We are currently cautious on the BRL. Although valuation is cheap, deceleration in global growth and rising downside risk for global equities and commodities mean there will be a better entry point to short USD/BRL. Shorting EUR/BRL is a more attractive trade given the risk of a stronger dollar in such macro environment.
- First, the real is cheap and has not reflected the improvement in the country’s terms of trade (Chart 1), probably weighed by the still poor pandemic situation and domestic factors. Moreover, with inflation running more than twice its trade partners, nominal rate could stay flat while real effective exchange rate adjusts upward.
- Second, tailwind from rising commodity prices is reversing. Soybean and iron ore prices – Brazil’s major commodity exports – have corrected over 20% and 50%, respectively. Deterioration in the country’s terms of trade should translate to softer exports and government fiscal revenue in the coming months (Chart 2).
- Third, although PMI and retail sales data show a booming economy, the strong recovery in domestic activity has been aided by large fiscal stimulus that is now becoming the point of contention in the market. A weakening Chinese economy should further depress demand of Brazilian goods going forward.
- Lastly, political risk will continue to weigh Brazilian assets at least until next year’s election, as highlighted by the market movement during the rally President Bolsonaro did earlier this month. With his probability of winning next year’s election becoming slimmer, it is not unlikely that the president will try to hold to power through unconstitutional means.
The saving grace is for BRL is that aggressive tightening of monetary policy put a floor on the BRL as carry trades are becoming attractive. In the near term, however, the BRL will remain volatile with a risk on the downside due to reasons above, despite its still cheap valuation. We would turn more positive on Brazilian assets once Chinese reflationary efforts intensifies and deceleration in global growth is troughing, which could materialize early next year.