Petrobras and improving policy outlook help Brazil's markets

At the construction site of a wing of the prestigious Sirio-Libanes Hospital in Sao Paulo, a security guard recalls how workers from the Schahin industrial group suddenly left the project 15 days ago.

The Brazilian engineering company declared last week it was filing for judicial protection after allegations it was involved in a vast corruption scandal affecting one of its main customers - Petrobras, the state-owned oil company. While Schahin declined to comment on the hospital project, it earlier said it was forced into Chapter 11 by its inability to access capital markets following the scandal.

"They stopped engineering work and everyone left," said the security guard. "It`s a pity because so many people have lost their jobs."

But while the Petrobras scandal might be hurting its contractors - Schahin was the third to enter bankruptcy proceedings - there are signs that the oil company might itself finally be emerging from the controversy, with important implications for markets.

Petrobras has promised it will deliver on Wednesday long-delayed audited financial results for 2014 - a move that if realised will lift part of the doldrums that have been afflicting Brazilian markets. Petrobras has until the end of next month to produce the results or risk triggering a technical default under some of its bond covenants. The release was delayed after auditor PwC last year refused to sign off because of the scandal.

"There will be an improvement in the perception of Brazilian risk," said Andre Guilherme Pereira Perfeito, chief economist at Sao Paulo broker Gradual Investimentos.

Petrobras, the bellwether stock of Brazil's Ibovespa index, has already rallied more than 60 per cent from its lows this year on expectations of the publication of the results. The Ibovespa, for its part, is up 7.89 per cent in the year to date while Brazil's currency, the real, has recovered to R$3.04 to the dollar after depreciating to more than R$3.31 last month.

The travails of Petrobras, some of whose former executives are accused of conniving with politicians and contractors to cream billions of dollars in kickbacks out of the company, are not the only elements that have helped improve sentiment.

Investors also sense that President Dilma Rousseff and her left-leaning Workers' Party, the PT, may have called a truce in a conflict this year over the balance of power with the dominant party in Congress, the centrist PMDB. This makes it more likely that her new finance minister, fiscal hawk Joaquim Levy, will have the political stability he needs to plug a gaping hole in Brazil's budget and help the country avoid losing its hard-won investment-grade credit rating.

Fear over mass street protests that swept the country in March is also receding after they proved to be peaceful. Investor confidence is improving in the government's determination to set the economy back on track with orthodox policies. Mr Levy has abandoned the price controls and fiscal largesse of Ms Rousseff's first four years in government, which ended last year.

"The perception is better," said David Beker, economist at Bank of America Merrill Lynch. "The biggest change here is now you look at economic policy and it makes more sense."

Analysts warned, however, Brazil is not out of the woods yet. Inflation was running at an 11-year high in the first half of April of 8.22 per cent year-on-year compared with the central bank's target of 4.5 per cent plus or minus 2 percentage points. Economists that participated in the central bank's most recent weekly "Focus" survey predicted inflation would end this year at 8.13 per cent, falling to 5.6 per cent next year. The real would end at R$3.25 to the dollar this year and R$3.30 next.

They also predicted a recession this year, with the economy to shrink 1.01 per cent before growing again by a similar amount next year. Unemployment has also begun to creep up, which could increase the risk of political volatility.

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"We are going through a very painful but necessary adjustment year," said Joao Pedro Ribeiro, economist with Nomura.

He said recent negative economic data concealed some bright spots for the market. Inflation was being pushed up as the government raised the prices of regulated sectors such as electricity generation. These prices had been suppressed during Ms Rousseff's first administration and their liberation now had been expected to produce a shock. But free prices, those not controlled by the government, had risen less than expected - a positive for the inflation outlook, he said.

With the market already beginning to price in the fiscal adjustment programme, the challenge for Brazil now was to come up with new ideas to stimulate an economic recovery. Slow growth could become the bigger threat to Brazil's credit rating once the fiscal adjustment programme began to produce results. Using the weaker real to boost industrial and agricultural exports while attracting investment to areas such as infrastructure are seen by the market as the most likely answers.

"Brazil has to find a way to grow a little bit more," said Nomura's Mr Ribeiro.

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