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Morningstar’s Agenda for its Annual Institutional Conference Welcomes Richard H. Thaler

Morningstar has announced the agenda for the Morningstar Institutional Conference taking place March 5-6 at the JW Marriott Desert Ridge Resort & Spa in Phoenix, Arizona. The conference, formerly the Morningstar Ibbotson Conference, is Morningstar’s premier event for institutional investors and wealth managers featuring thought leaders from academic institutions, the financial services industry, and Morningstar. Attendees will discuss current investment trends, the latest portfolio strategies, and perspectives on the U.S. and global economies.

Morningstar is pleased to welcome back Richard H. Thaler, the Ralph and Dorothy Keller Distinguished Service Professor of behavioral science and economics at the University of Chicago Booth School of Business. Thaler will discuss how investor behavior affects retirement plan design and how to apply behavioral principles to money management.

Additional speakers include:

Brad DeLong, professor of economics and chair of the political economy major at the University of California, Berkeley, will address investing for a 30-year horizon.
Roger Ibbotson, Ph.D., founder of Ibbotson Associates (which Morningstar acquired in 2006), professor of finance at Yale School of Management, and partner at Zebra Capital Management, will present new research that challenges long-held assumptions about the relationship between risk and return, and proposes a new paradigm for understanding investment performance—popularity.
Ben Inker, co-head of asset allocation, GMO, will explain his firm’s framework for determining an optimal retirement strategy that relies on dynamic asset allocation.
Kevin L. Kliesen, business economist and research officer, Federal Reserve Bank of St. Louis, will share his outlook for the U.S. economy.
Sallie Krawcheck, chair, Ellevate, and former president, Global Wealth and Investment Management division of Bank of America, will share research-based insights into how to meet the needs of women investors, who represent $11 trillion in investable assets but are still considered a “niche” market in the financial industry.

Thought leaders from across Morningstar will present new research during a series of breakout sessions on topics such as:

Annuities, retirement, and defined contribution plans.
Automated portfolio construction.
Efficient income investing.
Financial wellness.
Minimizing downside risk while preserving returns.
Modeling individual stock risk.
The Morningstar Analyst Rating™ for funds in action.
New approaches to capital market forecasting and asset allocation.
Preserving wealth with behavioral science.
The U.S. labor market and global economic outlook.

“This conference is our premier event for institutional investors that provides attendees with intimate access to prominent academics, industry leaders, and researchers from across Morningstar,” Daniel Needham, president and CIO of Morningstar’s Investment Management group, said. “The agenda touches on all the factors that contribute to the end investor’s financial outcome with an emphasis on long-term, ‘total wealth’ investing. We’re excited to present the latest research on such topics as behavioral economics, the drivers of market performance, dynamic asset allocation, and efficient income investing. We’ll also explore the future of the defined contribution market and the outlook for the global economy.

“Attendees will hear from researchers and business leaders about how they harness investor behavior and employ the latest asset allocation and portfolio construction techniques to create outcomes-oriented solutions for investors. We believe this new paradigm will come to dominate the financial services industry.”

Sustaining the Final Frontier through Investment

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While Africa continues to be an increasingly attractive investment destination, this has not resulted in comparative increases in foreign direct investment, with India for example receiving more foreign direct investment over the last four years than the whole of Africa combined. As the largest private investor in Africa, Old Mutual Investment Group is well positioned to capitalise on its unique advantage as a market leader on the continent and will continue to implement strategies in line with the projected future impact of Africa’s growing economies on investment returns.

Against this backdrop, we continue to see that improving perceptions of Africa as an investment destination are being underpinned by strong GDP growth, favourable demographics through a rapidly urbanising population and rising middle class, reduced political risk and improved corporate governance.

As such, the world is finally awakening to the emergence of Africa and its exciting GDP as the next big regional growth story.

China continues to expand its investment on the continent, while figures show there is also an increasing appetite for investment from the Middle Eastern economies, Asia, Latin America, the rest of Europe and the UK.

