Prophets

Brazil Bulls Can Take Comfort in Options Markets

Investors are likely to receive more upside for the amount of downside risk they bear.

Demonstrators demand the resignation of President Michel Temer as markets go into a tailspin.

Photograph: Bloomberg

Investors are fleeing Brazil, yet options prices indicate that Latin America’s biggest economy should still be able to implement reforms that will benefit growth despite a corruption scandal that has ensnared President Michel Temer.

The benchmark Bovespa index of stocks slumped 8.8 percent following a May 18 report that Temer condoned a deal to pay the jailed former House Speaker Eduardo Cunha to not testify in the country’s biggest graft probe. The benchmark’s biggest one-day drop since the 2008 financial crisis came amid heightened uncertainty and concern that Temer’s implication in the scandal would prevent him from instituting a program of reforms considered critical to lifting Brazil out of a two-year downturn that saw the economy shrink 3 percent last year.

Leading lawmakers and a third of Temer’s cabinet have been implicated in the Operation Carwash scandal, which has uncovered systematic bribery of public officials in return for contracts with state-owned and private companies.

The Bovespa is little changed since the news emerged and options prices suggest the worst is over for the country in terms of damaging corporate and political revelations. More specifically, options prices on the Bovespa stock index indicate that the potential for the country’s equities outweighs the risk. In other words, the options market predicts that investors will receive more upside for the amount of downside risk they bear, making for an attractive investment.

The dot plot below shows how the attractiveness of the Brazilian Equity Index has improved since the scandal broke on May 18. The box shows the ratio of expected upside to downside of Brazilian equities inferred from option prices. A dot higher in the box signals more attractiveness to the upside. The blue dot represents attractiveness on May 18 and the red dot how attractiveness had improved by May 25.

Much like a corporation that recovers after revealing a slew of damaging news in one fell swoop -- a so-called big-bath write-down -- Brazil may now be in a position to focus on its problems, rather than ignore them, and implement the changes necessary to restore growth and the integrity of the political system.

Shares in Royal Dutch Shell Plc climbed 35 percent in 14 months after it took an $8.2 billion charge in October 2015 because of failed exploration projects in Alaska and elsewhere. Volkswagen AG has become the world’s biggest carmaker by volume and its shares advanced 23 percent in two months after it took a $7.5 billion write down, also in October 2015, following an admission that it had cheated on emissions tests for diesel vehicles.

Temer has said he will press ahead with reforms that helped make the Bovespa stock index and Brazil’s currency, the real, the best performers in emerging markets last year. He has passed a law limiting future budget spending increases to zero in real terms, embarked on unpopular pension and social security reforms that seek to lift the retirement age to 65, and is planning to overhaul education, labor and tax laws before the 2018 election.

Brazil is forecast to return to growth in 2017, posting a rise in gross domestic product of 0.7 percent, accelerating to 2.3 percent next year, according to a consensus published by Bloomberg on May 26. The options market tends to agree.

Options that show rising and higher-than-average optimism that the stock market and real will advance from current levels suggest Brazil will be able to force through reforms, even if Temer doesn’t survive.

Bloomberg Prophets Professionals offering actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.

    To contact the author of this story:
    Ash Alankar at alankar@bloomberg.net

    To contact the editor responsible for this story:
    Robert Burgess at bburgess@bloomberg.net

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