Brazil

Highlights Preserving the fiscal spending rule is becoming economically unviable and politically unfeasible. Breaking the fiscal rule – the most likely scenario in our view – will push up the risk premium on Brazilian markets. Keeping government borrowing costs well below nominal GDP growth is critical to stabilizing the public debt-to-GDP ratio. This cannot be achieved without the central bank’s purchases of government bonds on a large scale. Continue shorting the BRL. A buying opportunity in stocks could emerge after the risk premium rises much more due to the break of the fiscal rule. Feature Chart 1The BRL And Commodities Prices Have Decoupled The Brazilian exchange rate has decoupled from commodities prices (Chart 1). Rising resource prices and the global risk-on environment have failed to produce a meaningful rebound in the real. The reason is that preserving the constitutionally mandated fiscal spending rule is becoming economically unviable and politically unfeasible. Authorities are about to throw in the “fiscal towel”. For some time, Brazil has been staring down two difficult paths: (1) life without fiscal stimulus, or (2) breaking the fiscal spending rule. In the first scenario, the Brazilian government will satisfy the interests of creditors, but inflict material pain on the economy. Yet, the conditions for stabilizing the public debt-to-GDP ratio are still unlikely to be met under this scenario. Without fiscal stimulus, nominal GDP growth will remain below borrowing costs. Besides, government revenue will dwindle, and the fiscal deficit will not narrow substantially. In the second scenario, domestic demand will recover, but the public debt-to-GDP ratio will surge and the outlook on public debt will become extremely troublesome. Therefore, inflating the country out of debt will likely become the sole feasible option in the long run. Below we present the two different policy roads for Brazil, and their effects on the economy, interest rates and financial markets. As we wrote in previous reports and reiterate today, fiscal tightening is not a politically viable scenario for President Bolsonaro. Given economic and political considerations, the president and Congress will likely resort to pump priming to engineer a strong economy before the October 2022 general election. Scenario 1: Life Without Fiscal Support If Bolsonaro and Economy Minister Guedes stick to the original 2021 budget, which allows rising government spending only at a pace of last year’s inflation rate, the economy will experience full-blown debt deflation. The fiscal thrust will be -8% of GDP in 2021, i.e., this amounts to a significant fiscal cliff (Chart 2). Given that the second wave of the pandemic is yet unchecked and the risk of another round of lockdowns continues to rise, the economy cannot handle such substantial fiscal tightening. The inflation rate will decline anew, probably heading towards or below zero (Chart 3). Chart 2Brazil: An Unprecedented Fiscal Cliff Chart 3Brazil: Inflation Remains Too Low Odds are that household, business and government nominal income will shrink (Chart 4). This would entail debt deflation – contracting revenues will severely undermine debtors’ capacity to service their debt.  In addition, real lending rates – which are already elevated – will rise as inflation drops (Chart 5). Chart 4Without Fiscal Stimulus, Nominal Income Will Shrink Again Chart 5Brazil: Real Lending Rates Are High   Chart 6Bank Loans Have Not Recovered Facing a renewed rise in NPLs, banks will curtail lending, thereby depressing final demand (Chart 6).   Rising commodities prices might not be sufficient to reverse such debt deflation in Brazil. The basis is that commodities exports make up 11-12% of GDP. The primary fiscal deficit is projected by the government to narrow from 9% to about 2% of GDP due to the adherence to the fiscal spending rule. In fact, the primary deficit might not narrow as much as the government expects due to the loss of government revenue stemming from very depressed nominal growth. This is very likely in the scenario of fiscal tightening. Market Implications Of Scenario 1: The currency will be initially supported at current levels as the government adheres to fiscal discipline. However, the real will likely depreciate later and act as a release valve as deflation takes a toll on the economy. Chart 7Brazil: A Steep Yield Curve Predicts A Break Of The Fiscal Rule Interest rate expectations will fall and the yield curve will invert, predicting another recession (Chart 7). Share prices of domestic-oriented companies, including small caps, will nose-dive as domestic demand is wrecked. Scenario 2: Breaking The Fiscal Spending Rule This is the most probable scenario of the two. With the pandemic still ravaging the country and no hope of effective and rapid vaccination, the economy cannot recover without additional and meaningful fiscal support.  Chart 8Brazil: COVID-19 Is Coming Back With A Vengeance The second wave of COVID-19 has surpassed the first one in terms of daily cases, hospitalizations, and deaths (Chart 8). Public and private hospitals are on the brink of collapse across the country. State and local governments will probably have no choice but to re-introduce lockdowns. Lockdowns affect low-income households disproportionately, as their jobs are in the service and informal sector, the most vulnerable under quarantine and social distancing rules. Government financial assistance for low-income households is therefore essential. Both Bolsonaro and the political parties holding sway in Congress have an incentive to resort to fiscal stimulus and break the spending rule. The effectiveness of such stimulus in reviving economic activity is the greatest because fiscal transfers to low-income households have the highest multiplier effect. This will also ensure a surge in the popularity of politicians ahead of the 2022 general election. Given Bolsonaro’s rising disapproval rate and the dismal performance of his candidates in last year’s municipal elections, the pressure is increasing to deliver strong economic performance to tout in his presidential campaign next year. Crucially, the strongest objection to breaking the fiscal spending cap has been from Economy Minister Guedes, but there are signs he might be becoming more accommodative. Lately Guedes has stated that he is considering capping health and education expenditures and public sector wages to renew the popular cash handout program, albeit at a smaller amount than in the last two months of 2020. Further, the Ministry of Economy has acknowledged that the second wave of the pandemic has been much tougher than expected, and that a renewal of emergency spending measures would provide a much-needed support to the economy.  However, Bolsonaro has objected to cutting social programs to maintain cash handouts. Chart 9The Brazilian Economy Will Relapse Overall, economic conditions are worsening, making adherence to the fiscal spending rule impossible (Chart 9). Faced between rearranging the budget or providing stimulus and breaking the fiscal cap, Bolsonaro and Congress will likely pursue the latter as reducing expenditures to maintain a smaller version of the cash handout program will not be enough to sustain domestic demand. Can Brazil grow out of its public debt by boosting nominal GDP via fiscal stimulus? We do not think so. Fiscal stimulus alone will be insufficient to inflate its way out of debt. Keeping government borrowing costs well below nominal GDP growth is critical to stabilizing the public debt-to-GDP ratio. This cannot be achieved without the central bank’s purchases of government bonds on a large scale. Fiscal stimulus will lead to another surge in the public debt-to-GDP ratio. Critically, the two conditions for stabilizing the public debt-to-GDP ratio will still be absent. Chart 10Borrowing Costs And Nominal GDP Growth Condition 1: Nominal GDP growth should continuously hover above government borrowing costs: While nominal growth will rise along with fiscal stimulus, so will local bond yields as the central bank lifts its policy rate and the risk premium widens. In short, the breaking of the fiscal rule will push bond yields meaningfully higher and borrowing costs will exceed the reviving nominal GDP growth (Chart 10). When public sector borrowing costs exceed nominal GDP, the public debt-to-GDP ratio will rise as a matter of arithmetic. In turn, the only way to satisfy the first condition is for the central bank and commercial banks to be willing to finance the government on a large scale, i.e., purchase government bonds en masse. This will bring down and cap government local bond yields below nominal GDP growth. Yet, this would amount to public debt monetization