Return To Junk Status "Only A Matter Of Time" For Latin America's Most Important Economy: Barclays

Brazil’s embattled President Dilma Rousseff suffered another setback on Monday when Vice President Michel Temer elected to drop his role as Rousseff’s day-to-day liaison in Congress.

As Reuters reports, "Temer is an important ally of Rousseff and his decision will further hamstring the unpopular president, who is facing calls for her resignation or impeachment as the economy flounders." Here’s more: 

Temer's decision is seen as a prelude to the departure of his Brazilian Democratic Movement Party (PMDB), the nation's largest, from the governing coalition of the Workers' Party to field its own candidate in 2018.


Valor Economico newspaper reported on Friday that the PMDB would formally announce its decision to break with the Rousseff government at a party congress on Nov. 15.


PMDB officials told Reuters the party would break with Rousseff's coalition at some point because it plans to field its own presidential candidate in 2018, but it was not considering leaving this year. The PMDB controls both houses of Congress and its break with the government would seriously weaken Rousseff.

The move comes as the government elected to drop one in four ministries in an effort to rein in spending although, as one Sao Paulo political analyst told Reuters, "[Temer’s decision] will reinforce market worries about the government's ability to execute economic policies."

Those worries come as the country struggles to cope with both fiscal and current account deficits and a nasty bout of stagflation, all of which we’ve discussed at length. Visually, the problem looks like this:

The political and economic turmoil (with the latter punctuated by a horrendous unemployment print for July) couldn't come at a worse time.

The country sits at the center of the global EM unwind and between the uncertainties surrounding the government's ability to implement austerity combined with the pain from falling commodity prices and sluggish demand from China, there are now very real questions about how long the country can maintain its investment grade rating.

Here's Barclays with more:

The global and domestic environments have soured, and the clock is ticking for Brazil to prove its creditors that it still belongs to the investment grade club. The Fed is about to embark on policy normalization that should, albeit gradually, put the period of easy dollar funding behind us. China seems to be accepting the inevitable fact that its large economy is structurally slowing and has so far resisted fighting the slowdown with fiscal stimulus as it did in the past. Commodity prices have been responding to this new outlook for some time, and they now look particularly vulnerable following China’s recent steps. 


For Brazil, the global backdrop, while still better than during most of its history, feels hostile relative to the one it faced in its recent past.


As they should, excesses have been exposed by tough times; however, this time, policy mismanagement likely carries more blame than complacency to the now gone good times. Brazil’s fiscal slippage accelerated ahead of the elections (Figure 1), in line with most of LatAm’s well-documented historical pattern. To varying degrees, most observers were not surprised by the Rousseff administration’s decision to boost spending before the polls. The surprise, instead, was how it handled it after winning the election.


The Petrobras corruption scandal eroded what was left of President Rousseff’s already damaged political goodwill.


This backdrop has left the country in a recession, its fiscal accounts shaky and consumer sentiment depressed. Latent social unrest may deprive the already weakened administration of the vigor needed to keep the country from losing its hard-earned investment grade rating.


The country is at a crossroads and markets are taking note. With the economy contracting and the central bank raising rates, 2y inflation breakevens are receding from recent highs. At the same time, however, long-dated breakevens are creeping up, likely a sign of rising fiscal concerns. Markets may be pricing risks that Brazil’s challenging fiscal dynamics could end up being monetized (Figure 2).


Doubts about the fiscal plan are thus raising questions of whether the central bank will remain committed to honor its inflation target at all times. The central bank, which is not independent, will be left between a rock and a hard place. On one hand it will be tempted to ease rates to support its battled economy as soon as near-term inflation and expectations stabilize. On the other, it will have to keep a hawkish eye on long-dated breakevens to avoid worsening credibility concerns.


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The takeaway: "We conclude that, under current circumstances, it is only a matter of time until Brazil loses its investment grade status."

Or, summed up in a picture: