Brazil’s investments shine amid a slump in other emerging markets

As volatility hits even the strongest emerging market economies, one nation is becoming a haven of calm and investors’ choice to mask the Federal Reserve’s (Fed) tightening streak: Brazil.

Stocks, bonds, and currencies in developing countries suffered the worst slump in decades, but one wouldn’t know it by looking at Brazilian assets.

Traders are getting double-digit returns from their currency, making the most bullish bets on bonds in 13 years, saving their local currency debt from a high-yield selloff, and calling their stocks “the hottest deal in town.”

The outperformance provides much-needed relief for investors in emerging markets that have been hurt in China, where growth is slumping.

In India, high oil prices are crippling the currency. In Africa, debt crises are brewing. And Eastern Europe has been battered by the euro’s slide.

Brazil is seen by many as the only major developing country with an economic formula (double-digit benchmark interest rates and a giant commodity exporting industry) that can withstand the financial pressure created by rising global yields.

Then there is next weekend’s presidential election. Optimism is now growing that the next government will implement market-friendly policies regardless of who wins.

“Brazil is really a kind of a safe haven that one would not have expected in the run-up to the election,” said Viktor Szabo, chief investment officer at abrdn in London.

“This is quite a difficult year for emerging markets in general, with inflation, the war in Ukraine, and central bank tightening. But Brazil stands out and is a solid investment story in both financial markets and the real economy.”

At the heart of this story is Brazil’s dogged pursuit of monetary tightening to contain inflation.

While many emerging market central banks proactively raised interest rates to prepare for Fed tightening, few were as aggressive as Brazil’s central bank.

Its benchmark interest rate is now almost seven times higher than 19 months ago.

The ploy has worked. Brazil has become the first developing country to announce a spike in inflation, seeing consumer price growth slow for three consecutive months, with the added help of tax cuts on fuel and other products.

The country’s real interest rate has soared to a world-record 6.58%. That is shifting the interest rate debate from hikes to a possible cut next year.

It is an enviable position for other emerging markets. Average inflation in the group is at the highest level in a decade, with double-digit price growth and negative real yields affecting most countries.

The benchmark emerging market local currency bond index is heading for the worst annual losses since at least 2009, and the dollar bond index is heading for the biggest drop since 1994. Stocks are experiencing the biggest selloff since the 2008 financial crisis.

In contrast, Brazil offers investors the best local currency bond yield this month and is also the only high-yielding country to post gains.

In dollar bonds, the sovereign risk premium over Treasuries has fallen 100 basis points since July, standing at the lowest level since the financial crisis relative to other emerging markets. Its stocks are generating the fifth-best dollar yield globally.

Franklin Templeton says Brazilian equities are the hottest deal in town.

The real’s performance is up the most this month since May, bringing its year-to-date return to 16%.

Considering that other emerging markets have produced carry losses of 6%, traders who switched to Brazil are 22 percentage points better off in 2022.

“There’s really nowhere else in the world that looks like this,” said Ayman Ahmed, a money manager at Thornburg Investment Management, referring to Brazil’s monetary tightening that led to this carry.

“They are so far ahead that the country has become an investor favorite.”

Brazil’s presidential election is arguably the most closely watched political event in emerging markets right now.

The battle between President Jair Bolsonaro and former leftist leader Luiz Inácio Lula da Silva proved closer than expected and has moved to a runoff on October 30.

Although Lula da Silva remains the favorite in the polls, Bolsonaro is gaining on him.

Investors believe that either market-friendly Bolsonaro will win or da Silva will prevail in a close race that will encourage him to pursue more fiscally responsible policies.

Both outcomes are seen as positive for risk immediately after the election, although political compulsions to boost social spending could return in the medium term.

The only scenario that could spoil the markets’ party is a contested result.

“The final vote remains a key test of Brazilian institutional strength,” said Robert Hoodless, head of the macro and currency analysis for Europe and the Americas at InTouch Capital Markets.

“As long as we don’t get such an ugly outcome, Brazil looks set to remain a must-have stock for most emerging market players.”

Foreign investors have reduced their bearish bets on the Brazilian real by about $5 billion following the first round of elections, according to local exchange B3 data compiled by Bloomberg.

FISCAL RISKS

The specter of a bad outcome – not just in the election, but in fiscal discipline and long-term political stability-always hangs in the air when money managers talk about Brazil. Therein lies the crux of the matter.

A lot could go wrong quickly in this volatile emerging nation, which keeps investors from turning bullish beyond a few months’ horizon.

“Regardless of a Lula da Silva or Bolsonaro victory, fiscal policy is likely to turn expansionary,” Brendan McKenna, a strategist at Wells Fargo in New York.

“Brazil already has limited fiscal space; so if public finances deteriorate further in the coming years and spending constraints are ignored, Brazilian assets could reverse course.”

But for now, investors’ immediate priority is to survive the liquidity squeeze and the Fed’s relentless path to higher rates. Most expect at least six months of volatility and need a safe haven to park and preserve their capital. Brazil answers that need.

“The country is in very good shape,” said Daniel Tenengauzer, chief market strategist at Bank of New York Mellon Corp. “So that’s basically the bias I have: to be long almost regardless of the outcome.”

With information from Bloomberg