and would produce substantial BRL depreciation. For now, the central bank is not considering this option at all. Rather, the monetary policy committee is getting ready to hike interest rates if the fiscal spending rule is broken. Condition 2: The primary fiscal balance should be in substantial surplus. There is no chance that the primary fiscal balance will move into surplus if more fiscal stimulus is enacted (Chart 11, top panel). Notably, in the 2000s the Brazilian government was able to deleverage by running large recurring primary surpluses (Chart 11). In brief, the second condition will be impossible to satisfy with expanding government expenditures. Chart 11Brazil's Debt Dynamics Are Out Of Control Chart 12The BRL Has Room To Sell Off   Market Implications Of Scenario 2 (Our Baseline): The Brazilian real would plunge as the fiscal rule is violated and inflation expectations rise. Crucially, the currency is not cheap according to its real effective exchange rate (REER) (Chart 12). In the near term the US dollar will likely rebound. However, in the medium to long run, the BRL will depreciate more versus other DM currencies than the greenback. We continue to recommend investors short the BRL versus an equal-weighted basket of the euro, JPY and CHF. The central bank will hike policy rates as fiscal consolidation is dodged but it might not be enough to offset the positive push of fiscal stimulus. Consequently, the economy will recover and inflation expectations will rise, as will domestic bond yields. Continue underweighting Brazil within an EM local currency bond portfolio.   Due to public debt unsustainability, we reiterate our underweight in Brazilian sovereign credit within an EM credit portfolio.   In regard to equities, the Bovespa index in US dollar terms has rolled over from its 3-year moving average (Chart 13). This seems to be a technical sign of a major top. Similarly, the small cap stock index in US dollar terms is facing a technical resistance (Chart 14). Investor sentiment will likely go sour as the BCB hikes rates and public debt sustainability is questioned. We recommend investors maintain an underweight stance in Brazilian equities relative to the EM benchmark for now. In the medium and long term, Brazilian share prices could rally on the back of high nominal growth. The investment strategy in this scenario should be going long stocks but shorting the BRL. Stay tuned. Chart 13The Bovespa Is Facing Resistance Chart 14Small Cap Stocks: The Rally Is Due For A Pause   Juan Egaña Research Associate juane@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes  

Highlights Barring dramatic policy actions, the ratio of public debt to GDP in Brazil is set to rise both continuously and significantly.   Authorities can only gratify either the government’s creditors by tightening fiscal policy, or the population by substantially relaxing their fiscal stance. Given that both the president and congressmen face re-election in two years, they will sooner or later choose to please the population at the expense of the creditors. In the near term, authorities might pass a tight 2021 budget to boost investor confidence. However, as the economy crumbles due to the fiscal cliff, President Bolsonaro will likely choose to considerably relax fiscal policy. Provided it is impossible to know when President Bolsonaro will shift his stance on fiscal policy, we are sticking with our structural underweight positions in Brazilian financial markets. Feature The Brazilian government is caught between a rock and a hard place: it must decide either to provide more fiscal stimulus to the struggling economy or to stabilize its mushrooming public debt by winding down fiscal stimulus. If the authorities opt for another round of fiscal stimulus to support domestic demand, they risk losing investor confidence as public debt becomes unsustainable. On the other hand, if the government chooses to aim for fiscal sustainability, they will at the very least need to let current fiscal stimulus programs lapse. This would amount to a fiscal cliff that would devastate the economy. Lingering economic fragility and the lack of a politically feasible and economically justifiable solution will likely lead to political infighting. The latter will damage business and investor confidence. There are already signs that financial markets are becoming uneasy with the sustainability of the nation’s public debt. There are already signs that financial markets are becoming uneasy with the sustainability of the nation’s public debt. Specifically, the term structure of local currency government bond yields has steepened pricing in a higher risk premium (Chart I-1). Neither growth nor inflation outlooks at this point warrant such yield curve steepening. Hence, the latter probably reflects worries about long-term public debt sustainability. Also, the Brazilian real has failed to rally in recent months despite rising commodities prices (Chart I-2).   Chart I-1Brazil: Risk Premium In Local Bonds Has Been Rising Chart I-2Commodities Prices And BRL: A Decoupling?   Faced with the dilemma between public debt sustainability and economic growth, President Bolsonaro will eventually opt for a relaxation of fiscal policy such that government spending limits will no longer be respected. If this happens, his prominent, fiscally conservative Economic Minister, Paulo Guedes will likely resign, and Brazil’s financial markets will plummet. How Large Has The Stimulus Been? Chart I-3Brazil: Fiscal Stimulus Has Been Large To begin, the Brazilian economy has been benefiting from fiscal stimulus (Chart I-3). The COVID-19 fiscal package, excluding credit-type stimulus, is the highest in the region at 8% of GDP. Of that, 67% has already been spent and the rest will be disbursed before year-end. The economy is now facing a non-trivial level of fiscal restraint over the remaining months of this year as fiscal transfers to low-income households have been halved, from 600 to 300 reais per person, and the loan repayment moratorium will expire before October. Concerning the loan moratorium, in March the government implemented a large-scale debt servicing postponement program for consumers and businesses. Altogether, the five largest banks offered a grace period of 2-6 months of principal and interest payments on loans, amounting to 235 billion reais. This is equivalent to 3.3% of GDP. The end of this loan repayment moratorium will likely mark the beginning of a surge in NPLs prompting banks to further tighten credit standards. Notably, new private credit originated by banks has been already shrinking for both households and businesses (Chart I-4). In terms of monetary stimulus, the transmission mechanism of monetary policy in Brazil has been partially broken. Households and companies have not benefitted much from the central bank’s rate cuts. While the SELIC policy rate has reached a historic low of 2%, the prime lending rates remain elevated both in nominal and in real terms (Chart I-5). Chart I-4Private Credit Origination Has Been Contracting Chart I-5Brazil: Lending Rates Are Very High In Nominal And Real Terms   Bottom Line: The economy is recovering from a very low base due to the massive stimulus provided by authorities (Chart I-6). However, provided central government non-interest expenditures are large - they now make up 24% of GDP - curtailment in government spending will have a materially negative impact on the economy. Public Debt Sustainability Brazil’s gross public debt has reached 92% of GDP and is set to move even higher as large fiscal deficits add to public indebtedness (Chart I-7). The social security deficit has also expanded sharply despite last year’s pension reforms (Chart I-7, bottom panel). Indeed, most of those social security savings will only come into effect after the 2022 presidential and congressional elections.  