Why Brazil’s equity market keeps dropping (Part 6)

Brazilian Equity Market 2013-07-07Enlarge GraphContinued from Why Brazil’s equity market keeps dropping (Part 5)

Despite the many factors working against the Brazilian markets right now, several may dissipate in the short term

The riots due to the transit fare hikes are likely to dissipate soon, driven by several factors. The main factor is that the government has yielded to many of the demands and excluded some taxes in order to reduce the fare hikes, increased its ability to prosecute corruption charges (leading to a high-profile conviction1), and criminalized corruption and embezzlement, earmarking petroleum royalties for education, healthcare, and a fiscal responsibility pact, among other initiatives. Protesters have laid some other points on the table, but the government has granted the bulk of the demands. Additionally, the end of the Confederations Cup will reduce attention to the spending on stadiums and avoid protestors targeting further games.

The steep fund outflows due to the U.S. Fed actions have already been reduced, as Brazil posted $400 million of inflows last week. This is likely driven partially by the drop in valuations due to the reasons discussed in this series. Additionally, anticipation towards the potential end to quantitative easing is starting to shift from a bearish signal to the market to a bullish signal, as investors read the Fed statements as confidence in the economy rather than a withdrawal of support at an untimely moment.

The disappointing macro data, on the other hand, is likely to remain depressed in the short term. Most recent indicators continue to show weakness, and leading economic indicators, such as the Manufacturing PMI and Service PMI, point towards continued pain in the economy. Inflation has stopped rising, but it’s not decreasing significantly and it continues to inch higher from time to time on the various inflation indicators in Brazil.

Finally, the regulatory actions discussed will have opposing effects at worse in the medium term. While the removal of the IOF tax (the financial transaction tax of 6%) greeted an unexpected (and perhaps uncorrelated) market pullback, in the medium to long term, the reduction of hurdles and fees for investment flows will increase direct investments into Brazil. The rise of interest rates may hinder growth in the short to medium term, but reigning back inflation was necessary in order to reduce investment risk and stabilize the currency.

Overall, although the near-term prospects for Brazil continue to look negative, the recent pullback in the market may offer an attractive entry for longer-term investors. In the near term, though, there isn’t a solid catalyst to bring the market higher, and the foreign exchange risk remains high.

  1. A lower house representative was convicted of corruption.