Brazil

The new fiscal framework will fail to prevent the rise of the public debt-to-GDP ratio as it relies on overly optimistic revenue growth. A rising public debt-to-GDP ratio will lead to a widening fiscal risk premium in Brazilian financial markets. We are making two new recommendations: downgrade Brazilian sovereign credit from neutral to underweight, and go long Brazilian CDS / short Mexican CDS.

Remain cautious and defensive overall. Stay long DM Europe over EM Europe. Look for EM opportunities in Southeast Asia and Latin America over Greater China.

The only feasible way for Brazil to stabilize its public debt-to-GDP ratio is by having nominal GDP growth meaningfully above government borrowing costs. This requires large fiscal stimulus to boost nominal GDP and much lower interest rates. These factors will constitute the economic policy anchor of Lula’s 3.0 presidency. When markets begin to price this in, the outcome will be chronic downward pressure on the currency.

Stay short Greater China assets. Stay long Japanese yen. Hold back on Brazil for now but look forward to opportunities in future.

Russia’s conflict with the West will escalate and trigger more bad news for risky assets this fall. Beyond that, stalemate looms. Latin American equities present a potential opportunity once the macro and geopolitical backdrop improve.

Executive Summary Brazil: The Economic Rebound Will Not Last Brazil’s goldilocks phase of economic recovery, improving fiscal accounts and falling inflation will prove to be short lived. On the contrary, the country will re-enter a period of stagflation – weak growth amid high core inflation – and the central bank will continue hiking rates. While headline inflation will continue dropping due to falling oil prices and government tax cuts on utilities, core inflation will remain above the central bank’s target due to high wage growth and high levels of indexation. The economy will weaken anew as the commodity windfall abates and continuous central bank tightening amid distressed household finances cause a drawdown in consumer spending. Public debt concerns will resurface as interest rates rise further and nominal GDP growth downshifts due to the retreat in commodity prices. Further, the imminent election of ex-President Luiz Inácio Lula da Silva will lead to higher fiscal spending and larger deficits. We expect Lula to win the election versus current President Jair Bolsonaro. While Bolsonaro might try to deny the outcome, and thereby bring a bout of market volatility, the military is unlikely to overthrow the democratic results. Bottom Line: The domestic and global macro dynamics are negative for Brazilian financial markets in absolute terms. Within EM equity and fixed-income portfolios, BCA’s Emerging Markets Strategy team recommends a neutral allocation to Brazil. For the currency, we reiterate our trade of shorting the BRL versus the MXN. Feature On the surface, the Brazilian economy seems to have recently entered a goldilocks phase: inflation has rolled over, economic activity is recovering, and the public debt-to-GDP ratio has downshifted. Financial markets have rebounded with stock prices rising by 15% in local currency terms, the BRL strengthening and 10-year domestic bond yields falling over the past two months. Financial markets have been pricing in that the Central Bank of Brazil (BCB) will turn dovish and, with it, hoping that the economy will achieve a soft landing.   Beneath the surface, however, this sanguine view of a goldilocks macro scenario shows signs of being short lived. As we see it, inflation will be sticky and will fall only gradually, the BCB will maintain a hawkish stance and will continue to hike rates, economic activity will disappoint, and fiscal accounts will worsen anew. Moreover, the likely election of former President Luiz Inácio Lula da Silva on October 2 (with a second round on October 30 if necessary) is not a solution to long-term structural problems. Inflation Will Be Sticky Chart 1Brazil: While Headline Inflation Rolls Over, Core Remains High After having one of the highest inflation prints among investable Emerging Markets, Brazil’s headline inflation has begun to roll over (Chart 1, top panel). While this shift has been celebrated by markets, odds are that going forward the decrease in inflation will be gradual and the core inflation rate, while moderating, will remain well above the central bank’s target range of 3.5% (+/-1.5%) for some time (Chart 1, top panel). First, core inflation measures – such as core, trimmed-mean CPI and non-tradable CPI − have not fully rolled over yet and remain at around 10.5%, well above the BCB’s target range (Chart 1, bottom panel). When core-type inflation measures are at around 10%, it suggests inflation is genuine and broad based and not limited to just energy and food prices. Second, the latest drop in the headline inflation rate is not due to easing inflationary pressures, but rather due to government tax cuts on gas and diesel alongside falling gasoline prices. Excluding fuel and gas, the prices for the rest of the consumer basket continued to rise materially in August. Consistently, the core inflation rate grew by 0.54% on a month-to-month basis. Third, as a sign of genuine and persistent inflationary pressures, wage growth is accelerating and unit labor costs are spiking (Chart 2, top and middle panels). As we have written repeatedly in our reports, wages, and specifically unit labor costs, are the most