This growing interest is being driven by significantly positive prospects for the continent over the next decade. It’s not merely a matter of resources, but also about providing the structures and systems required by the burgeoning growth in the middle class, which is now larger than that of India.

The real story remains that of the developing consumer market across the continent, driving the growth of the retail sector. These consumers are increasingly accessing services in banking, insurance and mobile telecoms. Housing and infrastructure development also remains a key theme as well as the substantial opportunities in agriculture.

Figures show that 10 years ago, there were 116 million people constituting the middle class in Africa. Currently, this figure stands at over 326 million people, about a third of the continent. This compares to about 54 percent of the population in Asia and 77 percent of the population in Latin America.

The corporate, governance and political landscape has also transformed significantly for the better over the last decade.

From a global viewpoint, Africa continues to offer high growth opportunities, while risk diminishes and fundamentals remain solid.

Our investment focus is largely directed at sustainable projects around key development themes, which also go beyond listed equity. These include alternative investment and fixed interest arenas such as low carbon energy, education, affordable housing, infrastructure real estate, agriculture, and unlisted debt, diversified across countries, asset types, managers, and economic/inflation cycles.

By investing in schools, housing and infrastructure, we are not only supporting the development of the continent and making a lasting, positive impact on the social landscape, but also ensuring sustainable returns for investors. While private equity investments on the continent remain long term and illiquid, they are giving us net real returns of 2% to 3% above listed assets.

Hywel George, Director of Investments, Old Mutual Investment Group

Liberalizing Brazil Like the Free Spirit of Carnival

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For nearly three centuries, Brazilians have been flocking to the streets adorned in colorful costumes for their annual Carnival. There’s no shortage of whimsy here, and it’s a time-tested tradition that attracts visitors from across the globe.

But there’s more to Brazil than just a big party. While its economy may not be prime for celebration right now, it did take years for Carnival to get internationally noticed. Why shouldn’t an emerging country also receive adequate time to build itself?

Last year, Brazil was slighted by investors as one of the “Fragile Five” emerging market economies because it was deemed as being over-dependent on foreign investment. Brazil was also one of the market economies hit hardest by capital flight after the US Federal Reserve announced plans to reduce stimulus policies that initially encouraged international investors to allocate money to so-called riskier assets.

We believe the lackluster image that has been given to Brazil may be unwarranted. Brazil maintains a strong fundamental growth story. The country has an ample supply of quality companies. Many of our holdings are market leaders in their respective industries and have strong businesses that are well-equipped to weather any economic or political swings.

The country has now grown to become the world’s seventh largest economy with a population of more than 200 million people. It is also South America’s largest country and abundant in natural resources.

Of course, these strengths do not mean Brazil is without obstacles. Corruption concerns and excessive government intervention in its economy are also driving up costs that make the country among the harder countries to conduct business in.

Brazil’s historical emphasis on supporting domestic industries also created a slew of taxes and tariffs that limited imports. With such a protected domestic market, companies had little reason to become efficient, and the prices of goods rose to an unfavorably higher price.

The country’s stock market is also hitting a bump on recent news of President Dilma Rousseff’s re-election in October 2014. Investors worried that her continued leadership would prevent policy changes. But we believe Brazil is learning from past outcomes, and we foresee Rousseff being more open to alliances with political counterparts who are more market-focused and business-friendly. We’re already seeing some shifts in motion.

Joaquim Levy was recently named finance minister, which signals that more market-friendly policies are likely to be adopted. His announced plan is to bring the primary surplus before interest payments down to 1.2% of gross domestic product (GDP) this year. He then plans to raise it back up to 2% moving forward after that. The whole point of doing this is to restore credibility, in hopes that greater certainty will boost private investment.

Former Treasury Secretary Nelson Barbosa is transitioning to planning minister, in charge of major infrastructure projects. This is vital to the development of Brazil’s rich natural resources industry. Often, the issue with having abundant resources is having the proper infrastructure upgrades (which require substantial funding) in place to keep up with growing demand.

