Standard & Poor’s surprised the market with its downgrade of Brazil’s sovereign rating to speculative grade late on Wednesday 9 September but the key question for equity investors is should they ‘buy the news’?
Research by UBS, published on 18 August, suggests courageous investors could profit from buying a country’s equities at the point of downgrade from investment grade. UBS analyzed the six instances when a MSCI GEM country was cut to sub-IG since 1996:
“Here, we analyze the opposite situation and find that the downgrade of a country below IG tends to be preceded by falling equity markets ahead of the downgrade, which is then a ‘Buy on the News’ event: Indonesia, Korea, Thailand (1997), Colombia (1999), Hungary (2011) and Russia (2015).”
Before the downgrade
The research confirmed the lagging nature of rating agency actions: in all six cases equity markets losses preceded the loss of IG status in the three, six and 12 months leading up to the event, with the average market fall in the 3 and 6-months before was 42% and 48% respectively ($), with average relative performance v. MSCI GEMs of -34% and -41%.
“Buy the news”
The research found that in the three months after the loss of IG, five of the six markets rose (the exception being Indonesia) with an average gain of 23% (33% ex-Indonesia) and a gain relative to GEMs of 11% (20% ex-Indonesia).
But not for long
However, the report also found that the ‘buy on the news’ trend in the first three months after a downgrade tended to fade over 6- and 12-months.
The case for debt is similar, although less clear
“There is less EMBI+ debt data for these episodes,” states the report’s authors, macro strategists Geoff Dennis and Howard Park. “However, equity market performance around the loss of IG has generally been backed up by the debt markets. For Hungary (2011) and Russia (2015), debt spreads rose by an average of 221bp and 302bp respectively in the 3- and 6-months before the loss of IG, with both underperforming overall EMBI+ spreads during the periods. Including also the available post-downgrade data for Colombia (1999), the average spread narrowing after the loss of IG status was 137bp, although nearly all of this was due to Colombia and Russia.”
Brazil Strategy In Context – Remain Underweight?
When UBS published the research the investment bank was underweight in Brazilian equities within MSCI GEMs, with a recommendation in place to look again at the market when there is visibility over the timing of the inflation peak and when rate cuts come into view. However, the authors argued that the scope for rapid rate cuts and the creation of a virtuous circle of a stronger Real and lower rates seemed to be more complex given the then recent cut in the 2015 primary surplus target.
“Nonetheless, with MSCI Brazil down 28% this year (and by 18% v. MSCI GEMs), this report suggests that the ‘final piece of bad news’ for Brazilian equities will be if the country loses its IG status,” says the report – with further falls following up to the downgrade. “A downgrade of Brazil to below Investment Grade could signal a near-term buying opportunity for equities.”
Such statistical analysis might provide the basis for a bullish case on Brazil but buyers beware: it is of course not guranteed that a downgrade will lead to a rebound. Also, Brazil’s outlook is complicated by a hugely complicated political crisis – made many times worse by corruption-fed conflict. And with policial paralysis – and no elections until 2018 (unless exceptional – and unlikely – constutional challenges are successful) Brazil is a still a long way from bottoming-out. But a three month rally? Possible.