Brazilian Risk Assets Slammed After New President Suffers First Corruption Scandal Crisis

Back on May 12, when Brazil's disgraced president Dilma Rousseff was impeached in a move that according to her was a "coup" and a "farce", we said that "Brazil's problems are only just starting" because "if Brazil is indeed seeking to cleanse its corrupt political class, Temer is hardly the right guy to do it. In fact, if markets believe that the Brazilian political situation will stabilize following the Rousseff "coup" as she calls it, we would be sellers for one simple reason: the man who may become Brazil's next president is almost as unpopular as the leader facing impeachment now, and stained by scandals of his own."

To be sure, the Brazil EWZ ETF peaked on May 12 and the price has been downhill ever since.

But the bigger problem is that the selling may have only just started, because what until recently was seen a salvation cabinet for Brazilian risk assets, is quickly turning into a just as substantial liability: as AP framed the "big question" two days ago, can acting Brazilian president Michel Temer "avoid ouster himself."

Some more of our observations:

Whether the Rio Olympics in just over two months are a disaster or not, however, one thing is certain - for months, the business community has been hoping that Temer would take over from the leftist Rousseff. But whether he'll have the ability or appetite to take on major reforms, such as overhauling a costly pension system, is unclear. "I think that Temer is not going to be able to govern if he assumes the presidency," said Jandira Feghali.

Today we got the first indication of just how much of an uphill climb the Temer administration will have when Brazil's Folha de S. Paulo newspaper reported that it has had access to recordings of conversations that took place in March between then-senator Romero Juca, who is currently Brazil's critical Planning Minister under Temer, and a former executive linked to state-run oil company Petrobras. In the conversations, the minister allegedly says a change in federal government leadership would lead to an agreement to prevent the wide corruption probe dubbed Carwash from proceeding.

Romero Juca

The immediate suggestion is that Juca himself, and likely Temer too, were implicated in Brazil's vast "carwash" scandal, and as a result the Rousseff impeachment was nothing but a smokescreen to deflect attention from their own involvement.

According to Bloomberg, Juca’s lawyer, Antonio Carlos de Almeida Castro, didn’t deny the conversations between the minister and the former company executive, but added he saw no criminal implications in the exchange. "At no time was Juca speaking against Carwash or seeking to interfere with the operation," Almeida Castro said in an interview.

In an interview with a local radio station on Monday, Juca said he didn’t “feel embarrassed” by the recordings and that he was still fit for his job. "I’m going to keep working to approve the fiscal deficit target."

Juca and his lawyer may not be concerned but others are. As Bloomberg puts it, "the allegations against Juca raised questions about whether Temer will be able to avoid the fallout from investigations into the massive kickback scheme at Petrobras that has rocked the political establishment in the past year, resulting in the detainment of lawmakers and businessmen."

Or precsely what we warned about less than 2 weeks ago. And if it took just 11 days for the first potential scandal to emerge, what will happen in aother 2 weeks, or a month? Temer will be president until Rousseff is ultimately booted from office six months from the date of her impeachment, a period that includes the critical Rio olympics: if his government is already mired in scandal, he will find himself just as impotent as his predecessor.

"Although not politically fatal, the content of the recording entangles Romero Juca in Carwash even further," analysts at MCM Consultores Associados said in a note to clients. "The pressure for Juca, an important name in political articulation and on the economic side, to leave the ministry will increase. The chances he leaves are higher, even because there could be more recordings."

MCM's Ricard Ribeiro added that "while fiscal target is likely to still be approved this week, eventual new accusations targeting Temer government members could be a risk for approval of reforms that demand largest vote in Congress, such as the pension regime overhaul."

Italo Abucater, the head of currency trading at ICAP Brasil, also chimed in saying that "I think this is too serious. This is the first crisis of many that may come through."

But as Arko’s Lucas de Aragao perhaps summarized it best when he told Bloomberg, "Temer is having his first big political crisis with Juca."

It won't be the last.

The revelation of Juca's recorded conversations could not come at a worse time for the new president: it follows a decision last week by the Supreme Court to authorize the release of Juca’s bank records and comes as Temer this week seeks the approval in Congress of measures aimed at shoring up government’s accounts.

The market reaction is hardly enthusiastic: as shown below, while the EWZ has tumbled to the lowest since early April, yields on local swap rates jumped, with the contract due Jan. 2019 rising 17 basis points to 12.63%. The move reflected the threat to both the government’s fiscal adjustment and governability in general, according to Luiz Eduardo Portella, partner at Modal Asset Management. The Brazilian real lost 1.3% while the cost to insure dollar-denominated government debt for five years rose 10 basis points to its highest level in nearly a month.

In retrospect, it would appear that rumors of Brazil's political and economic resurrection have been greatly exaggerated.