Chart I-6The Economy Is Recovering From A Low Base Chart I-7Brazil: Public Debt And Fiscal Deficits   Public debt-to-GDP ratios only stabilize if (1) governments run large primary fiscal surpluses or (2) nominal GDP growth exceeds government borrowing costs. Neither of these two conditions can easily be met in Brazil. Provided that the primary fiscal deficit presently stands at 7.5% of GDP, drastic budget tightening would be required to push it towards a surplus. Such fiscal tightening would ravage the economy and, hence, is not politically feasible. Notably, Brazil ran large primary fiscal surpluses (about 3.5% of GDP) from 1999 to 2012 which allowed it to stabilize its public debt dynamics. The second stipulation - that nominal GDP growth exceeds government borrowing costs - has not been satisfied since 2013 (Chart I-8). With government bond yields at about 5.5%, nominal GDP growth would need to rise to and remain above 7-8% in order to reduce the public debt-to-GDP ratio. Chart I-8Public Debt Burden Rises When Borrowing Costs Are Above Nominal GDP Growth Chart I-9Brazil: Core Inflation Is Too Low Provided that potential GDP growth in Brazil is probably 2% or lower, nominal GDP growth that is consistently above 7-8% would require inflation to be 5% or higher. Chart I-9 illustrates that core inflation in Brazil is currently only at 1-2%, well below the central bank’s target range. With fiscal policy set to tighten and a partially broken monetary transmission mechanism, it will be impossible for inflation to rise to 5%. Hence, the second stipulation cannot be met in Brazil without drastic policy action being taken. Bottom Line: Barring dramatic policy actions, Brazil will continue experiencing a steep uptrend in its public debt to GDP ratio. What Will Authorities Do? Authorities are likely to pass a tight 2021 budget later this year to boost investor confidence. However, as the economy crumbles again, President Bolsonaro is likely to opt to relax fiscal policy. The government has already submitted to Congress its 2021 budget which entails a substantial fiscal cliff. The government’s non-interest spending is expected to shrink by 23% from estimated 2020 levels, which is equal to 5.7% of GDP. This is what the fiscally conservative Economy Minister Guedes aims to accomplish in his attempt to cap public indebtedness. Guedes hopes that structural reforms will boost the country’s growth potential so that economic activity can do well in face of fiscal tightening. However, there have been little structural reforms in Brazil in the recent years. As a result, it is unrealistic to expect decent economic growth at times of material fiscal tightening. Chart I-10Brazil: Nominal Income Growth Is Very Low On the whole, Brazilian authorities are facing a political economy dilemma. On the one hand, considerable fiscal tightening would gratify creditors but devastate the already weak economy. Specifically, employee income has already slowed to a record low of 4% in nominal terms. Further fiscal tightening would be a political suicide (Chart I-10). On the other hand, failure to dramatically tighten fiscal policy will lead to a revolt in Brazil’s bond and currency markets and will result in higher borrowing costs for both the public and private sectors. President Bolsonaro faces re-election in two years and realizes that he will lose the election if employment and income do not improve substantially. As a result, the odds are high that president Bolsonaro will eventually abandon fiscal austerity. Notably, there are already signs that the president is wavering on the 2021 budget. In particular, he is contradicting himself on the need either for fiscal tightening or the extension of stimulus. Besides, different members of his cabinet have spoken against fiscal consolidation, in general, and against the golden fiscal rule that caps government spending, in particular.  Critically, Bolsonaro’s popularity has risen recently to its highest level since his election because of fiscal transfers to low-income households launched in March. This makes it certain that heading into the elections Bolsonaro will try to attract votes from low-income families by resorting to a fiscal transfer to support their income. This will be a drag on public finances but will boost his re-election chances. Because they are also facing re-election in late 2022, the Congress will likely support the president in his modification of the constitutional fiscal spending rule and his pursuit of a more relaxed fiscal policy, generally, and in his provision of income support for low-income households in particular. However, Economy Minister Guedes will likely resign if his fiscal austerity program is abandoned. The central bank has been clear that it will pursue easy money policies only as long as fiscal consolidation remains on track. If fiscal austerity is thwarted, the central bank might consider raising interest rates. Such action would clash with Bolsonaro’s attempt to engineer a strong economy going into the 2022 elections. It is possible that the central bank president and its leadership will come under fire from the president’s administration and might also quit. Public debt-to-GDP ratios only stabilize if (1) governments run large primary fiscal surpluses or (2) nominal GDP growth exceeds government borrowing costs. Neither of these two conditions can easily be met in Brazil. What will Bolsonaro do when faced with a creditors’ revolt that would raise government bond yields? He might pressure the central bank to launch a quantitative easing program, i.e., the purchasing of government bonds that would bring yields down. This would amount to public debt monetization. Fiscal easing funded by the central bank would boost economic growth, both real and nominal. In such a scenario, it is possible that nominal GDP growth would reach or exceed 7-8% while local currency government bond yields would be capped at 5-6% by the central bank’s purchases. This would entail high inflation, negative real interest rates and signify a central bank that is behind the inflation curve. These conditions would be an ultra-bearish cocktail for the exchange rate. Given 96% of public debt is in local currency, the cost to government finances from currency depreciation will be minimal. Companies and banks, however, have large foreign currency debt exposure and depreciation in the exchange rate will be painful for them. However, this is the least painful way out of the economic deadlock the nation is in. Bottom Line: Brazilian authorities are faced with a political economy dilemma. They can only gratify either the government’s creditors by tightening their fiscal policy, or the population by substantially relaxing their fiscal stance. Given that both the president and congressmen face re-election in two years, they will sooner or later choose to please the population at the expense of the creditors.   Investment Strategies In The Short And Long Term Chart I-11Brazil Versus EM: Domestic Bonds And Sovereign Credit In the short term: So long as the government adheres to fiscal tightening, economic growth will surprise on the downside. The central bank will then reduce the policy rate ever further. In this scenario, local fixed-income and sovereign credit markets could outperform their EM peers (Chart I-11). Equities will struggle as domestic demand disappoints. In the near term, stocks will likely underperform local currency government bonds, so long as fiscal tightening is maintained (Chart I-12). Notably, equities are not cheap – the average of the trailing and forward P/E ratios is close to a record high (Chart I-13). Chart I-12Brazil: Stock-To-Domestic Bond Ratio Is Overbought Chart I-13Brazilian Equities Are Not Cheap   The impact on the currency remains uncertain. It might find support as worries about public debt sustainability are put on hold, commodities prices rise, and the broad trade-weighted US dollar weakens further. However, investors could also look beyond the near term and question the feasibility of such a tight fiscal stance ahead of the 2022 elections. In this context, investors could foresee the government abandoning its fiscal frugality in favor of populist and fiscally expansionist policies. In this case, the currency will struggle. Heading into the elections Bolsonaro will try to attract votes from low-income families by resorting to a fiscal transfer to support their income. In the medium and long term: President Bolsonaro will ultimately opt for considerable fiscal easing, probably next year, in order to bolster economic growth and household income before the 2022 elections. Expansionary fiscal policy will boost growth and benefit the stock market. Yet, it will be very negative for fixed-income markets, sovereign credit and the currency. Local bond yields will rise as investors sell out of bonds. The only way that authorities would be able to cap government domestic bond yields is via quantitative easing, i.e., the central bank’s purchasing of government bonds. This will amount to public debt monetization and will lead to substantial exchange rate depreciation. Chart I-14The Brazilian Real Is Only Modestly Cheap The trade-weighted currency in Brazil is only one standard deviation below its fair value, i.e., it is cheap but not very cheap (Chart I-14). Hence, public debt monetization and higher inflation and lower real rates will cause the exchange rate to plummet.    