Sometimes in the world of finance the simple approaches can work out the best. I’m not an equities person, but I’ve seen comparisons of the worst performing stocks/sectors for one year being the strongest in the following year. It can sometimes work better for currencies for two reasons. Firstly, companies can go bust or have irrecoverable shift in valuation, because companies can go bust, countries less so. Secondly, exchange rates are far more subject to over-shooting (see Dornbusch’s seminal paper on exchange rate overshooting back in 1976), in part because it’s harder to ascertain an equilibrium level or valuation. This can make them more prone to investor sentiment rather than valuation.
I raise this point because we’ve seen this dynamic play out to a degree with Latin American currencies so far this year. Brazil was hammered last year, down 35% against the dollar against a complicated backdrop of rising inflation, interest rates chasing it higher, together with a slowing economy, not to mention the political backdrop. Currently, Brazil is outperforming and is comfortably up on the year, whereas Mexico is dragging behind and still in negative territory (both against US dollar). This is against the backdrop of what has been a pretty volatile year for many asset classes. So, could this be the start of a reversal of fortunes for the Brazilian real?
At the time of writing, the potential of the end of the current political gridlock has provided some support for the currency. The thing is governments and leaders change, often the underlying problems don’t, so any euphoria likely to be short-lived. The problems facing Brazil are deep-rooted, especially the lack of investment over recent years (down nearly 20% YoY end of 2015), rising inflation (above 10%) and continued current account deficit (narrowing, but still more than 3% of GDP). It was no surprise to see lose its investment grade rating earlier this year (S&P) and even a change of government is unlikely to repair the credit outlook.
For the currency, this is going to lead to some tough times ahead and the better performance seen in recent weeks is going to struggle to be sustained. Only once inflation is under control we start to see longer-term investment in the economy can the currency have the chance of a more sustained turn-around. A move towards last year’s high on USDBRL near to 4.25 is on the cards for mid-year and the real will have its day, but probably not this year.