The Brazilian government’s declining popularity under Rousseff is adding pressure on the country to address all the economic problems it’s facing, and we expect to see more discipline in the fiscal and economic policies that it rolls out. For Brazil to continuing growing on the world stage, it needs to focus on exports, which currently account for only 10% of the nation’s GDP.

Over the long-term, increased exports would support the Brazilian currency and help reduce imported inflation. In turn, this would lower domestic interest rates and debt servicing costs, potentially supporting consumer demand.

We expect that Brazil’s growing young population will also help foster demand by driving urbanization, industrialization and domestic consumption. As purchasing power rises, there will be potentially many new investment categories that service this population, including shopping mall developers, retailers, financial services providers and consumer goods companies. This will foster a stronger economy.

In short, what Brazil needs more of right now is liberalization – the freedom to change, adapt and grow – much in the unobstructed way that Carnival has been able to evolve these past centuries. Because Brazil cannot afford another restrained economy or “lost decade” like the one it experienced in the 1980s. That is one party we wouldn’t want to attend.

By Nick Robinson, Director – Head of Brazilian Equities at Aberdeen Asset Management

Legg Mason Announces Hire Of Seasoned ETF Professionals

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Legg Mason has hired Rick Genoni and Brandon Clark to lead the firm’s strategy in the ETF product category. The team joins Legg Mason from The Vanguard Group where they collectively had nearly 18 years of experience in the ETF business. Mr. Genoni led Vanguard’s Index and ETF product management team and Mr. Clark led Vanguard’s ETF Capital Markets Group.

“Our product development agenda is driven by our clients’ needs and preferences. The ETF vehicle continues to evolve beyond the delivery of traditional index-based passive products and we want to have the ability to offer an ETF vehicle where it is beneficial to clients and consistent with our affiliates’ existing investment process. At the same time, we believe there is also significant opportunity to create innovative new products within the ETF structure to solve client needs,” said Thomas Hoops, Executive Vice President of Business Development for Legg Mason.

Mr. Hoops continued, “Rick and Brandon’s deep experience in this segment will allow them to work with our affiliates to identify the best opportunities in this growing segment. They have also both successfully launched and grown an ETF product line within a traditional mutual fund firm and have experience in the educational partnership necessary for success with both distribution partners and clients.”

Rick Genoni said, “The opportunity to build a new business at a large, global asset management firm is a very exciting one. Legg Mason, with its strong, investment oriented culture and exceptional investment affiliates, was an attractive partner. Both we and Legg Mason are excited about the opportunities available for asset management firms to create innovative new ways to serve investors in an ETF structure.”

Both men have significant experience in structuring and creating innovative products, and working with regulators and other relevant parties to launch those products. In their respective roles, they had responsibility for ongoing management of the firm’s ETF lineup and index mutual funds and maintaining relationships with market makers, exchanges and other important capital markets stakeholders. As part of each of their roles, they educated institutional and retail clients on using these products in portfolios and represented the firm on ETF market structure issues.

Miami, the Next Singapore: Making the Case

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There is a lot to Miami ‒ and more broadly speaking, to South Florida ‒ than tourism and real estate.

Art Basel has given us bragging rights as a cultural crossroads. eMerge has given us the confidence to envision an emerging technology nexus. And more than 1,000 multinational company offices, together with Miami’s bustling international trade, unquestionably make South Florida an international business gateway.

But lately, we have also begun to tout our credentials as a hotbed for financial services, a Singapore of the Americas.

So, it is only fair to ask: Does Miami, a.k.a. South Florida, really have the chops to be taken seriously as a financial services hub? Or is it just a lot of wannabe chatter? Until now, the case for Miami as a budding financial polestar has rested largely on anecdotal evidence. Sure, new firms have been setting up shop. Scout Ventures, a New York-based venture capital firm, recently opened an office in Miami, and hedge fund Universa Investments moved its headquarters from Southern California to Coconut Grove. But at the same time, other financial firms ‒ such as Canada’s RBC Wealth Management and Britain’s Lloyds TSB Bank ‒ have left town.

So, anecdotally, it’s a tie.

