NEW YORK, July 30 (IFR) - Struggling Brazil took another blow to the chin this week when S&P put the country's BBB- credit rating on negative outlook, setting the stage for a potential downgrade to junk.
The other agencies could soon follow S&P's lead, as the government of President Dilma Rousseff fails to get to grips with the country's deteriorating credit metrics.
A brief recovery in asset prices earlier this year has not stuck, and since a sharp downward revision of government surplus targets, investor confidence - never high - has waned.
"It is a big concern that the country will lose its investment grade over the next 12 months," Javier Murcio, a portfolio manager at Standish, told IFR.
"Brazil is a major investment for global investors, and some accounts can only invest in investment grade (credits). This will have repercussions in terms of flows."
Just a few weeks ago, hopes were running high that Latin America's largest economy was headed in the right direction under Joaquim Levy, Rousseff's new US-educated finance minister.
Levy was tasked with getting the country's financial house in order, and his appointment cheered many in the market with the belief that he could orchestrate a reversal of fortunes.
Brazilian credits rallied and even Petrobras - at the centre of a corruption scandal that has touched the highest tiers of government - was able to return to the capital markets in June.
But the turnaround suffered its own turnaround on July 22 when Levy, facing up to depressed government revenues from the anaemic economy, slashed the previous surplus goals.
This year's primary surplus target was cut to 0.15% of GDP from 1.1%, while for 2016 it was revised downward to 0.7% from 2%.
"The combination of the revision of the fiscal target figures plus the move by S&P has made a downgrade to sub-investment grade more likely than it was before," said Pablo Goldberg, an emerging market portfolio manager at BlackRock.
In the wake of the surprise decision on targets, five-year CDS reached around 300bp - a wide not seen since March, when there were widespread fears of a Petrobras default.
Brazil's 2025s were trading at around 290bp over Treasuries on Tuesday, close to March levels and even wide of 2025s issued by junk-rated sovereigns Turkey and Indonesia.
"The market is beginning to price Brazil as a BB credit," said Murcio.
The back-up in spreads is already having an impact on the primary, which saw a flurry of issuance earlier this year when sentiment was on the rise.
Sugar and energy conglomerate Cosan postponed a July debt sale due to market conditions, and other issuers are likely to find it tough to win over skittish investors going forward.
"What worries me about getting more involved in Brazil is that there are more shoes to drop," said Jack Deino, head of emerging market portfolio management at Invesco.
The Petrobras corruption investigation still has many more months to run, and as it drags on it is simultaneously worsening the gridlock in Congress - and delaying meaningful change.
"It creates an obstacle for Levy and his team to deliver on any of the reforms they are trying to implement," said Brigitte Posch, head of EM corporate debt for Babson Capital Management.
Unlike S&P, however, Moody's and Fitch have Brazil two notches inside high-grade at Baa2 and BBB, respectively - which might make it look cheap to lower-quality sovereigns.
"If Moody's decides to downgrade Brazil but keep its outlook on stable, the market will rally," said Invesco's Deino.
"If it comes with a negative outlook, that might generate a buying opportunity."
But S&P is warning of a one-in-three chance of "further slippage" in the government's fiscal numbers - and that it will be quite a while before the economy gets back on its feet.
"As much as the market has discounted some ratings action, longer term - if they don't find a political resolution - a downgrade to junk may be inevitable," said Pablo Cisilino, a portfolio manager at Stone Harbor, which has about US$50bn of EM assets under management.
"So we are cautious about Brazilian assets at this stage."
A version of this story appears in the August 1 edition of IFR Magazine, a Thomson Reuters publication
Reporting by Paul Kilby; Editing by Marc Carnegie