(Bloomberg) -- As volatility batters even the strongest economies of emerging markets, one nation is turning into a haven of calm and investors’ choice to hide out the Federal Reserve tightening spree: Brazil.
Developing-nation stocks, bonds and currencies are witnessing their worst meltdown in decades, but one wouldn’t know that looking at the Latin American country’s assets. Traders are raking in double-digit carry returns from its currency, making the most bullish bond bets in 13 years, sparing its local-currency debt from a high-yield selloff and calling its stocks “the hottest trade in town.”
The outperformance is providing much-needed relief for emerging-market investors who have been stung in: China, where growth is slumping; India, where high oil prices are crippling the currency; Africa, where debt crises are brewing; and eastern Europe, which has been whipsawed by the plunge in the euro.
Brazil is seen by many as the only major developing nation with an economic formula -- double-digit benchmark interest rates coupled with a giant commodity-exporting industry -- that can withstand the financial pressure created by soaring global yields. And then there’s next weekend’s presidential election. Optimism is now growing that regardless of who wins, the next government will pursue market-friendly policies.
“Brazil really is kind of a safe haven which one would not have expected in the run-up to the elections,” said Viktor Szabo, an investment director at abrdn in London. “This is quite a difficult year for emerging markets overall, with inflation, a war in Ukraine and central-bank tightening. But Brazil stands out, and is a solid investment story both in the financial markets and in 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 pro-actively raised interest rates to prepare for Fed tightening, few were as aggressive as Banco Central do Brasil. Its benchmark rate is now almost seven times what it was 19 months ago.
The ploy worked. Brazil has become the first developing nation to herald a peak in inflation, seeing consumer-price growth ease for three successive months -- with some added help from tax cuts on fuels and other products. The country’s real policy rate has soared to a world-beating 6.58%. That’s shifting the debate on interest rates from hikes to a potential cut next year.
“Local rates look more attractive in Brazil, given high real rates, while inflation peaked in April and has steadily declined since then,” said Sarah Glendon, a senior analyst at Columbia Threadneedle Investments in New York. “While the central bank will stay on hold for several months, rate cuts could begin as soon as the second quarter of 2023.”
Traders Bet That Brazil’s Hawkish Central Bank Will Change Tack
That’s a position to be envied by other emerging markets. Average inflation in the group is at a decade high, with double-digit price growth and negative real yields battering most countries.
The benchmark for emerging-market local-currency bonds is heading for the worst annual losses since at least 2009, that for dollar bonds toward the biggest decline since 1994. Stocks are witnessing the sharpest selloff since the 2008 financial crisis.
In contrast, Brazil is handing investors the best local-currency bond returns this month and is also the only high-yield nation to post a gain. In dollar bonds, the sovereign risk premium over Treasuries has tumbled 100 basis points since July, taking it to the lowest level since the financial crisis relative to other emerging markets. Its stocks are generating the fifth-best dollar returns globally.
Carry returns on the real are rising this month by the most since May, taking year-to-date returns to 16%. Given that other emerging markets have produced carry losses of 6%, traders who switched to Brazil are 22 percentage points better off in 2022.
“There isn’t really anywhere else in the world that looks like that,” said Ayman Ahmed, a money manager at Thornburg Investment Management, referring to Brazil’s monetary tightening that led to this carry. “They’re so ahead of the curve, the country has become a darling for investors.”
Brazil’s presidential elections are arguably the most watched political event in emerging markets right now. The battle between President Jair Bolsonaro and former left-wing leader Luiz Inacio Lula da Silva proved to be closer than expected and has gone into a run-off due Oct. 30. While Lula is still the poll favorite, Bolsonaro is gaining on him.
Investors believe either the market-friendly Bolsonaro will win, or Lula prevail in a close race that will encourage him to pursue more fiscally responsible policies. Both outcomes are seen as positive for risk in the immediate aftermath of elections, even though political compulsions to boost social spending could return in the medium term. The only scenario that could ruin the markets party is a contested result.
“The final vote remains a key test of Brazilian institutional strength,” said Robert Hoodless, the head of foreign exchange and macro analysis for Europe and the Americas at InTouch Capital Markets. “So long as we do not get to such an ugly outcome, Brazil looks set to remain a must-have for most emerging-market players.”
Foreign investors have reduced their bearish bets on the Brazilian real by about $5 billion after the first round of the election, according to B3 local exchange data compiled by Bloomberg. In the week ended Oct. 21, the nation attracted the biggest inflow among emerging-market exchange-traded funds.
Fiscal Risks
The specter of an ugly outcome -- not just in the elections but in long-run fiscal discipline and political stability -- always hangs in the air when money managers talk about Brazil. Therein lies the nub. A lot of things could quickly go wrong in this volatile emerging nation and that’s stopping investors from turning bullish beyond a few months’ horizon.
“Regardless of a Lula 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 limitations are ignored, Brazilian assets could reverse course.”
The fragility of the political situation was in evidence over the weekend when tensions escalated, leading to a rout in Brazilian assets on Monday. The real was the worst performer in emerging markets with a 2.5% loss.
But looking beyond volatile headlines, investors’ priority is to survive shrinking liquidity and the Fed’s relentless path toward higher rates. Most foresee at least six months of volatility, and they need a refuge to park and preserve their capital. Brazil answers that need.
“The country is in pretty good shape,” said Daniel Tenengauzer, the chief market strategist at Bank of New York Mellon Corp. “So that is basically the bias that I have: to be long almost regardless of the result.”