For a change, let’s forget the anecdotes and allow the numbers to do the talking, starting with the most basic one of all: How many financial services firms do we have in South Miami? The answer to that question, simple as it sounds, turns out to be rather complex.

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For starters, financial services firms come in a variety of species, most of them kissing cousins. There are commercial banks, investment banks, hedge funds, mutual funds, asset managers, private equity firms, broker dealers, real estate investment funds, wealth management firms, private banks and family offices.

Databases, such as IPREO, Pitchbook, Thomson ONE, are a good point of departure for analyzing this maze, but often the databases don’t agree on how to categorize the firms. Compounding the confusion, firms sometimes categorize themselves differently than do the databases. Unsure of one firm’s lineage, we asked its CEO “So are you a private equity firm or a family office?” The answer: “We’re hedge fund.” Aha!

Beyond the often murky boundaries between venture capital and private equity, between multi-family offices and wealth management firms, are two distorting characteristics of the money business: mystery and bravado.

On the one hand, South Florida, from Miami to the Palm Beaches, has long been a magnet for wealthy global citizens, many of whom would prefer not to appear on anyone’s radar. On the other hand, there are plenty of investment advisors, who are more than happy to embellish their investment banking credentials, or wealth managers eager to exaggerate their importance.

So, first, we had to acknowledge that some pools of investment money being managed in South Florida will defy detection. And second, we had to weed out marginal players by applying minimum standards for inclusion in the hedge fund count, the investment bank club, the list of international banks, etc.

Even so, coming up with accurate numbers for the different segments of the South Florida financial services industry was a cumbersome process. But once we felt comfortable with our figures, we asked experts in each of the industry segments to validate them.

The results are presented in the accompanying infographic. South Florida is home to 50 community banks, 59 international banks, 60 hedge funds, 63 wealth management firms, 19 private equity firms, 13 investment banks, and more than 200 family offices, not to mention a few upstart venture capital firms, a $7 billion mutual fund and more real estate investment funds than we even dared to count.

Is that a lot? Does that make Miami a financial services hub? By all indications, it does. That’s not to say Miami is in the same league as New York. But it does deserve to be in the conversation. But this begs another question: How do South Florida’s numbers stack up against those of Chicago, San Francisco, L.A., Houston?

That is the next challenge. Stay tuned.

You can check the Miami Finance Infographic PDF in the attachment above

The Author: Ian McCluskey is Vice President of Newlink Financial Communications.

Citi Announces $100 Billion, 10-Year Commitment to Finance Sustainable Growth

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Citi has announced a landmark commitment to lend, invest and facilitate a total of $100 billion within the next 10 years to finance activities that reduce the impacts of climate change and create environmental solutions that benefit people and communities. Citi’s previous $50 billion goal was announced in 2007 and was met three years early in 2013.

With this $100 billion initiative, Citi will build on its leadership in renewable energy and energy efficiency financing to engage with clients to identify opportunities to finance greenhouse gas (GHG) reductions and resource efficiency in other sectors, such as sustainable transportation.

As part of a commitment to helping cities thrive during this period of unprecedented urban transformation, Citi will seek to finance and support activities that enable communities to adapt to climate change impacts and directly finance infrastructure improvements that increase access to clean water and manage waste, while also supporting green, affordable housing for clients, including in low- and moderate-income communities.

“Citi has demonstrated its deep commitment to not only taking environmental consequences into account, but also finding innovative ways to finance projects that lead to sustainable growth,” said Michael Corbat, Chief Executive Officer of Citi. “For more than 200 years, Citi’s mission has been to enable progress by facilitating economic growth and financing transformative projects. The core mission hasn’t changed, but the way we approach it has. Incorporating the principles of sustainability into everything we do improves our own operations, enhances our clients’ work, and contributes to a better world.”

“Reducing carbon emissions and becoming more climate resilient is a key priority and major challenge for the world’s megacities and their business communities,” said James Alexander, Head of the Finance and Economic Development Initiative at C40 Cities Climate Leadership Group, a network of the world’s biggest cities working to become more sustainable. “C40’s ongoing partnership with Citi is helping global cities overcome their climate finance challenges. Today’s announcement from Citi will add further opportunities to help cities achieve their climate targets, and allow businesses to become more sustainable.”

