News In Charts: Investors Hope For Change In Brazil

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Brazilian assets have staged an impressive recovery since March, outperforming most other emerging markets. The catalyst has been a further deterioration in public support for President Rousseff ahead of elections due in October – her share of the vote is insufficient, at present, to avoid a run-off. Investors appear hopeful that this will force a change of course. S&P’s rating downgrade in March may have been the trigger, making the incentive for the next administration to deliver compelling – whoever ends up winning the autumn election. But it will not be easy. There are serious structural impediments to the effective transmission of monetary policy; and slippage in the pursuit of fiscal targets due to political brinkmanship could make adjustment much more costly next year.

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Brazilian assets have staged an impressive rally from this year’s lows. The Bovespa index has risen by some 30%, measured in US dollar terms. Sovereign bond yields and CDS prices have both come in considerably. And the real has strengthened by almost 10% since January’s trough, outperforming other major emerging market currencies.

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In part, this positive momentum is due to improved sentiment on emerging markets more broadly. Brazil’s abundant foreign exchange reserves, a relatively low debt-to-GDP ratio and elevated sovereign yields continue to present an attractive risk-return profile for many investors, notwithstanding a deteriorating external account. None of these factors is new, however. Waning popular support for Ms Rousseff has, in our view, provided the catalyst for the recent outperformance of Brazilian assets. The latest polls indicate that her share of the vote in October’s election has shrunk to less than 40%, materially reducing her chances of an outright win. This, in turn, will force a sea change on the domestic policy front.

Stagflation fatigue

Brazil is in stagflation. Real GDP growth has remained weak, coming in at a mere 2.3% in 2013. Worse still, it is likely to be even weaker in the near future. Our own central projection is for a 1.6% rate of expansion this year, rising only to 1.8% in 2015.

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At the same time, inflation has been stubbornly high, at 6.3% in the twelve months to April. And this is despite a cumulative 375 basis point tightening of the Selic rate since April of last year, which has taken the real policy rate close to 5%. Inflation expectations remain elevated, with the two-year breakeven rate still above 6%.

Against this economic backdrop, Brazilians have started to vent their frustration. Surveys point to sharp falls in both consumer and business confidence. Despite a buoyant labour market – with unemployment at just 5% – and still positive real wage growth, patience is running out.

Need for a better policy mix

The incumbent administration has largely carried forward President Lula’s demand-side policies, opting to address Brazil’s economic slowdown by doubling down on the consumer-led model. Ms Rousseff took the path of combining simultaneous heavy fiscal and monetary stimulus – intended to support GDP growth – with an interventionist approach aimed at containing inflationary pressures through the use of extensive price controls, ad hoc tax breaks for industry, subsidised provision of credit and active involvement in the foreign exchange market. With the benefit of hindsight, it is clear that Ms Rousseff miscalculated, prescribing the same old medicine but in a much less forgiving environment, characterised by worsening terms of trade and tougher liquidity conditions. The prospect of Fed tapering meant that counting on foreign capital inflows to mask fundamental imbalances was not going to work anymore.

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Under Ms Rousseff’s guidance, international investors steadily lost faith in Brazil. The central bank’s credibility as a fully independent entity was compromised, despite a meaningful pick-up in consumer price inflation through the second half of 2012 and into 2013. When persistently high inflation finally made an increase in the Selic rate unavoidable, Ms Rousseff undermined its potency by continuing to expand the supply of credit by publicly-controlled lenders at below market rates.

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But, as we have argued in a recent note, the game-changer was S&P’s downgrade of the country’s sovereign rating to BBB- this March. A return to ‘junk’ status would have severe repercussions, both economically and politically. As such, it effectively added to the pressure on Ms Rousseff, lowering the bar for the adoption of a more orthodox approach to policy.

The tide appears to be turning, with elements of an improved macroeconomic picture starting to fall into place. The central bank has exhibited a somewhat greater sense of autonomy and the end of its aggressive tightening cycle, which has been in place for more than a year now, may be close at hand – at least this is the message from the modest decline in market breakeven rates. In this regard, signs of easing in food price inflation have certainly helped. Fiscal discipline has moved higher on the government’s agenda – although there is still a lot left to be desired on this front. Also, a gradual phasing-out of certain subsidies and price controls, including on fuel, is now being discussed. And, lastly, more emphasis has been placed on supply-side initiatives – for example, related to the launch of infrastructure concession programs.

