Brazil Euphoria Getting Overdone

Market euphoria over new Brazilian President Bolsonaro remains strong. Yet the economy remains weak and the new government is still untested. We think market optimism on Brazil is due for a reset, like what was seen with Mexico and AMLO.


Jair Bolsonaro was sworn in as President on January 1 and he has hit the ground running. In a little more than a week, he has followed through on several of his campaign promises by decree and promised that there is more to come. To someone who has been following Brazil for three decades, the huge rightward shift is simply amazing. In a clear snub to leftists, Bolsonaro withdrew invitations to his inauguration from Cuba and Venezuela.

Bolsonaro has issued numerous executive orders already. Responsibility for certifying indigenous territories as protected lands was transferred to the Ministry of Agriculture, which is feared to favor industrial interests over the indigenous peoples. Other measures include eliminating a division of the Ministry of Education that sought to expand access for higher education for disadvantaged communities. The Ministry of Labor was dissolved.

Paulo Guedes is Bolsonaro’s point-man on the economy. A Chicago-trained economist who studied under Milton Friedman, Guedes represents a clean break from the statist model of Brazil’s past. Guedes has identified three pillars of improve public finances: pension reform, privatization, and tax reform. Therefore, he has pledged to slash pension spending, sell off state assets, and simplify a complex tax code. Privatizing Eletrobras is reportedly being considered, along with ports, highways, and wind farms.

The choice of Justice Minister Sergio Moro is noteworthy. As a judge, Moro headed up the Car Wash corruption investigation and jailed former President Lula. As such, Moro is seen as clean and trustworthy in a country where politicians seldom really are. Given Bolsonaro’s strong anti-corruption platform, Moro will be under pressure to deliver.

Government officials are reportedly still working on the pension reform proposal. A final draft is expected to be submitted to Bolsonaro early next week. Reports suggest that the government has decided yet on which parts of the reforms proposed by former President Temer will be kept. Raising the minimum retirement age is a given. Bolsonaro claims the support of 300 deputies (out of 513 total) in the lower house, a clear majority but still short of the two thirds needed to amend the constitution as needed for pension reform.

So far, investors love Bolsonaro. The Bovespa is trading at record highs, while the real is the strongest since October 29, the day after the second round of the election was held. Yet we cannot help but think that investors have gotten overly bullish on Bolsonaro and his reform prospects.



Lula was the first leftist president since before the long period of military rule. Bolsonaro’s popularity is a direct result of a backlash to the policies of Lula and his successor Dilma Rousseff.

The military held power in Brazil from 1930 to 1945, led by Getulio Vargas. Democracy returned in 1945, leading to a succession of democratically elected presidents (including a second period for Vargas in 1951 until his suicide in 1954) and an extended period of economic prosperity. Juscelino Kubitschek was elected president in 1956, with Joao Goulart as his running mate. Kubitschek favored diversifying the economy and opening it up to foreign investment,

Goulart had moved up the ranks of the Brazilian Labor Party (PTB) to eventually become party president. Goulart was the Labor Minister for President Vargas. In that role, Goulart pursued what was then considered to be controversial policies that favored labor, such as improving the social safety net and raising the minimum wage.

After serving under Kubitschek, Goulart remained Vice President in the 1960 elections under new President Janio Quadros. Goulart then became president in 1961, when Quadros resigned. Congress was reluctant to appoint him President as many felt Goulart was too far left for the nation. A compromise was reached that made him President, albeit with curtailed powers. For now, a military coup was averted.

However, a referendum in 1963 allowed Goulart to assume full presidential powers. Goulart then embarked on his so-called Basic Reform Plan. This was meant to reform many areas of the economy, such as education, taxes, and land. He nationalized several oil refineries too.

The military felt this leftward lurch was too much and so there was a coup in March 1964. Goulart fled the country for Uruguay and Ranieri Mazzilli became interim president. The junta eventually named senior leader and Army Chief of Staff General Humberto Castelo Branco to the presidency. All political parties were suspended, and new presidential elections were scheduled for October 1966. Goulart was the last leftist leader of Brazil until Lula was elected in 2002.

There has been much debate about the US role in the 1964 coup. Concerns about the direction of Brazil under Goulart first arose in 1962 during President Kennedy’s administration. Robert Kennedy traveled to Brazil in 1962 and met with Goulart to warn him of the presence of anti-American leftists in his administration. As is well-documented elsewhere, the US had a heavy hand in the region during the Cold War.

Declassified US documents suggest that at the very least, the CIA funneled aid and support in covert action ahead of the coup. The US went so far as to set up US Navy positions off the coast of Brazil as the coup got under way in case help was needed. It appears that Brazilian military forces really didn’t need the US help when all was said and done, as Goulart was quickly and efficiently overthrown.

