S&P Adds to Brazil's Woes, Warning of a Possible Credit Downgrade

By Carolyn Cui Features Dow Jones Newswires

S&P Global Ratings delivered more bad news to Brazil, warning Monday that it may cut the country's sovereign debt rating because of its troubled political situation.

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S&P said questions surrounding the president's political future could stall efforts to enact fiscal and economic reforms. Reports surfaced last week that President Michel Temer is embroiled in corruption allegations. He has denied the allegations.

The credit rating firm placed Brazil's long-term foreign and local currency sovereign credit ratings on its negative credit-watch list, which indicates that Brazil could be downgraded in the next three months.

"Near-term uncertainties around President Temer's political viability and the potential for a prolonged or disruptive transition process have heightened downside risk to the rating," S&P wrote.

S&P currently rates Brazil at BB, two steps below investment grade. Fitch Ratings last week affirmed its BB rating for the country, while Moody's Investors Service keeps Brazil at Ba2, still with a stable outlook.

But some investors shook off the S&P news, believing that much of the risk related to Brazil is already reflected in prices that tumbled last week. The iShares MSCI Brazil Capped exchange-traded fund plunged 16% on Thursday after the political news broke. That nearly wiped out in one day all of its gains for the year, though it has recovered a bit since then.

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Brazil's stock index the Ibovespa was up 1.6% on Tuesday, while Brazil's currency strengthened 0.2% against the dollar. Prices for its benchmark 2027 bond, however, fell 0.14%.

Analysts said that if Brazil is downgraded it would have to offer higher yields to issue new debt but a ratings cut was unlikely to keep the government out of the bond market.

"A lot of investors are still treating this selloff as a buying opportunity," said Aryam Vázquez, a global macro strategist at SunTrust Investment Advisory Group. But "of all the potential scenarios that could evolve in Brazil, they are all negative," he added.

Political risk consultancy Eurasia said there is a 30% chance that Mr. Temer stays in power. But that would likely leave him with a weakened mandate and his ability to deliver reform would be compromised.

Mr. Temer could step down or Congress might remove him. Either scenario would likely lead to an extended period of political paralysis, analysts said.

Until last week, Brazil was one of the best-performing markets in the developing world, largely driven by investor expectations it would push forward economic and fiscal reforms.

In response to the S&P decision, Finance Minister Henrique Meirelles said Brazil remains committed to reforms.

Some investors are skeptical. With the growing political turmoil, the president is unlikely to get enough support on important issues. A crucial upcoming vote on pension reform is likely to be postponed, according to S&P.

The other issue is whether the central bank is able to continue lowering interest rates. Brazil's central bank action has helped bring down inflation to as low as a 3.77% annual rate in mid-May. But the Brazilian real has weakened by 5% against the dollar since Thursday, and some worry inflation could begin to rise again.

Without economic reform and low inflation, "what Brazil has been gaining is just short-term hot investment money," Mr. Vázquez said.

Others say the threat of a downgrade by S&P could increase pressure on the government to crack down harder on corruption.

"That's probably a good thing in the longer term," said Stephen Bailey-Smith, an investment strategist at Global Evolution Fonds AS.

The Denmark-based investment firm is sticking with Brazil. "We don't believe this is the end of the reform cycle," Mr. Bailey-Smith said. If a reasonable reform-minded and relatively clean leader takes over, "we can then move on."

Some analysts added that regardless of how Brazil shakes out, other emerging markets won't necessarily be affected. Improving economic outlooks for many developing countries, higher commodity prices and a slower-than-expected tightening process in the U.S. could boost shares and bonds in other markets.

(END) Dow Jones Newswires

May 23, 2017 17:00 ET (21:00 GMT)