Featuring: BRAZIL | U.S.-CHINA DISAGREEMENTS | LATAM AIRLINES
This week we explain how the interaction of Brazil’s political, economic and public health crises are contributing to an increasingly fragile fiscal outlook, discuss the gradual resurfacing of U.S.-China disagreements to the forefront of market concerns, and highlight another high profile corporate bankruptcy in Latin America as we prepare for additional dislocations in the market.
Release of controversial cabinet meeting recording confirmed low odds of Bolsonaro’s impeachment, but Brazil’s tense political environment will further complicate the uphill battle for economic and fiscal recovery from COVID-19
Market Event: There was no “smoking gun” against President Bolsonaro in the recently released recording of a cabinet meeting in which the president made comments that some have interpreted as an intention to interfere with a federal police investigation against his family and inner circle. This provided some market relief on hopes that political noise/risks would subside. Meanwhile, Brazil has now become the latest global COVID-19 hotspot with new daily cases still on the rise.
Gramercy View: We continue to believe that Bolsonaro’s impeachment remains highly unlikely for the time being and the lack of clear incriminating evidence in the recently released recording further supports this view. However, we do not expect Brazil’s political environment to improve materially any time soon as investigations into the president’s family and inner circle are ongoing and his handling of the COVID-19 pandemic is coming under increasing scrutiny and criticism.. An additional wrinkle in the political risk outlook could be introduced if the economic fallout from the pandemic turns out to be even worse than expected (most forecasts see the already sluggish economy in 2019 contracting 5.0-7.5% YoY in 2020), which could lower Bolsonaro’s approval ratings and make him a more attractive political target. Regardless, the unpredictable and noisy current political environment is exacerbating the outlook for any economic and fiscal recovery even once the pandemic is under control. We are particularly concerned on the fiscal front, where Brazil entered the crisis with an already stretched profile that will be further materially weakened by the forceful stimulus measures associated with COVID-19. Fiscal costs are estimated at 6-7% of GDP so far, which is considerably higher than the EM median and will likely grow as the authorities try to counteract the economic and social impact of the crisis. Despite reformist minded forces in Congress being acutely aware of the possibility and risks of a serious fiscal crisis, it is difficult for us to construct a post-crisis political environment that will be conducive to a fiscal adjustment of the scale that will be required. As such, we expect the sovereign debt burden to continue to edge higher and anticipate that it will likely reach at least 90% of GDP this year from less than 80% in 2019. This will cement Brazil’s position among the sovereigns with the heaviest debt burdens globally and raise serious concerns about fiscal sustainability over the medium term. In combination with political and policy uncertainty likely increasing ahead of the 2022 presidential elections, those trends do not bode well for private sector confidence and willingness to invest, which will weigh on growth just as the economy attempts to bounce back from the COVID-19 shocks.
U.S.-China tensions reigniting as Beijing’s new national security law adds to existing pressure points between the two countries
Market Event: The Chinese government is expected to pass a draft resolution this week proposing a new national security law to prohibit activities that could “endanger national security” in Hong Kong. The measure would allow the Chinese government to pass the law onshore, circumventing Hong Kong’s democratically elected legislature, which would be unprecedented. In response, the U.S. State Department has declared Hong Kong as “no longer autonomous” from China, recommending that Congress reconsider Hong Kong’s special trade status with the U.S.
Gramercy View: We view this as an escalation in the U.S.-China standoff that is pivoting away from trade and into other areas where the two superpowers have disagreements (e.g. national security, human rights, technology, and finance). We recall that, in 2018-19 and prior to COVID-19, the trade war weighed heavily on markets, with slight relief only upon the signing of Phase 1 of the trade deal in early 2020. The current tensions surrounding Hong Kong, geopolitical battle over COVID-19, and the importance of China to President Trump’s 2020 reelection campaign could lay the groundwork for more volatility rather than stability. The Trump Administration is already considering sanctions or visa restrictions for Chinese Communist Party officials, among other retaliatory measures. However, we think such measures will likely take a significant amount of time to progress through Congress, especially if the House leadership feels that their intention is to shift domestic political attention from the White House’s response on the pandemic. We see a decent likelihood that protests resume in large scale in Hong Kong in response to this law, with negative implications for the Hong Kong economy. Large-scale protests (as we saw in the second half of 2019) could continue to inhibit economic growth, particularly in sectors like retail, which are heavily linked to Mainland Chinese consumers. Finally, the State Department’s declaration lays the groundwork for U.S. Congress to review, and potentially revoke, Hong Kong’s special trade status with the U.S. Revoking the trade status, if implemented, could affect the preferential tariffs, visa-free travel, and other aspects of the commercial relationship between the U.S. and Hong Kong.
Latam Airlines Group SA has filed for Chapter 11 Bankruptcy
Market Event: Latam Airlines is Latin America’s largest air carrier, an industry that has been among the hardest hit by the COVID-19 pandemic. Travel bans and general avoidance of flying forced the company to reduce capacity by 95% in April and May. This follows Colombia’s Avianca Holdings’s bankruptcy filing earlier in May.
Gramercy View: Unlike Avianca, which had experienced troubles previously, Latam Airlines generated $2.3 billion of EBITDA in 2019. Fitch had set rating at BBB+ until mid-March and yet downgraded the company from BB to default within a week. This also highlights the weakness within Latin America more broadly, as high corporate debt levels in combination with weaker sovereign balance sheets have left many businesses in a tough position and without official sector support. Latam Airlines contrasts with Lufthansa, Air France and American Airlines, among others, that have received emergency funding from their respective governments. As such, we expect additional downside surprises moving forward and are prepared for additional dislocations in the market.
Please contact our Co-Heads of Sovereign Research with any questions:
Kathryn Exum, Senior Vice President, Sovereign Research Analyst
[email protected]
Petar Atanasov, Senior Vice President, Sovereign Research Analyst
[email protected]
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