Since the end of military rule in 1985, Brazil’s political landscape has been dominated by four parties: 1) President Temer’s Brazil Democratic Movement (MDP but originally known as PMDB), 2) Brazil Social Democracy Party (PSDB), 3) Workers’ Party (PT), and the Democrats (originally called the Liberal Front Party or PFL).

Voter fatigue with these traditional parties helps explain the rise of Jair Bolsonaro and his Social Liberal Party (PSL). The PSL was founded as a liberal party in 1994 but was transformed into a right-wing party with the acceptance of Bolsonaro into the party last January. His stance as an outsider seemed to resonate with voters, as did voter fatigue after years of PT rule under Lula and Rousseff.



Bolsonaro inherits a sluggish economy. The IMF expects GDP growth of 2.4% in 2019 and 2.2% in 2020 vs. an estimated 1.4% in 2018. GDP rose only 1.3% y/y in Q3, and data in Q4 suggest that the slowdown carried over. As such, we see downside risks to these growth forecasts.

Price pressures are still easing. IPCA consumer inflation rose 3.86% y/y in mid-December, the lowest since mid-June. December IPCA data will be reported Friday and is expected to ease further to 3.71% y/y. The inflation target fell to 4.25% this year from 4.5% in 2018, but the tolerance range remains +/- 1.5 percentage points. Thus, inflation is below target and moving towards the bottom of the 2.75-5.75% target range.

Pipeline price pressures are still easing. PPI rose 10.69% y/y in November, the lowest since May. IGP-M wholesale inflation rose 7.5% y/y in December, the lowest since June. These readings suggest potential for further deceleration in IPCA inflation.

The central bank will have a new president. Roberto Campos Neto takes over for Ilan Goldfajn and comes from a stint at Banco Santander (Brasil). No date has been set for the transition, though Goldfajn has said his successor should be in place by March. The notion of central bank independence has been bandied about, but so far, no timetable has been set by the incoming administration.

With growth sluggish and inflation below target, markets have pushed out tightening expectations. Markets do not see a start to the tightening cycle in Brazil until H2 2019. Next COPOM meeting is February 6, and rates are widely expected to be kept steady at 6.5%.

The fiscal accounts remain weak, underscoring the need for pension and tax reforms. The nominal consolidated budget deficit was -7.1% of GDP in November and reflects a primary deficit equal to -1.5% of GDP. The OECD sees this narrowing to -6.5% in 2019 and -6.1% in 2020, but we think much of this improvement is predicated on reform passage.

The external accounts are likely to deteriorate modestly. The 12-month total trade surplus has widened three straight months, with imports slowing significantly in Q4. However, the IMF sees the current account deficit widening to -1.6% of GDP this year and -1.8% in 2020 from -1.3% in 2018. FDI inflows will more than cover this shortfall.

Foreign reserves have edged lower recently. Reserves peaked near $383 bln in May but have fallen to $374.7 bln in December. This is the lowest since December 2017 but still covers nearly 15 months of imports and are equivalent to nearly 9 times the stock of short-term external debt. Lastly, Brazil’s Net International Investment Position has fallen to only -27% of GDP, the lowest since 2015.



The real is outperforming after underperforming the last two years. 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 behind only the worst performers ARS (-50.5%), TRY (-28%), and RUB (-17.5%). So far in 2019, BRL is the best EM performer at +5%, with COP a close second at +4%. Our EM FX model shows the real to have STRONG fundamentals, and so we expect this outperformance to continue.

USD/BRL is trading at its lowest level since October 30 near 3.6875. The pair is on track to test the October 29 low near 3.5865, but further moves beyond that will be difficult until concrete progress has been made on reforms.

Brazil equities are outperforming. In 2018, MSCI Brazil fell -8% and compares to -17.5% for MSCI EM. So far in 2019, MSCI Brazil is up 16.5% vs. a 4.5% gain for MSCI EM. With growth likely to remain sluggish, we expect Brazil equities to start underperforming, as suggested by its VERY UNDERWEIGHT in our EM Equity Allocation model.

Brazil bonds are outperforming. The yield on 10-year local currency government bonds is -18 bp YTD and is behind only the best EM performers Argentina (-137 bp), Chile (-33 bp), and Russia (-30 bp). With inflation likely to remain low and the central bank on hold for much of this year, we think Brazil bonds will continue to outperform.

Our own sovereign ratings model showed Brazil’s implied rating steady at BB/Ba2/BB. Actual BB-/Ba2/BB- ratings are likely to be kept steady until the incoming Bolsonaro government reveals both its intent and its ability to enact pension and other structural reforms.