World Events Encourage Institutional Investors to Consider Seismic Shifts in Investments

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Large institutional investors are likely to make significant shifts in asset allocation in 2015 in response to divergent market and macro-economic trends, a new BlackRock survey has found.

The poll of 169 of BlackRock’s largest institutional clients representing $8 trillion in assets, found these investors are focused on growth rates in developed economies, divergent monetary policies and the potential for deflation. As a result, respondents predicted significant moves in their portfolios towards alternative investments and less traditional fixed income strategies that aim to provide returns across varying market conditions. Senior investment professionals at the surveyed institutions also expressed concerns about escalating geo-political tensions.

“Mixed economic growth forecasts and shifting monetary policies are significant challenges for our clients. These conditions are testing investors’ ability to generate sufficient returns to meet their long-term liabilities,” commented Mark McCombe, Senior Managing Director and Global Head of BlackRock’s Institutional Client Business. “In today’s environment, we advocate proactive risk management. We believe institutional investors should also consider alternative and non-traditional asset allocations, particularly longer dated ones that allow institutions to ride out the expected near-term volatility.”

Low rates, deflation fears in Europe and Japan

Investors are challenged by historically low interest rates and patchy economic growth in many developed economies, although they retain near universal confidence in central bank policy, according to the survey.

Investors are anticipating continued low rates with 74% believing it was unlikely the US 10-year Treasury note would rise above a 3.5% yield over the next year, while 88% also believe it is unlikely the Fed will tighten too much too soon. Meanwhile, 56% believe Europe will likely enter a deflationary regime. However, 63% believe that the European Central Bank will maintain its credibility with investors. More than two-thirds of respondents (69%) believe China’s growth will dip below 7%.

Real estate, real assets and flexible fixed income strategies favoured

Senior investment professionals expressed increased appetite for allocations to real assets, real estate, private equity and unconstrained fixed income. Six in 10 anticipate increasing allocations to real assets and approximately half plan to add to real estate (50%) and private equity (47%). Conversely, more than a quarter (26%) anticipate decreasing allocations to cash and 39% will decrease investment in fixed income. Fixed income portfolios are also changing, as many investors are moving out of core and long duration strategies while increasing allocations to unconstrained (35%), emerging market debt (38%), US bank loans (33%) and securitised assets (23%).

Mr. McCombe added: “The trend towards alternatives isn’t new, but what is surprising is the level of conviction institutions towards physical assets like real estate and infrastructure. We believe many institutions are structurally under-invested in real assets, and it is great to see they are more bullish on these strategies than they were 12 months ago. The moves in fixed income are also significant and highlight the importance of manager selection and mandate flexibility in a time of yield scarcity.”

Regional Results

European institutions strongly favour real assets and real estate: In Europe, senior investors were even more bullish on real assets and real estate. 69% anticipate increasing allocations to real assets against 2% saying they would decrease allocations, while 66% plan to add to real estate versus 9% who said they would decrease allocations. 36% intend to increase allocations to private equity against 14% who would decrease, while contrary to the global trend a net 9% said they would increase allocations to public equities (40% to increase versus 31% to decrease).
Asia-Pacific institutions allocation changes in line with global investors: In Asia Pacific, institutions are showing similar appetites for increasing allocations in real assets (64%), real estate (54%) and private equity (43%) as their global peers while 44% of them anticipate moving out of fixed income. Within fixed income, allocations to high yield and long duration are expected to decrease, with unconstrained (41%), emerging markets (38%) and short duration (32%) gaining favour.
US and Canada institutions pare equity and cash exposure and add to alternatives: US and Canada respondents’ reactions to the sustained bull market in equities were to reduce their exposure with 39% indicating they would decrease equity allocations. Additionally, 20% of respondents in this region are planning on reducing cash holdings. As with their counterparts around the world, alternative strategies and assets are attracting interest, with more than a third of the respondents saying they would increase investment in private equity (46%), real estate (34%) and real assets (53%).

