Is equities enthusiasm ignoring the bigger picture?

Be careful what you wish for.

It’s a message that fair-weather investors scrambling to buy stocks in emerging markets right now should be mindful of – not least when it comes to Brazil.

That is because much of this enthusiasm is built on wishful thinking, in this case, high hopes for liberal economic reforms under the president Jair Bolsonaro.

Analysts say assets managers have been raising their exposure to EMs since November, and this became something of a gold rush in January.

Spurred by news that the US Federal Reserve would not be raising interest rates as quickly as expected, investment banks joined the charge.

The optimism is inevitable, given the hit endured by EMs last year – the iShares MSCI Emerging Markets exchange-traded fund (EEM) fell by 17%.

Brazil is setting the pace, with a rebound that was already in bull market territory by the time Bolsonaro won the first round of elections in October.

The benchmark Bovespa index soared to a record high recently as investors enthuse about the president’s promise to transform the country’s dire public finances.

Why the enthusiasm – and is it justified?

Investors are targeting stocks in emerging markets for obvious reasons.

They are currently cheaper than US stocks because the dollar is expensive, and as it falls this will boost the value of investments in dollar terms.

After interest rate rises last year shadowing those of the Fed, global rates are now shifting back in favour of EMs, and trade tensions between the US and China are also expected to ease.

In the case of Brazil, there are high hopes in particular that Bolsonaro can finally achieve what his predecessor failed to do – meaningful pension reform to ease unsustainable debt.

But investors should be wary.

First, the latest scramble is nothing new: EM stocks all dropped sooner than the main global indexes before the dotcom bubble burst in 2000, during the global financial crisis, and in 2016 – and then started to rebound earlier.

Second, there remain fears of  “secular stagnation” in the global economy and a key variable for most EMs will be China, where GDP grew 6.6% in 2018, its slowest pace since 1990 – and whether the government in Beijing acts to stimulate its ailing economy. Analysts are not convinced.

Finally, with their shape-shifting investor base EMs remain volatile – raising the stakes when it comes to political risk.

This has risen up the agenda globally, especially in regions such as Latin America where a new brand of populism has emerged that is attractive to investors by hitching a ride on free-market rhetoric but troubling for many citizens.

Political change can have a rapid impact on investment, especially in capital-intensive areas in Latin America such as mining, placing an onus on investors to sharpen their risk management and intelligence gathering.

Brazil in the spotlight

These factors set the scene for the real questions about Brazil that optimists should be asking.

First and foremost, Bolsonaro’s political instincts are explosive.

Statistically at least, Brazil resembles a war zone – in 2017 it suffered a record 63,880 homicides, and between 2006 and 2016 some 553,000 people lost their lives to violence.

The new president’s response has been to ease rules on gun ownership, promise security forces a free hand in tackling crime, and lob rhetorical grenades at vulnerable minorities most likely to be caught up in the bloodshed.

There was a time in Brazil when a populist could get away with that – but Latin America’s largest economy now hosts a complex, sophisticated and plural society protective of rights and the rule of law.

Investors are well advised not to ignore the social consequences of knee-jerk policies – with the inevitable risk that these can fuel the instability that is bad for their investments.

Second, don’t take Bolsonaro’s commitment to free markets entirely for granted.

He makes much of his admiration for Brazil’s former military dictatorship – a third of his cabinet are former army officers – whose interventionist reflex was a key characteristic of their rule between 1964 and 1985.

A clear sign of the detachment with which the new president views markets was his decision to sub-contract economic policy to the University of Chicago-trained banker Paulo Guedes.

The pensions headache

Last but not least, investors and credit rating agencies see the pension reforms unveiled recently as the litmus test of Bolsonaro’s resolve to restore confidence in Brazil and regain the investment-grade rating it squandered in 2015.

The pensions deficit is without doubt a ticking fiscal bomb – in 2017 it amounted to a breathtaking US$61.3bn – and hence the most pressing issue Bolsonaro faces if he wants to deflate a ballooning budget deficit of 8% of GDP.

But it is the complex politics of reform that investors will scrutinise most closely.

Bolsonaro talks tough – but the constitutional character of pensions means reform must be backed by three-fifths of congress, and he will need to do some sophisticated horse-trading.

A key question, therefore, is whether he possesses the skill to build such a super-majority behind an unpopular reform in a system where there is visceral distrust of the political class.

The omens are already poor: recently Bolsonaro was badly defeated in congress over moves to tighten secrecy rules for public officials.

There have also been signs of disagreement between the president and Guedes over how radical the cuts should be, and cracks are appearing in Bolsonaro’s Social Liberal Party.

More worrying still for this presidential rookie, pension reform is unique for its capacity to unite a diverse coalition of opponents affected by it.

In Brazil, that includes many on the right of politics – not least retired police officers and members of the security forces who might otherwise be natural Bolsonaro allies.