The research team at Deutsche Bank explains that Brazilian markets were rocked on Thursday after local media reported that as part of plea-bargain agreement, JBS owners Joesley and Wesley Batista had secretly recorded conversation with President Temer.
“The recordings were expected to clearly show the involvement of Temer in a bribing scheme yet once they surfaced on Thursday night they were not as damaging as expected. President Temer has pledged not to resign yet his political situation remains very fragile: the Supreme Court opened a formal investigation on the matter, cabinet members have stated they could resign, Lower House representatives have filed requests for impeachment, and there have been some rowdy street demonstrations against the President.”
Should Temer resign or have his mandate cut short by the electoral court (TSE) he would be replaced by Lower House President Rodrigo Maia. The interim President would have 30 days to call for an indirect election in which Congress chooses a new President to complete Temer’s term. And while there is some pressure from the opposition via street demonstrations demanding direct elections, we believe this outcome is unlikely.”
“What about the reforms and the BCB’s easing cycle?
The best outcome for reforms would be a swift transition via indirect elections to a new government that would ideally maintain Temer’s economic team and commitment to push the reform agenda through Congress. However, the outlook for reforms and especially the controversial social security reform has deteriorated markedly. Assuming the BRL does not depreciate in a sustained manner very low inflation and sluggish growth could still allow the BCB to cut interest rates although the scope for a 125bp cut at the next COPOM has narrowed.”
“Rates & FX Strategy Update
We see ~50 bp of value in the Jan18-Jan19 sector of the curve, which in our view is more dependent on monetary policy. Beyond that we believe it is a call on the future of the reforms – for now, we expect steepening to reign. On the FX front, the USD/BRL has recovered to a level consistent with a swift transition to a new pro-reform government. If this happens the BRL could rally back below 3.20 or remain range bound.(3.22-3.35) If Temer remains in power for some time (the most likely scenario) we see some USD/BRL upside (towards 3.60) although the healthy state of Brazil’s external accounts and the BCB’s ample room to intervene via swaps limit the extent to which the BRL will sell off in the near term.”
“Sovereign & corporate strategy update
We see further re-pricing pressure in Brazil sovereign bonds after Thursday’s +40bp initial reaction and thus move Brazil to underweight in our sovereign recommendations. We have observed a parallel shift of the cash curve along with a sharp widening of the basis: we expect cash bonds to catch up as the market sells off further and favor a curve steepener and a basis tightener in selling 10y CDS vs. 47s. We also revise our recommendation on Argentina to marketweight. On the corporate front we turn cautious and advocate an underweight stance on Brazilian corporates (within EM ex-Asia) with a preference for Petrobras’ 5-year sector and select higher-quality exporters and multinationals.”