Wealthy Nations Daily Update - Brazil Downgrade

We wrote yesterday about the risk of Brazil being downgraded to junk, and a few hours later rating agency S&P took the market by surprise with the earlier-than-expected announcement, that it cut the country’s rating by one notch to sub-investment grade BB+. S&P have kept a negative outlook saying they believe there is “a greater than one–in–three likelihood of a further downgrade due to a further deterioration of Brazil's fiscal position, potential key policy reversals given the fluid political dynamics, including a further lack of cohesion within the president's cabinet, or due to greater economic turmoil than we currently expect.”

Even before the announcement, which was made after the local market closed, Brazil’s financial markets had already plunged closer to bear market territory. To start with, the Brazilian real is the worst performing major currency against the dollar, so far this year having fallen ~30%. It has weakened a further 2% (at time of writing) today as markets come to terms with the quicker-than-expected downgrade. The nation’s Ibovespa equity index has fallen over 21% (or almost 38% in US dollar terms) from its peak in early May. Brazil’s bond yields are some of the highest across emerging markets; the benchmark ten-year USD issue is currently trading at 5.56% over Treasuries, having widened 160 basis points from January lows. Also the Brazil 5 year CDS (credit default swap) spread has spiked up to all-time high 428bps intra-day today, and is now trading much wider to the LatAm universe.

We do not think that this will be the last we hear from rating agencies, for one, S&P’s negative outlook signals the likelihood of a further cut within the next 9-12 months. Second, we believe Fitch will downgrade their very generous BBB (negative outlook) rating for Latin America’s largest economy, initially by one notch. The Fund has never held any Brazil debt, whether sovereign or corporate as our fundamental analysis of Brazil alongside our macro views have made us reluctant to add exposure to the country, despite the offering of high yields.