Brazil lost its treasured investment grade status from S&P last week when the agency cut the country’s rating from BBB- to BB+ and maintained a negative outlook. Always attentive to investment calls from institutions with solid track records, we felt compelled to ask ourselves, could it be time to look at Brazil?

Brazil has not been worth looking at since April 2008 when, with immaculate timing, S&P upgraded the country to investment grade. Patiently biding their time through a seven-fold increase in the Ibovespa over the previous six years, the analysts over at S&P made their call within 6% and a few weeks of the all-time high for Brazilian equities. Since that fateful last day in April, the Ibovespa has fallen 32% in local currency terms and a whopping 67% in US Dollar terms.

So, could S&P be making another breath-taking call? Could Brazilian equities, today depressed and unloved, represent an attractive investment opportunity?

Well, the first thing we should note is that the Ibovespa is a notoriously lousy index and over the period in question, its performance mostly represented the collapse of two state-owned, commodity-dependent giants (Vale in iron-ore and Petrobras in oil) and a clutch of so-so steel companies. Over the period, Vale managed to lose 70% of its value, Petrobras 82% and Usiminas, a bell-weather steel company, 86%, all in local currency terms. In fact, out of the 147 Brazilian stocks Bloomberg reckons had listings over the period, 62% actually rose, as high quality, non-commodity private sector companies performed pretty well while the index was in free-fall.

So, it is not that the Brazilian equity market has dropped to bargain basement levels so much as that a couple of hopeless, government-controlled entities, a few uncompetitive steel stocks and the currency have plummeted while everything else has been tooling along. And the valuations of reasonably successful Brazilian companies reflect this reality, as anything a foreign investor might want to buy in Brazil (like Cielo, credit card processing; Totus, software; Ultrapar, gasoline stations; Ambev, beer and CCR, toll roads) trades on a PE multiple of between 16-21x. While these valuations are hardly excessive, they are definitely not bargain basement.

However, surely the drop in the currency has the potential to blossom into a significant positive for Brazil? After all, the Real has fallen a hefty 60% since its peak in July 2011 and is back to levels last seen in the pre-commodity boom year of 2002. The issue, of course, is that oil, mining and agriculture account for 62% of Brazil’s exports and the prices of these things are all down big time too. Brazil’s top five exports, iron ore, sugar, oil, soy and coffee have witnessed price declines of 62%, 67%, 61%, 50% and 25% respectively since 2011. Unfortunately, Brazil’s terms of trade have moved decisively against the country over the last four years and arguably all the currency drop has been able to achieve is a moderate amelioration of the move’s worst effects. There has been a swing into positive territory for Brazil’s trade balance since March 2015, but only a small one.

(We are going to ignore, possibly until another time, the potential attractions of Vale, where consensus opinion claims another 10 years of bear market in iron ore is still in front of us due to big, fat mines coming on stream in politically stable countries. We also plan to sidestep Petrobras, iconic, reserve-rich symbol of Brazil’s growth potential turned corrupt, incompetent pawn of raving socialist politicians).

Undoubtedly, Brazil is in a tight corner. It has to pay so much interest on debt from abroad that the current account deficit is 4.3% of GDP even with a trade surplus. The government spends so much on payroll and social security that it can only afford to spend 1% of GDP on public investment and the World Economic Forum ranks the quality of the country’s infrastructure 120 out of 144 countries. The government budget deficit is expected to approach 9% of GDP this year and the inflation rate has been in relentless acceleration, topping 9% in July. GDP growth has been negative over the last five quarters and the country has lost 900,000 jobs in the twelve months ending July. Dilma herself (the country’s president) is down to impeachment-worthy single digit favourability ratings.

Sometimes though, dire economic circumstances can be hugely positive for investors. Sometimes, countries in tight corners run out of inappropriate options and are forced to do the right thing. Could Brazil’s government, after so many years of populist interventionism be compelled to implement some free market orthodoxy?

There have been a few signs of movement in this hopeful direction. Dilma has said she wants to cut down the number of ministries from 39 to 10. She has also announced a new $64bn private sector-financed infrastructure investment plan.

Dilma tried selling investment concessions once before, in 2012, but her left-wing instincts held down the allowable rates of return so only 20% of the money showed up and then only for the airports. No-one wanted the railroads or the ports – projects that might actually help agriculture and industry. This time, although details remain vague, officials promise the terms will be more attractive – specifically, the caps on investment returns are thought to have been removed. In an encouraging speech, Barbosa, Dilma’s Planning and Budget Minister, even went to far as to say that “The increase in investments in the Brazilian economy must be done by the private sector”. Although, it must be remembered that the Brazilian government has run out of money so that really does only leave the private sector. Sadly, two-thirds of the $64bn will not be auctioned off until 2019 and some projects are re-hashed versions of projects that failed in 20123, but still.

Continuing with the theme of free market orthodoxy, the government also announced a “sliding scale” to limit access to full pensions for a few years in an attempt to address Brazil’s ruinously generous pensions. This is nice but not nearly enough. Payroll taxes equal 35% of gross pay in Brazil. Without meaningful reform, payroll taxes will equal 80% of gross pay by 2050. The government spends the same in pensions on 1 million public sector workers as it does on 27 million private sector workers. Even government spokesmen admit this plan is a “temporary solution”. The government needs to sit down with the labour unions, pensioners and employers and hammer out a lasting reform.

To us, these latest announcements are hardly worth analysis.

Brazil needs a wholesale privatization programme, starting with Petrobras and ending with every last port and lowly toll-road. It needs drastic cuts to public sector pay, employment and pensions and reform of social security to make the system solvent and bring down payroll taxes to no more than 10% of payroll. It needs the government to get out of the subsidized credit business. The labour market regulations enshrined in the constitution (30 days of vacation, employer-funded transport and meals, the 13^th salary) need to be phased out and the whole labour market deregulated. If Brazil’s government announced measures like these, Brazilians would have to duck to avoid being hit by the wave of foreign investment that would pour into the country.

So, although we are attracted by the contrarian nature of Brazil today as an investment and respect S&P’s gutsy call, we cannot construct the sort of positive case the Ibovespa would need for anything more sustainable than a dead cat bounce. Brazilian stocks, at least the ones anyone would want to buy, are not cheap; the currency is just compensating for lower commodity prices and there are no prospects for real economic reform.