Investors Are Exuberantly Bullish on Europe After Promise of ECB Action

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Global investors are significantly more positive on the outlook for Europe after the European Central Bank’s announcement of quantitative easing to reflate the region’s economy, according to the BofA Merrill Lynch Fund Manager Survey for February.

An overall total of 196 panelists with US$559 billion of assets under management participated in the survey from 6 February to 12 February 2015. A total of 157 managers, managing US$459 billion, participated in the global survey.

Europe’s profit outlook is at its best since 2009, according to panel members. A net 81 percent of regional specialists see the economy strengthening in the next year. Against this background, a record net 51 percent make the region their top pick in equities over a one-year horizon, up from January’s net 18 percent. A net 55 percent are already overweight.

The U.S. has been the main loser from this rotation. Overweights on U.S. equities have declined to a net 6 percent, down 18 points versus last month.

Overall, fund managers have increased their allocations both to stocks (a net 57 percent overweight, up six points month-on-month) and cash (a net 22 percent overweight, a five-point rise). This is at the expense of bonds, which are now seen as overvalued by a net 79 percent. Bonds are also perceived as the asset class most vulnerable to increased volatility this year.

Despite exuberance over Europe, the global growth outlook is little changed. This reflects declining expectations on China. A net 58 percent of respondents now expect that country’s economy to weaken over the next 12 months, the survey’s lowest reading on this measure in nearly two years.

“The ECB has successfully vanquished global deflation fears and induced the return of reflation trades in February,” said Michael Hartnett, chief investment strategist at BofA Merrill Lynch Research. “Sentiment has gotten ahead of the fundamentals on European equities. It is as if there is not a single bear left. We will need to see a strong recovery very soon to keep the bulls happy,” said Manish Kabra, European equity and quantitative strategist.

Eurozone only

Investors’ new bullishness on Europe is strongly focused on the Eurozone. Non-Euro markets are out of favor. Last month, France and Italy stood out as their worst picks, but a net 42 percent of regional fund managers now intend to underweight the U.K. and Switzerland this year. They have also shifted to a negative stance on Sweden.

Autos are now European regional investors’ favored sector. A net 26 percent are overweight, a month-on-month gain of 12 percentage points. The travel and leisure area has also gained support with a 10-point rise.

In contrast, banks and insurers saw notable declines in sentiment. Month-on-month falls of 32 and 20 percentage points, respectively, have taken both into underweight territory. Utilities are now the region’s least favored sector.

Inflation fuelled

Anxiety over potential Eurozone deflation has declined with the ECB’s QE announcement. Indeed, inflation expectations are picking up. A net 29 percent of fund managers expect global core CPI to be higher in a year’s time, up from a net 14 percent a month ago.

A potential geopolitical crisis is now clearly respondents’ major tail risk. One in three identifies it as their major concern.

Gold glisters again

China’s weakening outlook is weighing on Global Emerging Markets equities, but net underweights on GEMs have declined by 12 percentage points since January to a net 1 percent.

Sentiment towards gold is also improving. Forty percent of survey participants expect the price to be higher in 12 months’ time. Last month, bears on the precious metal still outnumbered bulls.

Only a net 3 percent now considers gold overvalued, compared to a net 20 percent as recently as December.

Many investors continue to see value in oil. A net 39 percent regard crude as undervalued, down slightly from January’s reading.

Generali IE: European Equities to Rally in 2015

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The European Central Bank (ECB) pulling the trigger on QE was the first big news of 2015. According to the Generali Investments Europe analysts, this will set the tone for financial markets for quite some time to come.

“Core government bond yields will stay extremely depressed”, said Klaus Wiener, Chief Economist of GIE, in his Market Perspectives for February 2015. “With core yields so low, investors will be pushed into riskier assets; as a result, Euro area stocks will rally with double-digit total returns now likely both this year and next”.