Local investors should overweight equities versus fixed-income if the fiscal stance is relaxed. International investors, on the other hand, should be cautious as the BRL depreciation will erode their foreign currency return in equities and local currency bonds. Sovereign credit will also perform poorly in this scenario. Bottom Line: Given that it is impossible to know when President Bolsonaro will shift his fiscal policy, we are sticking with our structural underweight positions in Brazilian equities, local currency bonds and sovereign credit, versus their EM counterparts. That said, if the 2021 budget is approved, Brazilian fixed-income markets could outperform their EM peers over the near term. We also continue shorting the real against an equally-weighted basket of the euro, CHF and JPY because the end-game in Brazil will likely be currency depreciation to boost nominal growth.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com   Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Please note that yesterday we published Special Report titled Do Not Overlook China’s Innovation Drive. Please click on it to access it. Today, we publish analysis on Brazil and Ukraine.   Chart I-1Brazilian Share Prices And Commodity Prices Move In Tandem A FOMO (fear-of-missing-out) mania has pushed equity prices higher around the world. Brazilian stocks, currency and credit markets, likewise, have been staging a rebound. There is evidence that in Brazil equity purchases by local investors have been driving up share prices.1 The absolute performance of Brazilian share prices and the exchange rate trend will likely depend on commodities prices and a global rally in risk assets (Chart I-1). In relative terms, Brazilian financial markets will underperform their EM counterparts because of the following: Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016 (Chart I-2). This is the first nominal GDP contraction in Brazil. Growth was feeble even before the pandemic struck, but the COVID-19 lockdowns were the last nail in the coffin for the economy. Given that Brazil has not been able to control the spread of the virus – having hit another high in daily new infections last Friday – major cities will be forced to maintain social distancing measures for longer, delaying a recovery in consumer and business confidence. Chart I-2The Level Of Economic Activity In Real And Nominal Terms Table I-1Brazil's Fiscal Package Is The Largest In The Region   While Brazil has deployed the largest COVID-19 fiscal package in the region (Table I-1), its economic recovery will lag behind the majority of EM and DM countries. State-sponsored loans have not been reaching small and micro businesses, which employ over half of the working force. Moreover, informal workers amount to about 20% of the country’s total population, and they also have not been receiving any economic benefits other than a $120 US dollar monthly stipend. Household income growth was subdued during the 2017-2019 recovery. To support their living standards, families were aggressively borrowing before the pandemic (Chart I-3, top panel). Now, with their income contracting and household debt servicing costs above 20% of disposable income, consumer loan defaults will mushroom (Chart I-3, bottom panel). Chart I-4 shows that non-performing loans (NPL) for households are rising as a share of total consumer loans. Chart I-3Household Income, Credit And Debt Service Chart I-4Mushrooming Consumer Delinquencies   The private banks’ NPL provisions are set to surge due to rising defaults. Consumer loans make up 53% of private banks’ non-earmarked (non state-directed) lending. Chart I-5 shows that bank share prices are highly correlated with the annual change in provisions (shown inverted). Hence, the further rise in provisions will continue undermining bank share prices. We published a Special Report on Brazilian banks on March 31 and their outlook remains dismal. Besides, facing high credit risks, private banks have tightened credit standards and loan origination is plummeting, further hurting the economy. The sheer size of the fiscal stimulus and the historic nominal GDP contraction will push the gross public debt-to-GDP ratio well above 100% by end-2020. As discussed in our previous reports,2 and provided local currency interest rates remain above nominal GDP growth, public debt is on an unsustainable trajectory (Chart I-6). Chart I-5Do Not Chase Brazilian Bank Stocks Chart I-6Government Bond Yields Are Well Above Nominal GDP Growth   Chart I-7The Social Security Deficit Is Widening The only way to stabilize the public debt-to-GDP ratio in Brazil is via the central bank conducting substantial quantitative easing, i.e. monetary authorities purchasing local government bonds. This will push local bond yields much lower and over time boost nominal GDP growth. With interest rate on government debt below nominal GDP growth over several years, the condition of public debt sustainability will be achieved. However, this amounts to monetization of public debt and, if carried on a large scale, it will suffocate the exchange rate – the currency would depreciate a lot. Furthermore, the projected BRL 800 billion (11% of GDP) in savings from the infamous pension reform will be impossible to achieve. Chart I-7 shows that the social security deficit has widened since March due to the shortfall in revenues. Given social security revenues are derived from taxes on workers and businesses, this deficit will continue to increase as employment and wages collapse while pension payouts remain fixed. Finally, the political situation is in disarray and a presidential impeachment might be inevitable. President Bolsonaro has become even more radical and is in conflict with various branches of power. Meanwhile, corruption and electoral fraud investigations against him and his allies continue to develop. The key risk to our negative view is as follows: One could argue that investors have lost faith in the Bolsonaro administration and are actually looking forward to his removal from office. Hence, the escalating political crisis culminating in Bolsonaro’s impeachment would be bullish for financial markets. This is a valid perspective given Vice-president Mourão – who has the backing of the army and adheres to a more centrist view on a wide range of issues - would assume the presidency in the case of impeachment. He would maintain orthodox economic policies and cooperate with Congress. This kind of thinking from investors might be taking its cues from the political dynamics and market actions in early 2016, when Brazilian markets bottomed seven months before then President Dilma Rousseff was impeached. Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016. In addition, the long-term political outlook for Brazil might be turning positive. The quite popular ex-Justice Minister Sergio Moro hinted last week that he could run in the 2022 presidential race. While he did not explicitly announce his candidacy, he stated that he wants to “participate” in the public debate by presenting a pro-market and anti-corruption alternative to Bolsonaro. If Moro runs, he will likely win given his enormous popularity. His victory will be accordingly cheered by international and domestic investors as he would run on a platform of structural reforms. Chart I-8The Brazilian Real Is Only Modestly Cheap Nevertheless, in the near term Bolsonaro will try to maintain his grip on power as long as he can. Foreseeing the risk of impeachment, he has strengthened his ties with the big coalition of small centrist parties in Congress. For now, it is not clear if Congress will vote for his removal. Importantly, the more radical and autocratic Bolsonaro becomes in a bid to save his presidency, the higher the odds of Economy Minister Paulo Guedes resigning. This was the case with the Ministers of Health and Justice and the Secretary of the Treasury. The latter was a key figure in drafting economic reforms. If Guedes resigns, it will send shockwaves throughout the nation’s financial markets. Bottom Line: Continue underweighting Brazilian equities and fixed income within their respective EM universes. We took profits on our short BRL/long USD position on June 4th due to tactical considerations. Investors should consider shorting the BRL again. The BRL is somewhat but not very cheap (Chart I-8). Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ukraine: An Opportunity In Bonds Is Still Present Investors should stay long local currency government bonds and continue overweighting the nation’s sovereign credit within the EM sovereign credit universe. Ukraine is pursuing prudent fiscal policy under the auspices of the IMF. With the government refraining from announcing a large-scale fiscal spending package amid the COVID-19 outbreak, its fiscal overall and primary deficits will widen to 8% and 4% of GDP, respectively. In particular, the increase in healthcare and social spending will be partially offset by both a reduction in discretionary spending and a cap on public wages. Such a conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. Critically, a prudent fiscal policy will allow the central bank to cut interest rates. Both headline and core consumer price inflation are well below the lower end of the central bank’s target band (Chart II-1). Nominal wage growth is heading toward zero and will probably deflate by the end of this year (Chart II-2). Falling domestic demand will ensure that any rise in inflation due to currency depreciation will be modest. Chart II-1Inflation Is Undershooting Chart II-2Wage Growth Is Subdued!   As a result of considerable disinflation, real interest rates are still very high. Elevated real rates warrant large interest rate cuts by the central bank. Deflated by core consumer inflation, the real policy rate is 8% and the real lending rate is 12% for companies and over 30% for consumer credit (Chart II-3). A conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. High real rates will entice foreign portfolio capital. Chart II-4 demonstrates that foreign investors have reduced their holdings of local bonds from $5.2 billion at the end of 2019 to $3.75 billion currently. Given the very low real rates worldwide, Ukraine is one of few markets offering high real rates with decent macro policies, at least in the medium term. Chart II-3Elevated Real Rates Warrant More Rate Cuts By CB Chart II-4Foreign Inflows Could Resume   With regard to the balance of payments, the recently announced $5 billion IMF loan should help ease short-term funding for the country. The 18-month arrangement will provide the immediate disbursement of $2.1 billion with a second disbursement of $0.7 billion expected by the end of September after the IMF program review. Importantly, plummeting imports and relatively resilient exports will narrow the current account deficit (Chart II-5). Exports should remain supported by food exports, which represents close to 40% of overall exports. Besides, the central bank also carries $25 billion in foreign exchange reserves, which compares with $18 billion in foreign funding requirements for 2020 (Chart II-6). So far, the central bank has refrained from selling foreign exchange reserves but might do so if the currency depreciates significantly. Chart II-5Current Account Will Balance Soon Chart II-6Foreign Funding Requirements Are Covered By FX Reserves   Bottom Line: We continue to recommend holding 5-year local currency government bonds currently yielding 11%. Even though moderate currency depreciation cannot be ruled out, on a total return basis domestic bonds will deliver decent returns to foreign investors in the next 6-12 months.  EM fixed income investors should continue overweighting domestic bonds and sovereign US dollar credit within respective EM portfolios. Andrija Vesic Associate Editor andrijav@bcaresearch.com     Footnotes 1     Investors ignore triple crisis and bet on equities 2     Please see Emerging Markets Strategy Countries In-Depth "Brazil: Deflationary Pressures Warrant A Weaker BRL," dated November 28, 2019 available at ems.bcaresearch.com Please see Emerging Markets Strategy Countries In-Depth "Brazil: Just Above "Stall Speed"," dated September 27, 2019 available at ems.bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Chart I-1Brazilian Share Prices And Commodity Prices Move In Tandem A FOMO (fear-of-missing-out) mania has pushed equity prices higher around the world. Brazilian stocks, currency and credit markets, likewise, have been staging a rebound. There is evidence that in Brazil equity purchases by local investors have been driving up share prices.1 The absolute performance of Brazilian share prices and the exchange rate trend will likely depend on commodities prices and a global rally in risk assets (Chart I-1). In relative terms, Brazilian financial markets will underperform their EM counterparts because of the following: Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016 (Chart I-2). This is the first nominal GDP contraction in Brazil. Growth was feeble even before the pandemic struck, but the COVID-19 lockdowns were the last nail in the coffin for the economy. Chart I-2The Level Of Economic Activity In Real And Nominal Terms Table I-1Brazil's Fiscal Package Is The Largest In The Region   Given that Brazil has not been able to control the spread of the virus – having hit another high in daily new infections last Friday – major cities will be forced to maintain social distancing measures for longer, delaying a recovery in consumer and business confidence. While Brazil has deployed the largest COVID-19 fiscal package in the region (Table I-1), its economic recovery will lag behind the majority of EM and DM countries. State-sponsored loans have not been reaching small and micro businesses, which employ over half of the working force. Moreover, informal workers amount to about 20% of the country’s total population, and they also have not been receiving any economic benefits other than a $120 US dollar monthly stipend. Household income growth was subdued during the 2017-2019 recovery. To support their living standards, families were aggressively borrowing before the pandemic (Chart I-3, top panel). Now, with their income contracting and household debt servicing costs above 20% of disposable income, consumer loan defaults will mushroom (Chart I-3, bottom panel). Chart I-4 shows that non-performing loans (NPL) for households are rising as a share of total consumer loans. Chart I-3Household Income, Credit And Debt Service Chart I-4Mushrooming Consumer Delinquencies   The private banks’ NPL provisions are set to surge due to rising defaults. Consumer loans make up 53% of private banks’ non-earmarked (non state-directed) lending. Chart I-5 shows that bank share prices are highly correlated with the annual change in provisions (shown inverted). Hence, the further rise in provisions will continue undermining bank share prices. We published a Special Report on Brazilian banks on March 31 and their outlook remains dismal. Besides, facing high credit risks, private banks have tightened credit standards and loan origination is plummeting, further hurting the economy. The sheer size of the fiscal stimulus and the historic nominal GDP contraction will push the gross public debt-to-GDP ratio well above 100% by end-2020. As discussed in our previous reports,2 and provided local currency interest rates remain above nominal GDP growth, public debt is on an unsustainable trajectory (Chart I-6). Chart I-5Do Not Chase Brazilian Bank Stocks Chart I-6Government Bond Yields Are Well Above Nominal GDP Growth   The only way to stabilize the public debt-to-GDP ratio in Brazil is via the central bank conducting substantial quantitative easing, i.e. monetary authorities purchasing local government bonds. This will push local bond yields much lower and over time boost nominal GDP growth. With interest rate on government debt below nominal GDP growth over several years, the condition of public debt sustainability will be achieved. However, this amounts to monetization of public debt and, if carried on a large scale, it will suffocate the exchange rate – the currency would depreciate a lot. Chart I-7The Social Security Deficit Is Widening Furthermore, the projected BRL 800 billion (11% of GDP) in savings from the infamous pension reform will be impossible to achieve. Chart I-7 shows that the social security deficit has widened since March due to the shortfall in revenues. Given social security revenues are derived from taxes on workers and businesses, this deficit will continue to increase as employment and wages collapse while pension payouts remain fixed. Finally, the political situation is in disarray and a presidential impeachment might be inevitable. President Bolsonaro has become even more radical and is in conflict with various branches of power. Meanwhile, corruption and electoral fraud investigations against him and his allies continue to develop. The key risk to our negative view is as follows: One could argue that investors have lost faith in the Bolsonaro administration and are actually looking forward to his removal from office. Hence, the escalating political crisis culminating in Bolsonaro’s impeachment would be bullish for financial markets. This is a valid perspective given Vice-president Mourão – who has the backing of the army and adheres to a more centrist view on a wide range of issues - would assume the presidency in the case of impeachment. He would maintain orthodox economic policies and cooperate with Congress. This kind of thinking from investors might be taking its cues from the political dynamics and market actions in early 2016, when Brazilian markets