Brazil Central Bank Preview

Brazil’s COPOM meets tomorrow and is expected to keep rates steady at 6.5%. The tightening cycle should begin in October, but much will depend on the real and how it trades around next month’s elections. Volatility is likely to remain high and tied to opinion poll results.

POLITICAL OUTLOOK

Presidential and congressional elections will be held on October 7. If no presidential candidate wins a majority, the top two vote-getters would go to a second round on October 28. All 513 seats in the Chamber of Deputies (lower house) will be elected, along with two thirds of the 81 seats in the Senate. The makeup of Congress will be crucial.

Former Brazil President Luiz Inacio Lula da Silva officially endorsed his running mate Fernando Haddad as the candidate for the Workers Party (PT). Lula will remain imprisoned and unable to run after electoral officials barred him. The endorsement came right before the September 11 deadline for the PT to name a replacement for Lula. According to the country’s “clean slate” law, anyone with a criminal conviction that’s upheld on appeal cannot run for elected office.

Presidential candidate Jair Bolsonaro was seriously wounded this month at a campaign stop. He is now in stable condition, but markets are trying to gauge the full impact of the horrific stabbing. The knee-jerk reaction was positive due to the notion that Bolsonaro would get the sympathy vote. Polls up until the stabbing had shown him leading the first round but losing to virtually all possible candidates (tied with Haddad) in the second.

Recent polls support this notion, but Haddad is also rising to the top. The most recent MDA poll shows Haddad (17.6%) and Bolsonaro (28.2%) as the two likely frontrunners. Ciro Gomes comes in third with 10.8%, followed by Geraldo Alckmin at 6.1%. In a runoff, the polls show Bolsonaro beating Haddad. However, markets remain wary of Haddad’s rising popularity after he received Lula’s official blessing. The race really remains too close to call.

 

A BRIEF HISTORY LESSON

The Monetary Policy Committee (COPOM) was created in June 1996. This was part of incoming President Cardoso’s efforts to reform the economy by introducing a more orthodox policy framework. Brazil later adopted formal inflation targeting in 1999 to enhance predictability and transparency. COPOM’s objective is to set monetary policy via the SELIC (overnight) rate in order to meet these targets.

The debate of central bank independence has been going on for years. While functionally independent, formal autonomy continues to be kicked down the road. Current Governor Ilan Goldfajn is a big proponent of independence since taking over in mid-2016. However, President Temer recently signaled that it would be left for the next Congress to consider.

COPOM is made up of the members of the BCB Board of Governors. This consists of the Governor and eight Deputy Governors that oversee 1) Monetary Policy, 2) Economic Policy, 3) International Affairs and Risk Management, 4) Financial System Organization, and Control of Farm Credit, 5) Supervision, 6) Regulation, 7) Institutional Relations and Citizenship, and 8) Administration. The Governor casts the deciding vote in cases where the COPOM is evenly split on a policy decision.

The inflation targets are set by the National Monetary Council (CMN). Initially established in December 1964, the CMN has evolved over time but it is currently comprised of the Minister of Finance, the Minister of Planning, and the BCB Governor.

The CMN recently cut the 2021 inflation target to 3.75% +/- 1.5 percentages points. There had reportedly been a split in the Council, with the Finance Ministry wanting to reduce it to 3.75% and the Planning Ministry wanting to keep it steady at 4.0%. The targets for 2019 and 2020 are 4.25% and 4.0% +/-1.5 percentage points, respectively. This compares to the 2017 and 2018 target of 4.5% +/- 1.5 percentage points. From 2006-2016, the target was 4.5% +/- 2.0 percentage points.

 

ECONOMIC OUTLOOK

The economy remains sluggish. GDP growth is forecast by the IMF at 1.8% in 2018 and 2.5% in 2019 vs. 1.0% in 2017. GDP rose only 1.0% y/y in Q2, down from 1.2% in Q1 and 2.1% in Q4. This is the weakest since Q2 2017 and reflects the negative impact of the truckers’ strike. While this was a temporary headwind, we see downside risks to the growth forecasts.

