Will jitters in Brazil prompt the next big equity sell-off?

The rating downgrade of Brazil’s sovereign debt to “junk” earlier this month is another alarm that the largest Latin American economy is on the path to recession, and has raised fears of a potential equity sell-off in the region.

With the country’s second-quarter GDP dropping by 1.9 per cent compared with the first quarter of this year, US rating agency Standard & Poor’s cut Brazil’s rating to BB-plus, the highest junk rating, from BBB-minus and warned it could lower the rating further in the coming months.

Brazil is the first Bric economy to lose investment-grade status since the financial crisis began.

According to S&P, Brazil’s economic activity is expected to decline 2.5 per cent in 2015 before contracting a further 0.5 per cent next year.

The rating agency also cited long-running corruption investigations into Petrobras, the state-owned oil company and the world’s largest issuer of high-yield bonds, as another destabilising factor for the country.

Is S&P downgrade actually a worry for fund managers investing in the region or does Brazil still offer opportunities for investors?

Most of the emerging markets, including Brazil, have seen consistent fund outflows over the past year and have been out of favour. In the past week alone, Brazilian equity funds saw outflows equivalent to 1 per cent of their assets under management, according to the latest report from Bank of America Merrill Lynch.

Roberto Lampl, head of Latin American Investments at Alquity, says the Brazilian economic model is “broken”, blaming the Government for not being reactive with its promised structural reforms.

The ratings action came on the back of increasing political problems in Brazil, which, according to S&P, “are weighing on the Government’s ability and willingness” to submit the 2016 budget announced at the beginning of the year after Dilma Rousseff was re-elected as president.

Political uncertainty in Brazil is the result of the inefficient economic policies of the Workers’ Party, which has been in power for 12 consecutive years, as well as Rousseff’s inability to manage the coalition with Michel Temer’s Brazilian Democratic Movement Party and to steer it through the recent corruption scandals.

Lampl says: “There is too much debt, too much reliance on the belief that China was going to buy Brazil’s iron ore infinitely, too much living beyond their means. Now they are living this crisis, yet are unable to come up with credible policies to restructure and improve.

“They need to realise their mistakes and stop hiking taxes. Reform is the path to growth.”

Corruption in the government and in Petrobras coupled with high inflation and falling commodity prices has left the Brazilian market “in tatters”, according to Chelsea Financial Services managing director Darius McDermott.

He says that Brazil’s large current account deficit means it will continue to suffer as the US dollar strengthens. According to data from the International Monetary Fund, the deficit reached 4.2 per cent of GDP in 2014, up from 2.4 per cent of GDP in 2012. Any increase in US rates would make dollar-denominated debt harder to repay.

McDermott says: “At the moment you wouldn’t touch Brazil with a barge-pole. There is probably more pain to come as the US starts to raise rates and the dollar strengthens further. So you might want to wait until the rate cycle has started before dipping your toes in.”

Some fund managers predicted the downward path in Brazil, but despite the worrying outlook will keep backing the region.

Sailesh Lad, manager of Axa’s WF Global Emerging Markets Bonds and Emerging Markets Short Duration Bonds funds, will continue to hold positions there. Although his Global Emerging Markets Bonds fund has been underweight in Brazil since early summer, Lad retains the holding in Petrobras in his Emerging Markets Short Duration Bonds fund. He says the holding is under review but he is not concerned about the company in the short term.

Hargreaves Lansdown head of passive investments Adam Laird is also optimistic about Brazil, especially in the long term. “Brazil has a young workforce and there is a lot of potential for growth. Our models show some positive signs on the Brazilian market’s current valuation, although we have less data than we’d prefer. However, we believe investors should be cautious about investing in this area. It’s only for more adventurous investors as part of a diversified portfolio.”

Omar Negyal, fund manager of the JP Morgan Emerging Markets Income fund, worth £261m, has a 10.2 per cent exposure to Brazil, which is one of the largest in the IA Global Emerging Markets sector, according to FE data.

Within the sector, the fund with the largest exposure to Brazil is the Templeton Global Emerging Market fund with a 18.1 per cent allocation, followed by the Aviva Investors Emerging Equity Manager of Manager 1 fund, which has a 10.3 per cent exposure in the region.

Negyal says: “As bottom-up driven stock investors, our positioning in Brazil is driven by our focus on finding attractively valued names that pay a dividend.

“Rather than a top-down view on the market leading to our overweight in Brazil, instead it is driven by our focus on individual stocks that look interesting given this is a market in which companies are obliged to pay out at least 25 per cent of their net income as dividends.”

Charlemagne Capital co-chief investment officer Julian Mayo says Brazil still has “very good businesses” that are well managed and continue to do well.

“The Brazilian market is dominated by state-owned banks and we think the cyclicality of these businesses is a concern at the moment. Our portfolio is more focused on the private sector and domestic-orien-ted companies.”

Despite the fact that GDP numbers do not look positive for next year, Mayo  believes that a gradual recovery “will come through”. He says that after credit downgrades, what usually happens is that “the markets move ahead”, but according to him that doesn’t mean “you will see a very bullish market”.

Mayo says the future of commodity prices remains key for Brazil as lower commodity prices result in lower oil export revenue for Brazil. “If we see a slight rise in the price of commodities we’ll see a difference, but this is unlikely to happen.”