Has Brazil turned a corner?

investment insights

Has Brazil turned a corner?

Stéphanie de Torquat - Macro Strategist

Stéphanie de Torquat

Macro Strategist

Five key points on what to expect in 2020

Despite sluggish growth in 2019 overall (consensus expectation for the whole year is 1.1%), investor sentiment towards Brazil has improved.

Two key reasons are easing external headwinds in a low-global rate environment, and the advent of domestic tailwinds – notably the approval of a robust and long-awaited pension reform.

However, in order for the “all clear” to be sounded on Brazil’s long-term path, some remaining challenges must be addressed.

 

2020 outlook is encouraging, but not short of challenges

Economic growth in Brazil should gather steam in 2020 from a low base but remain below its historical record, rising from 1.1% in 2019 to around 2.0% in 2020 (LO forecasts).

Growth in Brazil should gather steam in 2020

However, the headwinds and potential downside risks should not be underestimated. Brazil still faces numerous structural issues that will need to be addressed in the coming years, and finds itself in a complex regional environment, whether from a political or an economic standpoint. In addition, the trade relationship between China and the US remains fragile. Any re-escalation would undermine global conditions and weigh on emerging economies such as Brazil.

The path to escape this subdued trend growth will have its share of obstacles.

 

Monetary policy will remain a support in 2020

The advancement of the historically important pension reform in Brazil last year allowed for a welcome anchoring of domestic inflation expectations. Coupled with low growth and easier monetary policy in developed economies, this allowed the Central Bank of Brazil to resume its monetary easing cycle initiated in 2016, cutting the policy rate by a cumulative 200 bps in the last five months of the year alone, from 6.5% to a historical low of 4.5% (chart 1).

The rate-cutting cycle is now likely complete, or very nearly so. However, given contained inflation, signs of slack in the economy (chart 2), and accommodative financial conditions in the developed world, a hiking cycle is also very unlikely at this stage.

Low rates should support investment

In all, rates should remain on hold at presently low levels throughout 2020. This should support investment in the quarters to come – especially given the relatively low levels of leverage in the private non-financial sector (chart 3) – as well as private consumption (see chart 2 again), which should also benefit from an improving labour market despite a still-high unemployment rate (chart 4). The uptick in money supply growth combined with a low non-performing loans ratio (Chart 4 again) indicates potential for credit-led growth in the private sector.

Will the reform momentum be sustained?

On the political front, the event that topped Brazil’s good news list last year was the well-publicised enactment of a major pension reform, after several years of efforts to contain the cost of the country’s highly generous social security system. The move is helping to put public finances back on a more sustainable path. The announced measures, which include higher minimum retirement ages and contribution rates, as well as less generous pension incomes, should allow the government to save nearly BRL 800 bn over the next ten years.

The primary budget should thus improve from a near-1.5% deficit to about a 1% surplus (as a percentage of GDP) by 2030, stabilising the debt ratio at just below 100% of GDP. Without a reform, the ratio would have increased to over 140% of GDP in the same timeframe.

The reform should also bolster investor and business sentiment, as it will allow for more efficient public investment, which social spending has crowded out so far (chart 5).

Without further reforms, investors’ anxiety will soon resurface.

Despite the reform’s long-term economic benefits, it will also unfortunately prove to be insufficient. A public debt ratio approaching 100% of GDP is high by emerging market standards. Without further fiscally consolidating reforms, investors’ anxiety regarding the fiscal credentials of the Brazilian government will soon resurface.

One positive signal in this regard is the fact that both congressional leaders (speaker of the Chamber Rodrigo Maia and Senate President Davi Alcolumbre) as well as pro-market Minister of Economy Paulo Guedes appear committed to additional reforms.

However, with the October 2020 municipal elections approaching, and much of the centre-right and centre already getting together to defeat Bolsonaro in the 2022 elections, the window of opportunity to advance new and complex fiscal reforms is very narrow. Let us not forget that the pension reform had been in the pipeline for almost four years and that Congress was able to use the groundwork of the previous administration to advance quickly.

On the other hand, efforts to simplify the highly complicated tax code, introduce more flexibility in extremely rigid government expenditures, and privatise some of the government’s public assets have not even begun. Moreover, these efforts will likely face much stronger opposition than the pension reform, especially given Bolsonaro’s divisive attitude and lack of legislative coalition.

 

Sound macro fundamentals despite weak public finances

From a fundamental standpoint – barring weak public finances – Brazil fares relatively well compared to other emerging economies. Inflation is contained and the financial system is sound.

From a fundamental standpoint, Brazil fares relatively well compared to other emerging economies

The current account deficit has admittedly widened over the past two years, but it remains in check and, more importantly, is fully financed by sizable foreign direct investment inflows (chart 6), while international reserves amount to almost one-fifth of the country’s GDP, in line with the rest of the emerging world average.

Finally, government debt is too high, but the vast majority is domestically held (chart 7), which mitigates the vulnerability. The external position is therefore robust.

 

Abating trade tensions should ultimately prove positive

In 2020, the external environment should remain conducive to Brazil’s continued positive momentum.

Brazil is admittedly one of the most closed emerging economies: trade openness, defined as exports plus imports as a percentage of GDP, is just over 20%, compared to ~40% in Peru; ~50% in Chile, Turkey, and South Africa; and ~80% in Mexico.

Brazil will benefit from the relative de-escalation of US-China trade tensions

But Brazil will still benefit from the relative de-escalation of trade tensions between the US and China initiated at the end of last year. First, higher commodity prices (e.g. oil, gold) are a support for the economy, and second China is by far Brazil’s main export market, distantly followed by the US (chart 8). We could argue that, in the short term, Brazil may lose some of the exports (e.g. soybeans) it had gained when China diverted its US-sourced imports to Brazil at the height of trade tensions last year. However, the truth is that in the long run, a trade war that hindered the growth of both China and the US would have had negative consequences for all their trading partners, without exception.

Obviously, there is no room for complacency whatsoever. Risks surrounding the implementation of the phase 1 trade deal, as well as upcoming key sticking points in the phase 2 discussion, mean that uncertainty remains and any re-escalation should lead us to revise our outlook for emerging markets – including Brazil.

Important information

This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.

Read more.