Brazil's Political Drama Intensifies as Dilma is Implicated, Lula Charged
March 29, 2016
by Charles Roth
of Thornburg Investment ManagementLearn more about this firm
Protests for Dilma's impeachment grow, sparking rallies in Brazilian asset prices. But much political and economic uncertainty remains.
Brazil's political crisis has quickly turned into a constitutional crisis, pitting the executive and judicial branches against each other as millions of protestors across Brazil hit the streets to demand the impeachment of President Dilma Rousseff. "This is how coups begin," the embattled leader said on March 17, effectively accusing prosecutors now investigating both her and her mentor and predecessor in office, Luiz Inacio Lula da Silva, of acting illegally.
A week before Dilma's startling pronouncement, Lula was in fact charged with money laundering as part of a swelling federal probe dubbed “Operation Carwash” into kickbacks to top politicians and private sector executives from Brazil's premier engineering and banking firms. Just days later a high-profile senator from Lula and Dilma's Workers Party, testifying under a plea bargain agreement, implicated Dilma for the first time in the scandal. Both Lula and Dilma, who was being investigated in a separate probe involving illicit manipulation of Brazil's fiscal accounts, deny all the allegations against them. Dilma then announced she was tapping her charismatic, erstwhile boss to be her chief of staff. Critics contend the move was meant to shield him, and by extension her, from prosecution, as sitting cabinet members can only be tried by Brazil's Supreme Court, to which Lula and Dilma had appointed a number of justices. In response, the lead prosecutor publically released secret wiretaps of Lula's phone. The most explosive recorded conversation involved Dilma telling Lula that she was sending him a document on the cabinet appointment “in case he needed it,” though another captured Lula saying the heads of Brazil's lower house and senate “are screwed,” while adding, “I don't know how many congressmen are under threat” and just waiting for a “miracle.” The drama is highly reminiscent of the U.S. Watergate scandal.
It's unclear whether Lula's cabinet appointment will stand, as a judge issued an injunction against it. Regardless, the release of the recordings fueled more public protests, complete with giant balloons of Lula dressed in prison stripes. At the same time, mainstream and social media have been rife with a 1988 quote from Lula's days as a Marxist labor militant: “In Brazil, when a poor man steals he goes to jail. When a rich man steals he becomes a minister.” Each development that lends force to Dilma's early exit from office prompts Brazilian asset prices to rally on hopes of policy reform, only to reverse course if it appears the government of Latin America's largest economy won't fall.
As Portfolio Manager Charlie Wilson noted in a December post, “markets cheer the push to impeach Dilma, but the rallies strike us as premature.” That view remains valid, even as political risk consultants and economists increasingly assess the odds that Dilma doesn't finish her term in 2018 at more than 50%. Roubini Global Economics handicaps a change in government at 70%, and contends a new government would be better positioned to push through stalled fiscal and economic reforms, which would certainly boost market sentiment. Reversals in capital outflows would support the currency and help restrain double-digit annual inflation in an economy that shrank 3.8% in 2015 and is expected to contract nearly that much again this year. Favorable turns in capital flows and currency dynamics would allow the central bank leeway to start cutting its benchmark interest rate, now at a crippling 14.25%.
While a renewed push for structural reforms and a turnaround in consumer and market confidence would unquestionably be positive for Brazil's people and investors, it's exceedingly difficult to predict how things will unfold politically or economically over the next year or two, the minimum time horizon for long-term investors like ourselves. But a few things are clear. Brazilian corporate earnings will continue to get worse before they get better, regardless of whether needed but painful reforms are actually pursued. That said, there are select Brazilian companies with strong business models that should be able to negotiate, or even benefit from, the adverse macro environment. Their valuations, however, will always be a key investment consideration for Thornburg portfolios. Given the earnings outlook, current valuations for most look stretched.
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