Brazil COPOM meets Wednesday amidst a worsening domestic and global backdrop. Markets are screaming for rate cuts, but it seems too early now as the pension reform outlook remains uncertain.
Pension reform is running into resistance in Congress. Lower house rapporteur just released a report containing proposed changes to Bolsonaro’s bill. Economy Minister Guedes reacted poorly, calling it a setback and accusing lawmakers of giving into pressure from civil servants. This suggests that relations between the government and Congress are likely to remain strained.
President Jair Bolsonaro said he was open to some modifications. However, he stressed that the final bill can’t jeopardize the planned BRL1.16 trln ($312 bln) in savings to be seen over the next ten years.
The pension reform bill is undergoing debate in a lower house special committee before moving to a full Congressional debate. Lower house Speaker Maia said he hopes to hold the special committee vote June 26. That means the first lower house floor vote won’t come until July at the earliest. Here, 308 votes out of 513 are needed to pass. A second lower house floor vote could come in August or September. Then it would go to the Senate for similar committee and floor votes.
Given all the necessary voting hurdles, there will be lots of horse-trading still to come. Most observers (including us) believe that total savings will drop significantly from the initial BRL1.165 trln figure. We see a final total of BRL600 bln in savings over the next ten years. Furthermore, we believe likely delays to an already long process will push final passage well into Q4.
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 to meet these targets.
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.
Last year, the CMN 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.
Bolsonaro inherited a sluggish economy and it remains sluggish. The IMF expects GDP growth of 2.1% in 2019 and 2.5% in 2020 vs. 1.1% in 2018. GDP rose only 0.5% y/y in Q1, the slowest since Q1 2017. Data so far in Q2 suggest weakness is carrying over. As such, we see downside risks to these growth forecasts. Indeed, the most recent weekly central bank survey shows market expectations for growth of 0.93% this year, half of what the central bank itself expects.
After an earlier spike, price pressures have reversed lower. IPCA consumer inflation was 4.66% y/y in May, down from the cycle peak of 4.94% in April. The inflation target was cut to 4.25% this year from 4.5% in 2018, but the tolerance range remains +/- 1.5 percentage points. Thus, inflation is still in the top half of the 2.75-5.75% target range.
Pipeline price pressures are easing too. PPI rose 7.75% y/y in April, down from the cycle peak of 8.02% in March. IGP-M wholesale inflation rose 7.6% y/y in May, down from the cycle peak of 8.6% in April. These readings suggest potential for further deceleration in IPCA inflation and so we do not think that rate hikes are in the cards this year. However, we think markets are getting ahead of themselves in looking for aggressive easing.
With growth sluggish and inflation easing markets are now pricing in rate cuts. Next COPOM meeting is this Wednesday June 19, and rates are expected to be kept steady at 6.5%. The CDI market is now pricing in two cuts by year-end that would take the SELIC rate down to 6.0%. The most recent weekly central bank survey shows market expectations for a year-end SELIC rate of 5.75% vs. 6.5% previously.
While it is too early to cut rates, the central bank should deliver a dovish hold this week that suggests easing is possible. This is a very similar situation to what we are seeing here in the US. That is, markets are pressuring the central bank to ease even as the bank awaits further information. The last move in Brazil was a 25 bp cut back in March 2018. After this week, the next COPOM meetings are July 31, September 18, October 30, and December 11. The deciding factor for a potential rate cut is likely to be successful passage of pension reforms.
The fiscal accounts remain weak, underscoring the need for pension and tax reforms. The 12-month nominal consolidated budget deficit remains stuck near -7% of GDP in April and reflects a primary deficit equal to -1.4% of GDP. The OECD sees the nominal deficit narrowing to -6.2% in 2019 and -5.9% in 2020, but we think this is too optimistic. Passage of pension reforms late this year won’t impact the numbers until 2020. Meanwhile, sluggish growth will depress 2019 tax revenues.
The external accounts are likely to deteriorate modestly. Exports had been contracting y/y three straight months through April before seeing a rebound in May. The IMF sees the current account deficit widening to -1.7% of GDP this year from -0.8% in 2018. FDI inflows will more than cover this shortfall, however.
Foreign reserves are still making record highs. At $386.2 bln in May, reserves cover nearly fifteen months of imports and are equivalent to 6 times the stock of short-term external debt. Lastly, Brazil’s Net International Investment Position is around -32% of GDP, hovering around -30% the last few years. All in all, Brazil’s external vulnerabilities remain relatively low.
The real has been doing better after underperforming for two years running. In 2017, BRL fell -2% vs. USD and was ahead of only the worst EM performers ARS (-14.5%) and TRY (-7%). In 2018, BRL fell-15% and was ahead of only the worst performers ARS (-50.5%), TRY (-28%), and RUB (-17.5%). So far in 2019, BRL is -0.4% and is behind only the best EM performers RUB (+8.5%), THB (+4%), MXN (+2.5%), PHP (+0.8%), PEN (+0.6%), IDR (+0.4%), and INR (-0.2%). Our EM FX model shows the real to have NEUTRAL fundamentals, and so we expect this outperformance to ebb a bit.
Brazil equities continue to outperform. In 2018, MSCI Brazil fell -7.7% compared to -17.4% for MSCI EM. So far in 2019, MSCI Brazil is up 13.4% vs. 6.3% for MSCI EM. With growth likely to remain sluggish, we expect Brazil equities to continue underperforming, as suggested by the VERY UNDERWEIGHT in our EM Equity Allocation model. One potential trigger would be a less dovish than expected central bank, as markets are betting heavily on rate cuts in H2.
Brazil bonds are outperforming. The yield on 10-year local currency government bonds is -127 bp YTD and is behind only the best EM performer the Philippines (-176 bp). With inflation likely to ease further and the central bank likely forced to tilt more dovish, we think Brazilian bonds can continue to outperform.
Our own sovereign ratings model showed Brazil’s implied rating steady at BB/Ba2/BB this quarter. Actual BB-/Ba2/BB- ratings are likely to be kept steady until the Bolsonaro government demonstrates its ability to enact significant pension and other structural reforms.