Price pressures are low but likely to resume rising. IPCA consumer inflation rose 4.19% y/y in August, decelerating for the first time after four months of acceleration. Mid-September IPCA will be reported Friday and is expected to rise 4.36% y/y. PPI rose 14.3% y/y in July, the highest since the series began in December 2010, while IGP-M wholesale inflation rose 8.9% y/y in August, the highest since September 2016. All the signs are pointing to significantly higher IPCA inflation ahead.

COPOM halted its easing cycle after the last 25 bp cut to 6.5% back in March. Heightened political risk forced the bank to remain on hold in May when another 25 bp cut was expected. Of the 34 analysts polled by Bloomberg, only 1 sees a 25 bp hike tomorrow. After tomorrow, the next policy meetings this year will be held October 31 and December 12. If inflation continues to trend higher as we expect, we think the first hike will be seen in October. Much will depend on the real and how it trades around the elections.

The fiscal outlook bears watching. We saw a cyclical improvement in the budget numbers as the economy recovers and interest rates fell, but the structural outlook remains poor given pension reforms are dead in the water. The 12-month nominal deficit was -7.0% of GDP in July, the lowest since February 2015. The Bloomberg consensus sees the nominal deficit at -7.5% in 2018 and -6.7% in 2019, which seem too optimistic.

The external accounts are worsening. The current account deficit was -0.5% of GDP in 2017, and the IMF expects the deficit to widen modestly to -1.6% in 2018 and -1.8% in 2019. However, export growth has been slowing noticeably this year while imports are surging, leading the trade surplus to narrow. This will likely put upward pressure on the current account gap.

Foreign reserves are near record highs and vulnerabilities remain low. At $381.4 bln in August, reserves cover over 15 months of imports and are 8 times the stock of short-term external debt. However, Brazil’s Net International Investment Position (NIIP) is a rather high -36% of GDP, so some vulnerabilities are present.

Note that outstanding FX swaps now stand at $68.9 bln. BRL stability in the early summer led to a period of no new swap issuance after June 22. However, this calm was shattered in late August and a new round of swaps was issued on August 30. Any significant currency weakness would lead to BCB losses that are reflected in the fiscal accounts. That’s what we saw back in 2015 and 2016.

 

INVESTMENT OUTLOOK

The real continues to underperform. In 2017, BRL fell -1.7% vs. USD and was ahead of only the worst EM performers ARS (-14.5%), and TRY (-7.2%). So far in 2018, BRL is -20% and is ahead of only the worst performers ARS (-53%) and TRY (-40%). Our EM FX model shows the real to have WEAK fundamentals, and so we expect this underperformance to continue.

USD/BRL traded at its highest level this year on August 30 near 4.1325 before dropping back briefly. The 4.0 area is likely to be a good base for USD/BRL, as the pair is on track to test the September 2015 all-time high near 4.2480. There is an upward sloping channel on the weekly chart dating back to 2007. The top of that channel comes in near 4.97 currently.

Brazilian equities continue to underperform. In 2017, MSCI Brazil was up 21% vs. 34% for MSCI EM. So far this year, MSCI Brazil is -19% YTD and compares to -11.5% YTD for MSCI EM. Our EM Equity Allocation Model puts Brazil at VERY UNDERWEIGHT, and so we expect Brazilian equities to continue underperforming.

Brazilian bonds have underperformed. The yield on 10-year local currency government bonds is +195 bp YTD. This is behind only the worst performers Argentina (+767 bp), Turkey (+684 bp), Indonesia (+205 bp), and the Philippines (+200 bp). With inflation likely to move higher and the central bank expected to start a tightening cycle soon, we think Brazilian bonds will continue underperforming.

Our own sovereign ratings model shows Brazil’s implied rating steady at BB/Ba2/BB. Actual BB-/Ba2/BB- ratings are likely to be kept steady ahead of the October elections, especially since pension reforms are dead in the water.