Still, there are risks. These relate primarily to structural impediments that prevent the effective operation of monetary policy as a means to control inflation, and to the upcoming election, which limits the government’s incentives to conduct painful fiscal reform.

Persistent inflation partly due to structural factors

The persistence of Brazil’s inflation problem is a self-inflicted wound – there are structural factors that have prevented the proper transmission of tighter monetary settings through the economy. We identify two prime sources of distortion, which ultimately lead to a re-distribution, instead of a successful harnessing, of inflationary pressures.

The first involves regulatory price controls, affecting – among other things – fuel prices, electricity tariffs and public transport fares. Subsidies may appear to enhance the purchasing power of consumers, but in reality they do not do so on any sustainable basis. Inflationary pressures cannot be contained for long simply by placing a cap on a subset of the consumption basket. Instead, such policies eventually disturb the adjustment of relative prices in the economy, pushing inflation higher elsewhere – particularly on the cost of services, in Brazil’s case.

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Price controls naturally have consequences for the market capitalisation of companies operating in regulated industries. For example, owing to artificially suppressed gasoline and diesel prices, state-controlled Petrobras has effectively been forced to sell below-cost in order to meet local demand. As a result, its share price has vastly under-performed its global peers. It is no coincidence that the stock has rallied by almost 50% since March, on speculation of reduced intervention by the next government.

The second source of distortion involves the extensive use of subsidised credit. A prime example is the TJLP rate. This long-term benchmark, used on loans to businesses by the Brazilian National Development Bank (BNDES), has not budged from 5% throughout the monetary tightening cycle. Moreover, not only does credit supplied from state-controlled banks represent more than half of total outstanding loans in Brazil, but this share has kept rising throughout Ms Rousseff’s presidency. As such, it is only natural to ask over how much of the credit in the economy the central bank really exerts control.

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Domestic politics a pivotal near-term risk

By effectively making success on fiscal consolidation the authorities’ only real option, S&P’s downgrade may have been a blessing in disguise. But, at the same time, the timing of this action – coming well before the presidential election – effectively gave Ms Rousseff some room for manoeuvre in the near term, allowing her to concentrate on vote-winning policies, rather than meeting this year’s ambitious budgetary targets.

Indeed, despite all the rhetoric, political survival appears to be the current administration’s overarching priority. Earlier this month, Ms Rousseff announced a 10% increase in welfare payments for low-income families and a 4.5% rise in the income tax exemption threshold in 2015, along with a vow to keep increasing the minimum wage by more than inflation. And while the primary budget surplus has expanded to 1.75% of GDP in the year through to March, it is short of the government’s own full-year target of 1.9%. This picture seems to confirm our long-held view that the announced cuts of around $20 billion in discretionary spending for this year may indeed have set the bar too high.

Conclusion

The scenario investors appear to be pricing-in is that the balance of incentives for the next government is skewed to delivering a better, more market-friendly economic policy mix.
In our view, the new government’s strategy for putting Brazil back onto a virtuous economic path should be twofold. First, economic policy must be anchored around credible budgetary targets. That would gradually dispel fears about a further deterioration in Brazil’s credit rating, stabilise the currency and pave the way for lower sovereign yields, facilitating a much- needed pick-up in investment. Second, the distortions implied by extensive subsidies, price controls and the heavy use of public credit must be removed, thereby creating a level-playing field for the effective transmission of monetary policy.

However, achieving success will be no simple task. The external environment is likely to be less favourable for Brazil next year than this. On our central view, the taper will have run its course and markets will instead be focusing on the timing of the first increase in the Fed Funds rate. Moreover, economic growth in China is likely to have slowed still further – by 2015, we may even be in a hard-landing scenario. As such, it remains to be seen for how long the positive attitude of investors towards Brazil will continue. What is certain, though, is that the country’s next President will have very little room for manoeuvre.

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