investment insights

    Brazil prioritises rate hikes and financial stability over growth

    Brazil prioritises rate hikes and financial stability over growth
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Key takeaways

    • The monetary tightening cycle is close to completion in Brazil: we expect another two interest rate hikes, taking the terminal benchmark rate to 12.25% in May
    • We see the country’s inflation remaining well above the central bank’s target and GDP stagnating in 2022
    • Brazil is one of the few major economies to offer positive real rates; it has an only-slightly negative current account deficit and much debt is held by local investors. The Fed’s expected hikes should therefore not increase the risk of capital outflows
    • Our forecast for the USDBRL exchange rate at the end of this first quarter is 5.25.

    Brazil’s central bank, the Banco Central do Brasil (BCB), gained its political autonomy a year ago and almost immediately became the first major economy to begin hiking its benchmark borrowing rate. The cycle is almost complete and the country now offers investors a positive real yield.

    In February 2021, the Brazilian parliament approved a law that leaves the central bank’s governor, Roberto Campos Neto, free from the threat of being fired by the government or interference over monetary policy. The governor’s four-year mandate is renewable once, halfway through the government’s term in office.

    Almost immediately, the BCB started its rate-hiking cycle. Since March 2021, when the country’s interest rate was 2%, Brazil’s monetary policymaking committee has lifted interest rates by a total of 875 basis points (bps). Including this month’s 150 bps hike, the benchmark or ‘Selic’ rate is now 10.75%. Rising food, commodity, and energy prices, plus a severe drought, drove consumer costs to an 18-year record rise of 10.7% in November 2021. Brazil’s economic growth slowed to a technical recession in 2021: the second and third quarters recorded contractions of -0.3% and -0.1%.

    Latin America’s biggest market began 2022 suffering from high inflation and a slowing economy. In January 2022, inflation rose 10.4%, compared with a year earlier. The BCB now explicitly targets price stability with a 3.5% annual inflation goal, and on 11 January already said that it would miss that level this year. Given the nation’s history of high public debt and spending, the central bank cannot afford to let inflation run unchecked.

    Prices in Brazil may have already peaked

    While inflationary pressures remain high, prices in Brazil may have already peaked, and the central bank is actively managing the risks. However, if the central bank fails to hold prices stable, it risks ‘de-anchoring’ expectations, undermining the effectiveness of its monetary policy.

    We expect further policy rate rises at the central bank’s March and May meetings of an additional 150 bps in total, which would take the terminal rate to 12.25%.

    Brazil’s policy rate adjusted for inflation is close to a three-and-a-half-year high, giving a real rate of around 0.2% (see chart 1). That compares favourably with most markets. For example, the US policy rate adjusted for inflation is -7.4%, and the yield on 10 year Treasury Inflation-Protected Security (TIPS) is -0.43%.

    In addition to Brazil, nominal and real yields are attractive in a handful of emerging economies compared with developed markets. Tightening cycles are well advanced in most emerging economies, with Russia and Brazil ahead of the rest. With around 200 bps more of hikes to come, most hiking cycles should peak by mid-2022 (chart 2). However, as the difference between developed and emerging market growth narrows, inflation is proving persistent and governments may prove less fiscally generous, creating a macro risk.

    Stalling growth

    As inflation is set to stay high through 2022, Brazilian monetary policy will remain contractionary and growth continue to stagnate in 2022. The highly commodity-dependent economy has benefited from booming demand in the wake of the pandemic with the country’s balance of trade reaching a record surplus of USD 61 billion in 2021. Demand from the country’s main export market, China, should remain supported thanks to loosening monetary policy designed to encourage growth. We forecast China’s economy to expand 5% this year.

    Brazil exported USD 67 billion worth of goods to China in 2020, of which around one-third was soybeans, according to the Institute for Applied Economic Research (IPEA). Bad weather last year disrupted the Brazilian soybean harvest, undermining some of the country’s export volume as China turned to more US suppliers. Brazil’s second and third biggest exports are crude oil and iron ore. The price of Brent crude oil has gained 24% year-to-date while iron ore has risen by almost one fifth as demand for use in steel production increased.

    The political agenda is likely to generate market volatility as the year progresses

    In October 2022, Brazil will hold both Congressional and presidential elections. Campaigning will intensify around July when political advertising begins, followed by a first televised debate scheduled for August. There are two main candidates, former President Luiz Inácio Lula da Silva and incumbent Jair Bolsonaro. Recent electoral campaigns have proven turbulent, and the political agenda is likely to generate market volatility as the year progresses.

    In an electoral year with Brazil politically polarised, the government may struggle to pass radical spending proposals. Markets will focus on fiscal policy, the country’s trade profile, and specifically commodity exports.

    Brazil’s gross government debt-to-GDP ratio declined in 2021 to 91%, from 99% the previous year, according to the International Monetary Fund. The fall in this debt ratio was mainly because the recovery boosted growth. There is little danger of sharp capital outflows even as the US Federal Reserve implements its rate hikes, thanks to Brazil’s positive rate differential with the US, as well as a contained current account deficit and a mostly domestically-held public debt.

    Similarly to our rationale for initiating Chinese debt exposure in 2020, we believe that it makes sense to expose portfolios to Brazil’s advanced monetary policy cycle, while diversifying away from geopolitical risks. We see value in Brazilian government debt in reais, as this offers opportunity to earn yield from carry trades. This is not based on a currency view as the real tends to be volatile.

    Along with support for the Brazilian economy from commodity prices through 2022, the BCB is more advanced than many other central banks in the monetary normalisation process. As a result, Brazil’s inflation and interest rates should peak before mid-2022. That, we expect, will leave the country’s inflation-adjusted interest rate among the highest of major emerging economies in the second half of 2022. Of course, we will closely monitor the risks, which in this case are linked to the domestic 2022 election cycle.

    In January we lowered our US dollar-Brazilian real forecast for the end of March to 5.25. We believe that the fair value of the USDBRL currency pair, based on Brazil’s debt to GDP ratio, is closer to 5.00, compared with today’s exchange rate of 5.06.

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