bottomed seven months before then President Dilma Rousseff was impeached. In addition, the long-term political outlook for Brazil might be turning positive. The quite popular ex-Justice Minister Sergio Moro hinted last week that he could run in the 2022 presidential race. While he did not explicitly announce his candidacy, he stated that he wants to “participate” in the public debate by presenting a pro-market and anti-corruption alternative to Bolsonaro. If Moro runs, he will likely win given his enormous popularity. His victory will be accordingly cheered by international and domestic investors as he would run on a platform of structural reforms. Nevertheless, in the near term Bolsonaro will try to maintain his grip on power as long as he can. Foreseeing the risk of impeachment, he has strengthened his ties with the big coalition of small centrist parties in Congress. For now, it is not clear if Congress will vote for his removal. Chart I-8The Brazilian Real Is Only Modestly Cheap Importantly, the more radical and autocratic Bolsonaro becomes in a bid to save his presidency, the higher the odds of Economy Minister Paulo Guedes resigning. This was the case with the Ministers of Health and Justice and the Secretary of the Treasury. The latter was a key figure in drafting economic reforms. If Guedes resigns, it will send shockwaves throughout the nation’s financial markets. Bottom Line: Continue underweighting Brazilian equities and fixed income within their respective EM universes. We took profits on our short BRL/long USD position on June 4th due to tactical considerations. Investors should consider shorting the BRL again. The BRL is somewhat but not very cheap (Chart I-8). Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1     Investors ignore triple crisis and bet on equities 2     Please see Emerging Markets Strategy Countries In-Depth "Brazil: Deflationary Pressures Warrant A Weaker BRL," dated November 28, 2019 available at ems.bcaresearch.com Please see Emerging Markets Strategy Countries In-Depth "Brazil: Just Above "Stall Speed"," dated September 27, 2019 available at ems.bcaresearch.com

Special Report

Highlights Our COVID Unrest Index reveals that Turkey, the Philippines, Brazil, and South Africa are the major emerging markets most at risk of significant social unrest. China, Russia, Thailand, and Malaysia are the least at risk – in the short run. Stay tactically overweight developed market equities relative to emerging markets. Go tactically short a basket of “EM Strongmen” currencies relative to the EM currency benchmark. Short the rand as well. Feature Chart 1Stimulus-Fueled Markets Ignore Reality With global fiscal stimulus now estimated at 7% of GDP, and central banks in full debt monetization mode, the S&P 500 is at 2940 and rallying toward 3000. It is not only largely ignoring the global pandemic and recession. It is as if the trade war never occurred, China is not shrinking, and WTI crude oil prices have never gone negative (Chart 1). In recent reports we have argued that “geopolitics is the next shoe to drop” – specifically that President Trump’s electoral challenges and the vulnerability of America’s enemies make for a volatile combination. But there are also more mundane geopolitical consequences of the recession that asset allocators must worry about. Such as government change and regime failure. COVID-19 and government lockdowns have exacted a heavy economic toll on households and political systems now face heightened risk of unrest. In many cases emerging market countries were already vulnerable, having witnessed outbreaks of civil unrest in 2019. Fear of contracting the virus, plus various isolation measures, will tend to suppress street movements in the near term. This year’s “May Day” protests will be minor compared to what we will see in coming years. But significant unrest will sprout as the containment measures are relaxed and yet economic problems linger. And bear in mind that the biggest bouts of unrest in the wake of the 2008 crisis did not occur until 2011-13. In this report we introduce our “COVID Unrest Index” for emerging economies, which shows that Turkey, the Philippines, Brazil, and South Africa face substantial unrest that can trigger or follow upon market riots. Introducing The COVID Unrest Index At any point in time, social and political instability depends on economic conditions such as unemployment and inflation, structural problems such as inequality, and governance issues such as corruption. In the post-COVID recessionary environment, additional factors such as health care capacity also carry weight. To identify markets that are most likely to face unrest, we created a COVID Unrest Index (Table 1). The overall ranking is determined by five factors: Table 1Our COVID-19 Social Unrest Index Initial Economic Conditions: A proxy for economic policy’s ability to respond to the crisis. This factor includes the fiscal balance and sovereign debt – which determine "fiscal space" – as well as the current account balance, public foreign currency debt as a percent of GDP, foreign debt obligations as a percent of exports, and foreign funding requirements as a percent of foreign currency reserves. Health Capacity And Vulnerability: A proxy for both a population’s vulnerability to COVID and its health care capabilities. Vulnerability to the pandemic is captured by COVID-19 deaths per million, share of the population over the age of 65, and likelihood of dying from an infectious disease. Health infrastructure is measured by life expectancy at age 60 and health expenditure per capita. Economic Vulnerability To Pandemic: A proxy for the magnitude of the COVID-specific shock to the individual economy. This factor takes into account a country’s dependence on revenue from tourism and its dependence on inflows from remittances. Household Grievances: A proxy for economic hardship faced by households, captured by the GINI index, which measures income inequality, and the “misery index,” which consists of the sum of inflation and unemployment. Governance: A proxy the captures the quality of governance from the World Bank’s World Governance Indicators – specifically the ability to participate in selecting government, likelihood of political instability or politically-motivated violence, and perceptions of corruption. The country ranking for the COVID Unrest Index is constructed by first standardizing the variables, then transforming them such that higher readings are associated with more favorable conditions. Finally, the five factors are averaged for each country to produce individual scores. Turkey: A Shambles On Europe’s Doorstep Turkey is the most likely to face mass discontent in the near future. It has all the ingredients for unrest: poor standing across all factors and the weakest governance score. From an economic standpoint, its foreign currency reserves are critically low while its foreign debt obligations are relatively elevated (Chart 2). This spells trouble for the lira, which will only further add to the grievances of households already burdened by a high misery index. Chart 2AEmerging Markets Face Debt Troubles Even With The Fed’s Help Chart 2BEmerging Markets Face Debt Troubles Even With The Fed’s Help President Erdogan has rejected suggestions of aid from the IMF. Fearing a revival of the main opposition Republican People’s Party (CHP), especially in the wake of his party’s losses in the 2019 municipal elections, he has banned cities that are run by the CHP from raising funds toward virus response efforts. This right is reserved only for cities run by his Justice and Development Party (AKP). Given that Erdogan does not face reelection until 2023, the move to suppress the opposition reflects general weakness and portends a long period of suppression and political conflict. Erdogan’s handling of the outbreak has also seen its share of failures. While he has opted for only a partial lockdown, a 48-hour full lockdown was announced on April 10 only hours in advance, resulting in crowds of people rushing to purchase necessities. Interior minister Suleyman Soylu tried to resign, but was prevented by Erdogan, breeding speculation about Soylu’s motives. Soylu may have sought to distance himself from the president’s handling of the crisis to preserve his image as a potential successor to the president, rivaling Erdogan’s son-in-law, Finance Minister Berat Albayrak. The point is that Erdogan is already facing greater political competition. Former ally and minister of foreign affairs and economy Ali Babacan recently launched a new party, the Democracy and Progress Party (DEVA). He has criticized the government’s stimulus package and decision to hold back on requesting IMF aid. Erdogan is also challenged by his