important drivers of genuine inflation. Chart 2Brazil: Wages Are Running Hot Very strong growth in nominal wages and unit labor costs poses risks to business profit margins. In an inflationary scenario, business owners will attempt to raise their selling prices to protect profitability. Thereby, they will try passing higher costs and further fuel price pressures onto consumers. When this occurs, the economy enters a wage-price spiral. In brief, unless the economy and labor market weaken substantially, core inflation will not fall within the central bank’s target range anytime soon (more on the business cycle below). Fourth, the Brazilian economy has high levels of indexation, which means that the prices of certain goods and services such as school fees, health insurance, and manual labor are linked to the past year’s inflation rate, which in 2021 stood at 10.1%. Particularly, about 40% of the Consumer Price Index is indexed, either formally or informally.1 This makes the BCB’s job of bringing inflation down to below 5% and closer to 3.5% that much harder. Another important variable indexed to inflation is the minimum wage, which rose by 10% in 2022 (Chart 2, bottom panel). The minimum wage has a particularly high impact on inflation due to the large share of workers who depend upon it. According to local consultant firm Tendências Consultoria, 38% of employed Brazilians earn the minimum wage. Bottom Line: Headline inflation is set to drop from current levels mainly due to falling energy and food prices as well as tax cuts. Nevertheless, in the coming months core inflation will remain well above the BCB’s target. Public Debt Concerns Will Resurface The latest improvement in fiscal accounts has been due to cyclical factors that are set to reverse. Thereby, public debt sustainability worries will resurface as cyclical tailwinds die down. Specifically, the amelioration of fiscal accounts and the decline in the public debt-to-GDP ratio has been due to nominal GDP growth exceeding government borrowing costs (Chart 3, top and middle panels). The public debt-to-GDP ratio has declined due to excessive inflation producing high nominal GDP growth. Rapid price increases likewise inflated government income through higher tax revenues. Nominal GDP in general and the GDP deflator in particular were lifted by the rally in commodity prices late last year and early this year (Chart 4). In particular, the GDP deflator has averaged 12% in Q1 and Q2 this year. Chart 3Brazil: Public Debt Dynamics Will Worsen Anew Chart 4As Commodity Prices Fall, So Will Brazilian Nominal Growth   Going forward, however, these cyclical tailwinds are set to dissipate. As commodity prices fall on the back of a global manufacturing recession, so will Brazilian nominal GDP growth (and its GDP deflator). Further, hawkish monetary policy will induce a growth slowdown in the nation’s economy and reduce inflation, albeit only modestly. All of these factors will bring down nominal GDP growth and, thereby, decrease fiscal revenues. Overall, as nominal GDP growth downshifts considerably and the central bank continues hiking rates, the interest rate on public debt will rise above the nominal GDP growth rate (Chart 3). This will lead to a rising public debt-to-GDP ratio. Further into the next year, fiscal accounts will come under more pressure as the government enacts an expansive fiscal budget. Both presidential frontrunners have explicitly stated that they will maintain cash handouts and tax cuts into the next year, at a cost of BRL 160 billion or 1.7% of GDP. President Jair Bolsonaro’s proposed budget for 2023 is already envisioning a primary deficit of 0.7% of GDP, compared to the current primary surplus of 2.5% of GDP (Chart 3, bottom panel). In fact, this budget does not even include the increase in cash handouts. Particularly, the leading candidate to win this year’s elections, former President Lula, will ease fiscal policy more than the current President Bolsonaro. In fact, Lula has stated that Congress should remove the fiscal cap and allow the government more discretion to increase spending. Lula’s key economic policies all entail higher fiscal spending and sizable deficits, which include maintaining and increasing cash handouts, a large infrastructure package, and higher spending on health. Provided Lula wins the presidency again (more on this below), odds are that fiscal policy will be very expansionary, and fiscal deficits will widen. The upshot will be rising worries about public debt sustainability. Bottom Line: Public debt sustainability concerns will resurface in the coming months as cyclical tailwinds (high nominal GDP growth) dissipate and a fiscally expansive government is elected. While Lula’s alliance with moderate politicians could see some pragmatic economic policies, his government’s fiscal policy will be expansionary. Overall, Lula’s policies in the years to come will warrant a long stocks / short currency strategy for Brazil as we argued in the report early this year. The Central Bank Cannot Afford To Go Dovish The BCB will remain hawkish and will continue hiking interest rates. While headline inflation has been ameliorating in the past months, central bank governor Roberto Campos Neto has admitted that most of the disinflation has been due to government policies (tax cuts on gas and diesel) and falling oil prices. Core inflation remains well above the central bank’s target range and has not yet rolled over decisively. Chart 5Brazil: Lending