Brazil’s economy, and its asset prices, suffers from two fundamental problems that generate the symptoms we observe: political crisis, fiscal imbalance, lack of growth and high inflation. These 4 macroeconomic ailments are the manifestation of two underlying fundamental problems, and until the authorities and economic establishment debate and act on those two fundamental problems in a credible fashion; asset prices would not recover decisively. The two problems are:

1-    The deviation from a basic but terribly important consensus: inflation is bad and fiscal discipline is important. That basic and profound consensus had dominated policy since Plano Real, and helped pull Brazil into the fold of countries converging to G7. In the last 3-4 years the consensus has been eroded.

2-    The state-sponsored capitalism system is a bad resource allocation mechanism, which explains why Brazil never sustained high rates of growth despite macroeconomic stability. Petrobras is only one of the elephants in the room.

For investors the key question is whether this is already priced in and it is time to reconsider Brazilian assets. In general terms, it is too early, though there might be idiosyncratic opportunities. A more generally benevolent view will depend on progress addressing the two fundamental flaws identified above. Obviously, these two are somewhat subjective factors to assess. Alternatively, economic performance and policy measures are easier to quantify and judge. The debt-to-GDP ratio can be measured and forecasted. But there is no rigorous response to what level of that ratio or at what point of its path to apparent stability would asset prices recover. Market participants might not be able to articulate rigorously why and when a country has turned the corner and all the bad news have already been priced in, but they certainly act on such notions. There is no threshold or one single model, but a combination of those and a qualitative assessment that a credible policy efforts is in place to effectively address the issues above. In other words, Brazilian assets will have significant upside once the debate and policy decisions seriously tackle those two fundamental issues, despite the fact that the real time photo of macroeconomic indicators would still be very far from desirable. True that the second issue, that of the resource allocation, has not changed dramatically in the last 5 years, and expecting a serious quick debate and action might be too demanding. But the Petrobras scandal made this fundamental economic issue a clearer challenge.

The macro picture is clear proof that the consensus on basic macro rules that helped Brazil get its investment grade rating and be part of the group of ‘good’ emerging markets, has been seriously eroded. Growth this year is expected to be around -2% and basically nothing next year. Inflation would end the year around 9%, the current account deficit is 4% of GDP and expected to shrink to 3.5% next year. And ‘one of the mothers’ of this problem, the fiscal deficit is almost 7% of GDP this year and expected to be around 5% next year. The fiscal adjustment has been recently deprived of its ambition, which means the government debt dynamics would not stabilize for another 2-3 years in the mid 70s as a percentage of GDP, if everything goes up to plan. A lot of this deterioration is due to exogenous shocks, especially commodity prices. But policy mistakes and negligence differentiates Brazil from many other emerging economies with similar vulnerabilities.

Moreover, those exogenous factors do not seem likely to improve for Brazil, as commodity prices are unlikely to recover (in part thanks to decelerating Chinese growth) and US interest rates are heading higher. The different between the fiscal deficit and the current account deficit shows the economy is going through external deleveraging, which is bound to continue.

The fiscal adjustment and the political crisis are getting all the attention. Rating agencies fall over each other to signal their focus on the fiscal adjustment and debt sustainability. The political crisis consumes locals focused on the government’s low popularity and the probability of presidential impeachment. This is obviously a difficult context for governability, the credibility of government policies, and as a consequence for expectations about the economic outlook (which then feeds into individual economic decisions that aggregate into poor results). The appointment of Joaquim Levy to the Ministry of Finance was meant to be the shock to break that vicious cycle, recovering some credibility of its fiscal policy. It is easy to read recent political obstacles as a dilution of that effort and its chances to produce a quick turn around. Almost everything points to further deterioration. However, the situation could also linger without massive deterioration for some time, eventually getting to that point in which it is too easy to be negative and miss the turning point. We are clearly not at that point, but once rating actions are out of the way, the first Fed hike happens, the fiscal effort shows some staying power and a chance to be augmented, we could be at the point in which Brazil credit becomes first a decent carry trade with more upside than downside (probability weighted). A similar logic would apply to local rates. Obviously, the local political crisis could be a wild card that requires careful monitoring. Again, it is clearly too early for that, given the signals produced by the political system about that consensus on basic macroeconomic balance.

Basic macroeconomic balance is most likely the key short to medium-term driver, but long-term growth depends also on improving the efficiency of the allocation of resources.

The Petrobras scandal is the (rather large) symbolic manifestation of the failure of state-sponsored capitalism, and if properly recognized should mark the implosion of that inefficient economic system. At least two large important sectors in the economy are dominated by centralized non-market decision making, which has a direct effect on growth: energy and credit allocation (banking for the most part). Ideally, the Petrobras scandal leads to reforms that augment the influence of market pricing and transparency in economic decisions across sectors. It might be too early to expect such economic and political introspection from a country immersed in a serious political crisis, but there is a simple and profound saying in emerging markets that applies here: it would be a shame to waste this crisis.