former prime minister Ahmet Davutoglu, who broke away from the AKP to form his own Future Party late last year. The obvious risk to Erdogan is that these opposition groups create a viable political alternative that voters can flock to – and they could form a united front amid national economic collapse. Brazil and South Africa have large twin deficits. Erdogan’s response, repeatedly, has been to harden his stance and double down on populist and unorthodox policies. These have not helped his popular standing, as we have chronicled over the past several years. At home his policies are generating excessive money supply and a large budget deficit (Chart 3). Abroad he has gotten the military more deeply involved in Syria, Libya, and maritime conflicts. The result is stagflation with the potential for negative political surprises both at home and abroad. Chart 3Twin Deficits Flash Red For Emerging Markets Chart 4Turkish Political Risk Has Room To Rise Our GeoRisk Indicator for Turkey shows that risks are rising as the lira falls relative to its underlying economic fundamentals (Chart 4). But it will fall further from here. Positive signs would be accepting IMF aid, cutting off the foreign adventures, selling off government assets, and restoring fiscal and monetary orthodoxy. But it is just as likely that Erdogan resorts to even more desperate moves, including a greater confrontation with Greece and Europe by encouraging more refugee flow-through into Europe. Erdogan has always been more popular than his Justice and Development Party, but after ruling since 2003, and now facing a nationwide crisis, his rule is increasingly in jeopardy. His scramble to survive the election in 2023 will be all the more dangerous to governance. Bottom Line: We booked gains on our short lira trade earlier this year but the fundamental case for the short remains intact, so we include it in our short “EM Strongmen” currency basket discussed at the end of this report. The Philippines: Yes, Governance Matters The Philippines is next at risk of instability. It is particularly vulnerable to a pandemic recession due to its dependence on remittance inflows and tourism for foreign currency (Chart 5) as well as its poor health infrastructure (Chart 6). While it is not in a vulnerable position in terms of foreign currency obligations, its double deficit (see Chart 3) means that significant stimulus will come at the expense of the currency. Chart 5Pandemics Hurt Tourism, Recessions Hurt Remittances Chart 6AEmerging Markets Face COVID-19 Without Developed Market Health Systems Chart 6BEmerging Markets Face COVID-19 Without Developed Market Health Systems President Rodrigo Duterte remains extremely popular even though the Philippines is suffering one of the worst outbreaks in Asia. Socioeconomic Planning Secretary Ernesto Pernia has resigned from his post due to disagreement over containment measures. Pernia’s vision of a partial lockdown contrasted with Duterte’s militarized containment approach – which includes the granting of extraordinary emergency powers.1 Meanwhile the lockdowns imposed on the capital and southern Luzon provinces will remain in place until at least May 15 after which Duterte indicated it will be gradually lifted. While Duterte will in all likelihood remain in power until the end of his term in 2022, he is using his popularity to secure a preferred successor. He is less capable of getting through a constitutional amendment that extends presidential term limits – he has the votes in Congress, but a popular referendum is not a sure bet given the economic crisis. He is widely believed to be grooming his daughter Sara or former aide Senator Bong Go for the presidential post, with speculation that he may run as vice president on the same ticket. Turkey and the Philippines have poor governance, putting them alongside international rogue states. Any hit to his popularity that upends his succession plan poses existential risks to Duterte as he has racked up many influential enemies and could face criminal charges if an opposing administration succeeds him. This risk will likely induce him to tighten control further in an attempt to maintain order and crack down on dissent. Autocratic moves will weigh on the Philippines’ governance score which is already among the poorest in our pool of emerging countries (Chart 7). Chart 7Governance Matters For Investors Over The Long Run Chart 8Duterte Signaled Top In Philippine Equity Outperformance Does governance matter? Yes, at least in the case of strongmen in regimes with weak institutions. Look at Philippine equities relative to emerging market equities since Duterte first rose onto the scene, prompting us to go short (Chart 8). Duterte obliterated the country’s current account surplus just as we expected and its currency has suffered as a result. For now, the Philippines’ misery index is not yet at a level that strongly implies widespread unrest (Chart 9), but the general context does, especially if constitutional maneuvers backfire. At 4% of GDP, the proposed COVID-19 stimulus package comes on top of the fact that Duterte’s “build, build, build” infrastructure plan already required massive fiscal spending. But the weak currency and higher unemployment will increase the misery index and chip away at the president’s popularity. If the people turn against Duterte, they will remove him in a “people power” movement, as with previous leaders. Chart 9Inequality, Unemployment, And Inflation Are A Deadly Brew The Philippines is also highly vulnerable to the emerging cold war between the US and China. Administrations are now flagrantly aligned with one great power or the other. This means that foreign meddling should be expected. Duterte could get Chinese assistance, which erodes Philippine sovereignty and its security alliance with the United States, or he could eventually suffer from anti-Chinese sentiment, which invites Chinese pressure tactics. Either course will inject a risk premium over the long run. The US is popular in the Philippines, especially with the military, and overt Chinese sponsorship will eventually trigger a backlash. Bottom Line: The lack of legislative or popular constraints on Duterte makes it more likely that he will undertake autocratic moves to stay in power – economic orthodoxy will suffer as a result. The Philippines will also see a sharp increase in policy uncertainty directly as a consequence of the secular rise in US-China tensions in the coming months and years. Brazil: Will Bolsonaro Become A Kamikaze Reformer? Chart 10Bolsonaro’s Handling Of Pandemic Gets Panned In Brazil, President Jair Bolsonaro’s “economy first” approach and dismissal of the pandemic as a “little flu” has not improved his popularity (Chart 10). His approval rating is languishing in the 30% range, lower than all modern presidents save the interim government of Michel Temer in the previous episode of the country’s ongoing national political crisis. The pandemic, and Bolsonaro’s response, have fractured his cabinet and precipitated a new episode in the crisis. The clash between the president and the country’s state governors and national health officials, who enjoy popular support, has led to the dismissal of Health Minister Luiz Henrique Mandetta and the resignation of the popular Justice Minister Sergio Moro. We have highlighted Moro as a linchpin of Bolsonaro’s anti-corruption credibility and hence one of the three pillars of his political capital. This pillar is now cracking, making Bolsonaro’s administration less capable going forward. Bolsonaro’s firing of the head of the federal police, Mauricio Valeixo, the catalyst for Moro’s resignation, has led to a Supreme Court authorization for an investigation into whether Valeixo’s dismissal can be attributed to corruption or obstruction of justice. A guilty verdict could force Congress to take up impeachment, an issue on which Brazilians are split. Earlier this week the president was forced to withdraw the appointment of Alexandre Ramagem – a Bolsonaro family friend – as the new head of the federal police after a minister of the supreme federal court blocked the appointment due to his close personal relationship with the president. Brazil’s structural reform and fiscal discipline are on the backburner given the need for massive emergency spending to shore up GDP growth. Reforms are giving way to the “Pro-Brazil Plan,” which seeks to restore the economy through investments in infrastructure. The absence of the economy minister, Paulo Guedes, from the unveiling of this plan has led to speculation over Guedes’ future. Guedes is the key reformer in Bolsonaro’s cabinet and as important for the administration’s economic credibility as Moro was for its anti-corruption credibility. Brazil’s