousseff and her successor, Michel Temer — would normally be enough to scare off investors.

Nevertheless, the country that put the 'B' in the bloc of emerging market powerhouses known as BRICS continues to deliver hefty returns on its stocks, even weathering a deep economic downturn and loose monetary policy.

Days ago, Brazil's central bank (Copom) surprised the market with a larger-than-expected rate cut, showing that it stands ready to act to help the country out of its deep recession. Lower rates tend to dim the allure of yield-hungry investors.

That may not prove to be the case for Brazil, however. According to MSCI data, Brazil's broad stock index returns topped 60 percent in U.S. dollar terms in 2016. Excluding dividends, this was the best-performing emerging market.

Most of this optimism within the market remains pinned on potential government reforms. In addition, the International Monetary Fund is now forecasting Brazil's growth to rebound from a steep contraction of more than 3 percent in 2016 to a "modest gain" of 0.5 percent this year.

"On the growth front, the good news is that about one-third of Brazilian exports are sent to either China or the United States," Douglas Johnson, managing director of Miami-based investment banking firm Cranganore, told CNBC in an interview.

"Better growth in those economies in 2017 will ricochet to Brazil."

Investors will abandon [Brazilian] assets if economic policy falters.
Douglas Johnson
managing director, Cranganore

The question remains whether investor optimism can hold, especially as Temer grapples with scandals of his own, as well as public discontent. Yet the country's political tumult is taking place against a backdrop of broad reform, which analysts expect to slowly take hold and enhance the allure of Brazilian assets.

Asset prices already reflect the good news, including the gradual transition to a reform-oriented government and macroeconomic imbalances that are being corrected.

"We like Brazilian assets from a risk-adjusted perspective but returns will likely not be as high, after the 2016 rally," said Marcela Meirelles, a sovereign analyst with asset management firm TCW.

"Brazil is a cornucopia of reform possibilities, all of which will help drive growth," Johnson said.

"The obvious candidate is the tax system. Other areas include a bloated, state-run pension system and rigid labor laws," he said — issues topping Temer's reform agenda. "They now need to be dismantled," Johnson added.

Meanwhile, stocks are rebounding, and are trading above their historical averages, which tends to anticipate an economic recovery.

"Further market outperformance would need to come from a faster-than-expected earnings recovery, which requires continued inflation and rate declines, and confidence on macro policy to restart private investment," Pablo Riveroll, head of Latin America equities at Schroders Investment Management, explains.

With Brazil's central bank moving aggressively to stimulate the economy, some economists think it could boost the effect of fiscal reforms.

Sao Paulo skyline
Getty Images

Still, risks do remain, with some fearing the country falling short of growth targets or reform efforts. "Investors will abandon assets if economic policy falters," said Johnson.

With only marginal growth expected this year and Temer battling negative public opinion, Brazil's margin for error is limited. Analysts say Temer's increasingly tenuous position could become an obstacle for his reform push. Without needed structural changes, investor fears could easily resurface, said TCW's Meirelles. However, all may not be lost.

"What's interesting is that Brazilian companies still thrive against a rigid, if not punitive, government backdrop," Johnson added. "For investors, that phenomenon tells me that companies could truly soar once they are unshackled from federal largess."