Rates Need To Rise Further Cyclically, booming credit growth, rising wages and fiscal stimulus all warrant monetary policy tightening. Private sector credit growth at above 20% entails that lending rates are not restrictive enough (Chart 5). Structurally, the return of President Lula only reinforces Brazil’s penchant for easy fiscal policy. The effect of Lula’s policies would be large fiscal deficits and structurally higher inflation. Both necessitate the BCB to respond with higher interest rates. Furthermore, given that Lula’s Worker’s Party disapproves of autonomy for the central bank, the BCB has a political incentive to over-tighten this year and reduce inflation early next year in order to not be caught up in a confrontation with Lula’s government over the trade-off between growth and inflation. We elaborated on the potential relationship between the BCB and the new government in our February 8 report. Finally, we believe the Fed will maintain its hawkish stance and continue raising interest rates. Consequently, the USD will continue overshooting, and Brazil’s exchange rate will weaken. This will lead the BCB to continue hiking interest rates.  All in all, we expect the BCB to continue tightening policy. The market is not pricing in any rate hikes in this cycle, but we believe the BCB will raise rates within the next three months. The central bank will maintain a hawkish stance until genuine inflationary pressures abate. The latter will require a material slowdown in economic activity. The Economic Rebound Is Both Fragile And Temporary Brazilian markets have rallied in the past two months on the back of improving economic data. However, when we look under the hood, the economic recovery is unsustainable. In fact, the nation’s business cycle is set to disappoint. Chart 6Brazil: The Economic Rebound Will Not Last First, the main culprit behind the recent economic recovery has been fiscal stimulus. The government and Congress enacted two measures to support demand and lower inflation in the form of cash handouts and tax cuts on utilities, each worth 0.5% and 1.2% of GDP respectively. As a result, the business cycle has defied the downbeat signal from our historically-reliable marginal propensity to spend indicator (Chart 6). Second, on the credit side, bank loans have been surging, further supporting the economy (Chart 7). Nevertheless, when looking closely at the data, a worrisome picture emerges: the credit binge has been driven by distressed households who often borrowed to pay their bills. This current scenario of a household-driven credit binge amid rising borrowing costs is not sustainable. Rising interest rates will choke off credit growth and the economy will slow: Consumers are relying heavily on credit to make ends meet. Chart 8 shows that household debt servicing is very high at 27.6% of disposable income (for comparison this ratio for US households is 9.5%), credit card usage is through the roof, and almost a third of all families have overdue bills.  Chart 7Brazil's Credit Binge Is Unsustainable Chart 8Household Finances Are Very Distressed Non-performing consumer loans are rising quickly (Chart 9). For non-financial corporations, the level of overdue loans is more subdued, but the increase is non-trivial.   As consumers and businesses start struggling to service their debt, banks will be forced to increase provisions and restrict credit (Chart 10). This will reverberate throughout the economy. Chart 9Brazil: Non-Performing Loans Are Rising Chart 10As Banks' Profitability Suffers, So Will Their Stock Prices   Finally, lower commodity prices will dampen income growth in this economy and will weigh on domestic demand. All in all, the Brazilian economy is set for a period of stagflation, i.e., weakening growth amid high core inflation. The eventual drawdown in bank credit and distressed household finances will dampen economic activity despite easy fiscal policy. Finally, the BCB will continue hiking rates amid the initial phase of the growth slowdown. The basis is that core inflation will remain very elevated and above the central bank’s upper range of 5%. Bottom Line: The current economic recovery will prove to be fleeting. Continued monetary tightening and fragile household finances will overwhelm the temporary fiscal relief, causing a growth deceleration. Elections Outlook: Lula Wins, No Military Coup Heightened political volatility around the October election poses near-term risks to Brazilian financial markets. We expect Lula to beat Bolsonaro in the elections. Bolsonaro has presided over a tumultuous four years of pandemic, inflation, and scandals, producing anti-incumbent sentiment among the electorate. His net approval rating is under water at -5.7%.  Opinion polls suggest that only 34% of Brazilians intend to vote for Bolsonaro – down from 40% in 2020. Bolsonaro never exceeded his peak of 45% approval after his election in 2018 and his approval rating has proven historically weak relative to other Brazilian presidents (Chart 11). Chart 11Bolsonaro Less Popular Than Previous Presidents By contrast about 44% of voters intend to vote for former President Lula. Lula’s polling has remained above 40% since early 2021 and he has maintained a nine-percentage point lead over Bolsonaro throughout 2022 (Chart 12). ​​​​​​​Chart 12Lula Maintains Large Gap Above Bolsonaro Despite Facing Competition On Left Wing The third-ranked candidate, Ciro Gomes, commands about 8% of voting intentions, is ideologically to the left, and thus mostly takes votes from Lula rather than Bolsonaro. Grouping voting intentions according to ideological blocs shows that the median voter leans to the left (Chart 13). If Lula does not achieve over 50% in the first round of the election, then the left-wing will consolidate around him in the second round of the election on October 30.   ​​​​​​​Chart 13Ideological Voting Blocs Suggest Median Voter Leans To The Left Chart 14Bolsonaro And His Liberal Party Have Not Benefited From Recovery From Pandemic The recovery from the Covid-19 pandemic has not helped Bolsonaro. His approval rating has been flat over the course of the crisis and its aftermath – his personal job approval has fallen 1% since January 1, 2020, while voting intentions for him and his Liberal Party have only gained 1% since then (Chart 14). Thus Bolsonaro’s support is stable but at a low level.​​​​​​​ Consumer confidence has fallen from 95, just after Bolsonaro won the election with 55% of the vote in 2018, down to 82.9 today. The “Misery Index” (unemployment plus inflation) has risen from 15.7% to 19.2% over the same period. Real wage growth has fallen from 0.7% to -2.3% today (Table 1). ​​​​​​​Table 1The Pocketbook Voter Is Not Better Off After Four Years Of Bolsonaro It is probable that Bolsonaro will contest or deny the results if he loses the election and mobilize his ardent supporters to protest throughout the country. This will not be enough to change the outcome of the election but it could cause a shock to business and investor confidence. This is especially true if the vote margin is extremely close and the outcome is genuinely controversial, though that is not our expectation. Note that while the US stock market rallied through America’s contested election in 2020 and subsequent rebellion, investors may not have as much confidence in Brazilian institutions.  Nevertheless the military is unlikely to overthrow the democratic results: Bolsonaro’s personal weakness: Bolsonaro has not achieved anything like exclusive personal control over the Brazilian Armed Forces or other major institutions. His lack of popularity, plus broad popular support for the post-1985 democratic system, makes it very unlikely that the military would risk its credibility for his sake. Brazil’s economic difficulties: Brazil’s structural economic weaknesses would make a military dictatorship economically unsustainable and as such the military is discouraged from seizing power. Better to retain its credibility and pin the economic woes on civilian leaders. International opposition: The military would lack foreign support for a coup d'état, particularly from the United States, where the Democratic Party supported the coup against Brazilian President João Goulart in 1964 in the context of the Cold War and ideological struggle against communism. Today the US wants to discourage Latin American governments from reaching out to authoritarian governments like Russia or China, whereas a coup would necessitate such outreach. Chart 15Lula Does Not Pose Existential Threat To Military Military sufficiency: The Brazilian Armed Forces have not been sidelined or aggrieved and do not stand to be disenfranchised under any Lula administration. While an extreme faction could attempt some surprise moves, the military as an institution is not at any kind of breaking point with regard to the political system (Chart 15).​​​​​​​ Investment Recommendations As to investment strategy, we have the following recommendations: Equities: BCA’s Emerging Markets Strategy (EMS) team continues to recommend a neutral allocation to Brazil within an EM equity portfolio. On the one hand, rising domestic interest rates and an ensuing domestic demand slowdown as well as the commodity relapse do not bode well for this bourse. On the other hand, Brazil’s equity valuations are attractive in both absolute and relative terms (Charts 16 and 17). Chart 16Brazilian Equities Are Cheap In Absolute Terms… Chart 17…But Command Neutral Valuations Compared To EM ​​​​​ Chart 18The BRL Is Not Cheap We will be more comfortable upgrading this bourse to overweight once financial markets fully price in fiscal risks related to Lula’s presidency as well as higher interest rates and a potential growth slowdown.  Currency: The real is now overextended and is modestly expensive according to its Real Effective Exchange Rate (Chart 18). Its failure to break above its 200-day moving average is a bearish signal. Critically, dropping commodity prices spell trouble for the BRL.   All in all, BCA’s EMS team continues to recommend that investors short the BRL versus the MXN, a position instituted on July 28 of this year. Local bonds and sovereign credit: For the reasons elaborated in this report, and given that we expect US bond yields to rise in the near term, the EMS team is closing the long Brazilian 10-year local bonds trade, which has yielded a 4.4% return since February 8th of this year.  The return of fiscal sustainability concerns, a potentially weaker BRL, and odds of political volatility lead us to maintain a neutral allocation to Brazil in EM domestic bond and sovereign credit portfolios. Juan Egaña Associate Editor juane@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Footnotes       1 Márcia De Chiara, “Indexação na economia transforma inflação de dois dígitos em 'bola de neve',” Terra, June 5, 2022, www.terra.com.br  Gabriela Cabral, “Inflação e indexação,” Brasil Escola, www.brasilescola.uol.com.br ​​​​​​​