Brazil’s Temer Gets Hosed in Car Wash

In a re-run of events from last year, it seems a Brazilian president faces corruption charges that will likely put an end to their presidency. Indeed, a year after the Senate opened impeachment proceedings against former President Dilma Rousseff, it is now current President Michel Temer's turn to go through the "Car Wash"-the name of Brazil's huge corruption scandal that has ensnared many politicians and business executives. Brazilian markets plunged on the news as Temer's chances of advancing necessary reform now look less likely. For investors, this is a keen reminder of how fleeting sentiment-driven rallies can be-particularly when other fundamental drivers are weak.

On Wednesday, Brazilian newspaper O Globo broke news that Temer was secretly recorded endorsing a bribe. The story claims Joesley Batista, executive of the meatpacking^[i] company JBS, reached a plea deal with Car Wash investigators two months ago, providing a list of the bribes paid to politicians over 10 years and agreeing to wear a wiretap to incriminate politicians. On March 7, he met with Temer and Batista admitted to paying a monthly "allowance" to former Lower House Speaker Eduardo Cunha in exchange for Cunha's silence on other politicians potentially involved. Temer indicated he knew of the payments and essentially authorized the bribe, which was reportedly 5 million reais (~$1.5 million). Separately, JBS executives also recorded PSDB party president, former presidential candidate and senator Aécio Neves demanding 2 million reais in bribes to pay his legal bills. The police tagged the money, following it from JBS's facilities in São Paulo to Neves's representatives.

At this point, the Supreme Court removed Neves from office and could eventually issue an arrest warrant (although they denied one request to do so Thursday). Several Congress members, including some from Temer's support base, asked for the president's resignation. Opposition representatives also filed an impeachment request in the House on charges of obstruction of justice. Temer, for his part, denied the contents of the news reports. Although it is possible Temer refutes the charges, his presidency is seriously threatened if tapes surface. With that, there are two scenarios: 1) Temer resigns; or 2) he continues to deny wrongdoing while the legislature brings impeachment proceedings.

Under the first scenario, a caretaker president would take over, with an "indirect election" to follow in 30 days. This means Congress would elect a new president to serve through 2018. The second scenario would be the longer, more drawn out process of impeachment proceedings-similar to the second half of 2015 leading into Dilma Rousseff's impeachment last December. Between those two scenarios, the first would allow some opportunity for a new president to maintain the current economic team and continue with reform-a positive. The latter elongates the period of political uncertainty, which likely weighs on Brazilian markets.

However, even if Temer remains in office or a new administration attempts to continue his agenda, reform measures will likely struggle to get back on track. Despite some early successes, like passing a social security reform bill, Temer has started running into difficulty garnering support for contentious issues like labor reform. The political base will be even further fractured going ahead, too. Brazilian equities fell -14% on Thursday, with the real down over -6% against the dollar as markets have already started pricing in the lowered probability of reform.^[ii]

Brazil's recent episode is a reminder to global investors that political developments can lead to big sentiment-driven rallies-but they can be fleeting if expectations fall short of reality. Brazilian markets enjoyed a big rebound in 2016 on the hope that replacing Rousseff with anyone would have been an improvement on the status quo. But after peaking in February this year, Brazilian markets have fallen off a bit. In my view, considering other headwinds facing the country-like a commodity price-dependent economy mired in recession-renewed political headwinds and uncertainty bode ill for Brazil's near-term prospects.