macro context is egregious. Its large public debt load – mostly denominated in local currency – raises the odds that the central bank will monetize the debt at the expense of the exchange rate, which has already weakened since the beginning of the year. Moreover, Brazil’s ability to pay near term debt service obligations is in a precarious position as the pullback in export revenues will weigh on its ability to service debt (see Chart 2). Our Emerging Markets Strategy estimates that Brazil is spending 16% of GDP on fiscal measures that will push gross public debt-to-GDP ratio well above 100% by the end of 2020 (Chart 11). Chart 11Highly Indebted Emerging Markets Have Limited Fiscal Room For Maneuver Given that Brazil already suffers from a relatively elevated misery index (see Chart 9), these macro challenges will translate into greater pain for Brazilian households and hence a political backlash down the road. The three pillars of Bolsonaro’s political capital have cracked: order, anti-corruption, and structural reform. The hope for investors interested in Brazil now rests on Bolsonaro becoming a kamikaze reformer. That is, after the immediate crisis subsides, his low popularity may force him to try painful structural reforms that no leader with political aspirations would attempt. So far he is taking the populist route of short-term measures to try to stay in power. Chart 12Bolsonaro's Meltdown Portends Melt-Up In Brazilian Political Risk Another sign of worsening governance is that military influence in civilian politics is partially reviving. This element of the country’s recent political turmoil has flown under the radar but will become more prominent if the administration falls apart and the only officials with sufficient credibility to fill the vacuum are military officials such as Vice President Hamilton Mourão. Financial markets may force leaders to make tough decisions to stave off a debt crisis, but risk assets will sell in the meantime as the lid on the country’s political risk has blown off and currency depreciation is the most readiest way to boost nominal GDP growth. Our political risk gauge will continue spiking – this reflects currency weakness relative to fundamentals (Chart 12). Bottom Line: Last fall we argued that Brazil was “just above stall speed” and that we would give the Bolsonaro administration the benefit of the doubt if it maintained three pillars of political capital: civil order, corruption crackdown, and structural reform. All three are collapsing amid the current crisis. As yet there is no sign that Bolsonaro is taking the “kamikaze reform” approach – that may be a positive catalyst but would require his administration to break down further. South Africa: Quantitative Easing Comes To EM South Africa faces an 8%-10% contraction in growth for 2020 and President Cyril Ramaphosa has overseen a large monetary and fiscal stimulus. The South African Reserve Bank has committed to quantitative easing in a bid to boost liquidity in the local financial market. South Africa’s highly leveraged households and those who mostly participate in the formal economy will find relief in lower debt-servicing costs and better access to credit. However, the large informal economy, and the rising number of unemployed, will not reap the same benefit from accommodative measures. This last group will benefit more from fiscal policy measures, such as social grants to low-income households. Ramaphosa recently announced a fiscal spending package totaling R500 billion, or 10% of GDP. Social grants to the poor and unemployed are all set to increase, which should help reduce the economic burden low-income households will face over the short term. The problem is that South Africa is extremely vulnerable to this crisis. Well before COVID the country suffered from low growth, persistently high unemployment, rising debt levels, and an increasing cost of social grants. The pandemic has increased dependency on these grants. South Africa is the most unequal society in the world (Chart 9 above) and runs large twin deficits on its fiscal and current accounts (see Chart 3). As the government’s financing needs rise, its ability to keep providing to low-income households will diminish. Yet the ruling African National Congress (ANC) is required to keep up social payments to stave off discontent and maintain its voter base – which consists of poor, mostly rural voters. The ANC must decide whether to implement stricter austerity measures after the immediate crisis to contain the fiscal fallout, which will bring unrest forward, or continue on an unsustainable path and face a market revolt. The latter option is clear from the decision to embrace quantitative easing, which further undermines the currency. Political pressure is mostly stemming from the left-wing – the Economic Freedom Fighters – which prevents Ramaphosa from taking a hard line on economic and fiscal policy. Bottom Line: There have been isolated protests across the country against the government’s draconian lockdown, and social grievances have the potential to boil over in the coming years given the long rule of the ANC and the country’s dire economic straits. Investment Implications It is too soon to buy into risky emerging market assets at a time when a deep recession is spreading across the world, extreme uncertainty persists over the COVID-19 pandemic, and the political and geopolitical fallout is transparently negative for major emerging markets. Remain overweight developed market equities relative to emerging market equities, at least over a tactical (three-to-six month) time horizon. Emerging market losers are countries with poor macro fundamentals, weak health care systems, specific competitive disadvantages during a global pandemic, high levels of inflation and unemployment, and ineffective social and political institutions. Turkey, the Philippines, and Brazil rank high on our list both because of their problems and because they are major markets. Chart 13Short Our 'EM Strongman' Currency Basket Not coincidentally these countries each have “strongman” leaders who have pursued unorthodox polices and ridden roughshod over institutional checks and balances. In each case, the leader is doubling down on populism while exacerbating structural weaknesses that already existed. Apparently greater financial punishment is necessary before policies are adjusted and buying opportunities emerge. Thus we recommend investors short our “EM Strongman Basket” consisting of the Turkish lira, the Brazilian real, and the Philippine peso, relative to the EM currency benchmark, over a tactical horizon. These currencies outperformed the EM benchmark until 2016 when they began to underperform – a trend that looks to continue (Chart 13). These leaders could get away with a lot more during a global bull market than during a bear market. It will take time for Chinese and global growth to revive this year. And their policies suggest bad news will precede good news. We would also recommend tactically shorting the South African rand on the same basis. While Russia, China, and Thailand also have strongman leaders, their countries have much better fundamentals, as our COVID Unrest Index shows. However, we do not have a bright outlook for these countries’ political stability over the long run. Russia, like all oil producers, stands to suffer in this crisis, despite its positive score on our index. In a previous report, “Drowning In Oil,” we highlighted how the petro-states face serious risks of government change, regime failure, and international conflict. This is clear with Iran and Venezuela in the above charts, and also includes Iraq, Algeria, Angola, and Nigeria. Our preferred emerging markets – from the point of view of political risk as well as macro fundamentals – are Thailand, Malaysia, South Korea, and Mexico. We warn against Taiwan due to geopolitical risk, although its fundamentals are positive. We are generally constructive on India, but it is susceptible to unrest, which we will assess in future reports. Roukaya Ibrahim Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 On April 16, Duterte ordered quarantine violators be arrested without warning. According to the UN, over one hundred thousand people have been arrested for violating curfew orders. The Philippines along with China, South Africa, Sri Lanka, and El Salvador were singled out by the UN High Commissioner for Human Rights are using unnecessary force to enforce the lockdowns and committing human rights violations in the veil of coronavirus restrictions. Duterte’s greenlight on a “shoot to kill” order against those participating in protests in violation of lockdown followed small-scale demonstrations in protest of Duterte’s handling of COVID-19.