Why S&P Warning Brazil With Junk Rating Might Actually Be Good

Brazil’s debt burden is now said to be 62.5% of GDP. Is it a coincidence that the Brazilian real hit a 12-year low against the U.S. dollar? Now consider that GDP may go from flat to negative. What does that tell you about the state of the economy there? Brazil is a nation which has historically had well above average growth, but that has come to a screeching halt under Brazil’s current political and economic structure.

Elsewhere, Moody’s and Fitch Ratings both have investment grade ratings for Brazil that are two rungs above junk ratings – but their outlook is negative or cautious. Still, there may be good news here if you can find a silver lining in a bad situation — what if this acts as the straw that breaks the camel’s back?

Brazilians must know that a junk bond rating would likely drive up their borrowing costs. And Brazil cannot survive without borrowing. Maybe this will force Brazil’s politicians to start thinking about their businesses again rather than just trying to appease the masses with unrealistic financial promises that cannot be sustained through time.

iShares MSCI Brazil Capped (NYSEMKT: EWZ) ETF was last seen up 1.5% at $28.94. That compares to a 52-week range of $27.54 to $54.56. This ETF has roughly $2.4 billion in assets and has average daily trading volume of over 14 million shares.

Petrobras shares have suffered endlessly under the current political system. Whether a regime change would help this state-run oil giant remains to be seen. Still, its shares were up 3.85 at $6.84 in new York trading. Petrobras has a 52-week range of $4.90 to $20.94. Its share slide from north of $30 and $40 in years past down to under $10 goes far beyond global oil price pressure, mainly because it can be forced to operate at losses and to sell oil and gasoline under fair market prices. it also stacks its common shareholders far lower than what traditional investors are used to.

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S&P did at least keep some of its local ratings safe. Still, Brazil has to rely on that foreign debt to keep its finances going. S&P said:

At the same time, Standard & Poor’s affirmed its ‘BBB-‘ long-term foreign-currency, ‘A-3’ short-term foreign-currency, ‘BBB+’ long-term local-currency, and ‘A-2’ short-term local-currency ratings on Brazil. The transfer and convertibility assessment is unchanged at ‘BBB+’. The ‘brAAA’ national-scale rating is unchanged as well, and the outlook on this rating remains stable.

This weaker economic trajectory is, in turn, having a larger-than-anticipated impact on Brazil’s fiscal position and underpinned the lowering of the government’s official primary, or non-interest, fiscal targets last week. We do not consider the lower targets to reflect a lessened commitment toward policy correction. These lower targets, though more realistic, highlight the challenges of persistent, lower revenue amid economic contraction alongside large nondiscretionary spending. It appears that the Ministry of Finance has less ability to make up losses through cuts in discretionary spending, which  Brazil has a track record of doing when there is political resolve, given the magnitude of revenue weakness.

One last thing investors need to consider about Brazil is that its history keeps getting in the way of its future. Brazil’s political climate gets positive on business and economics from time to time, followed by periods where it cannot live up to its social promises. It is a vicious cycle, and the disparity the haves and the have-nots in Brazil makes the disparity there much worse than in the U.S. and other developed nations.

Brazil has the chance to be one of the greatest economies in the world. It just keeps getting in its own way. S&P’s full warning can be read in full.

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