Over the past few months, the outlook for the euro area economy has improved due to a number of factors. Above all, as the ECB’s various programs increasingly unfold their impact, faster loan growth in the private sector is likely. In addition, the euro area economy will benefit from the sharp decline in oil prices and the strong depreciation of the euro. All in, while some significant headwinds remain (e.g. geopolitical risks, weaker growth in emerging markets) a relapse into recession has become increasingly unlikely. If anything, some macro indicators of the euro area could start to surprise positively over the next few months.

On the fixed income side, yields have continued to drop, in some cases even to new historical lows. Since US yields are likely to rise in response to solid domestic conditions and the nearing of a first key rate hike, the transatlantic yield spread will reach new highs. Non-financial corporate bonds are still attractive in relative terms.

Just like the economy, equities stand to benefit from the weaker euro and the much lower oil prices. Even more importantly, with the low-yield environment to persist as a result of the ECB’s QE, investor demand will remain high for this asset class. As a result, GIE expects euro area stocks to outperform many of its peer markets in the developed world over the coming months.

The Inevitable Levy Let-Down

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Since Joaquim Levy took over as Brazil’s finance minister, Brazilian markets have been surprisingly resilient. On the back of Levy’s commitment to produce a primary surplus of 1.2% of GDP, expectations that Brazil will avoid losing its investment grade status had increased sharply prior to the Petrobras downgrade last week. As a consequence the real gained 4.8% against the dollar, and 10-year sovereign bond yields were down since Levy’s appointment (see Chart 10).

Although gross public debt and the fiscal deficit have deteriorated sharply since 2011, many view Levy’s presence as enough to prevent a sovereign downgrade. Such confidence that Brazil will evade a downgrade indicates a belief that Levy can and will do whatever it takes to solve Brazil’s fiscal problems. This assumes that he will be given autonomy by President Dilma Rousseff to implement fiscal reforms and that Congress will pass a budget with sufficient cuts to achieve the targeted primary surplus. Given the scope of the recently announced deficit, we are not confident that Brazil will be able to achieve its fiscal target and are sceptical that Brazil will avoid a downgrade.

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The 2014 Brazilian deficit, the largest since 1999, increased sharply from last year. The Brazilian central bank announced a primary budget deficit of 32 billion Real ($13.76 billion) for 2014, equal to 0.63% of gross domestic product. This was the first primary deficit in over a decade and a sharp fall from the 91.3 billion Real surplus of 2013 (see Chart 11). The country’s overall budget gap, which takes into account debt servicing costs, doubled in 2014 to 6.7% of GDP, one of the highest among the major economies according to the IMF. Additionally, the steady decline of public sector finances is leading to a wider current account deficit, despite weaker growth and low investment.

Levy appears committed to repairing the severely unbalanced macro conditions through deep fiscal adjustment. However the true extent of the fiscal gap is unclear and it is doubtful Levy will have support from Rousseff and Congress to implement the necessary reforms. Due to Rousseff’s lack of fiscal transparency in her first term, additional outlays exist which make the deficit even larger; an investigation by the Federal Audit Court may conclude that 40 billion Real ($15.6 billion) in expenditures were improperly accounted for since 2012 and must now be fully recognized in the government’s budget; and as much as 8 billion Real ($3.1 billion) of an estimated 30 billion Real ($11.7 billion) in public investment subsidies that have been deferred since 2012 will need to be registered in 2015. This off-balance-sheet spending will deepen the fiscal shortfall and complicate Levy’s efforts to produce a primary budget surplus. Levy recently announced plans to raise taxes on fuel, financial transactions and imports, which will boost revenues by 0.4%of GDP. However, the reforms represent the limits of his powers to improve fiscal conditions without additional congressional approval. As the unfolding Petrobras scandal increasingly occupies Rousseff’s attention and impairs her ability to govern, congressional gridlock is becoming more likely. Despite the optimism surrounding Levy’s efforts, once the true extent of his challenge comes to the fore, markets could be brought back to reality.

Opinion article by Alex Wolf, Emerging Markets Economist at Standard Life Investments