Brazil Optimism Overdone, Reality Check Overdue

Brazil optimism is taking a hit as markets reassess political risk. President Bolsonaro fired Secretary-General Bebianno over allegations their PSL party misused campaign funds in last fall’s elections. The timing is bad as it comes just as the government submitted its pension reform bill to Congress, where reports suggest growing pushback from lawmakers against the reforms.      POLITICAL OUTLOOK

President Jair Bolsonaro personally delivered his pension reform proposal to Congress this week. It is estimated to save up to BRL1.16 trln ($312 bln) over the next ten years. Details include setting the minimum retirement age at 65 for men and 62 for women. The plan would also remove the automatic link between social security benefits and the minimum wage and would also increase the social security tax paid by some workers.

More importantly, retirement benefits would be proportional to the years of contributing to social security. Benefits would start at 60% of the average salary and moves up to 100% for those contributing for 40 years. The amounts paid in would also depend on average salaries, with those earning paying a greater share. Lastly, any federal reforms will be extended automatically to states and municipalities.

Now comes the hard part, which is selling the plan to Congress. There will be lots of horse-trading, leading most observers to believe that total savings will drop significantly from the initial BRL1.165 trln figure. Many of the main points in the reforms require a Constitutional amendment. As such, the process will likely be slow going forward. Once all the procedural hurdles are passed, the reforms need to be approved by both houses of Congress in two separate votes each requiring three-fifths. According to Vice President Mourao, about 250 deputies currently support the plan vs. 308 needed to pass it in the lower house.

Even the optimists do not see the reforms approved before the summer ends. Even then, everything must fall perfectly into place. The task has become harder with the recent departure of presidential Secretary-General Gustavo Bebianno, who served as an important liaison to Congress. He was the leader of the PSL party but was fired over allegedly misuse of campaign funds during last year’s elections.

 

A BRIEF HISTORY LESSON

The Brazilian pension system started out the 1920s as a fractious combination of public and private systems. The system was unified in 1966 with the creation of the National Social Security Institute (INPS) that basically covered all workers in the formal sector. It was a mandatory “pay as you go” model in which current workers contributed to the fund. Employers matched these inflows and the proceeds were paid to retirees as pension payments.

Initially, INPS did not cover the informal sector, domestic servants, and rural workers. Rural workers weren’t covered until 1971, with domestic servants covered a year later in 1972. Note that a private sector pension system didn’t fully develop in Brazil until the late 1970s. To state the obvious, it is the public sector system that is crying out for reforms.

Originally, public sector benefits included health care as well as food and housing assistance. Those were spun off by President Fernando Collor and the pension system was renamed the INSS. Still, the 1988 Constitution requires universal coverage of benefits that include healthcare, pensions, and social assistance.

The problems plaguing Brazil’s public pension system are not unique to Brazil. A combination of demographic shifts coupled with too-generous public sector payouts are straining pension systems worldwide. The task of fixing the system is more difficult in Brazil, however, as retirement benefits are enshrined in the 1988 Constitution.

Demographic changes are the major factor behind the growing pension shortfall. Brazil’s population is aging rapidly. In 1988, there were 6 elderlies (65 and older) to every 100 working-age individuals. By 2015, that number had doubled to nearly 12. The OECD forecasts that this number will triple by 2050. In addition, life expectancy in Brazil has risen from 64 years in 1988 to 75 in 2017. On average, Brazilians retire at age 58.

The other side of the coin is that benefits to public sector employees are too generous. Men are currently able to draw full pensions after 35 years of contribution and women after 30 years. Setting a minimum retirement age will address part of the problem, but the pay-ins and/or the payouts also need to be adjusted. Even with previous adjustments to payouts, the system provides 75% of average income. Simply put, this cannot be sustained.

 

ECONOMIC OUTLOOK

Bolsonaro inherited a sluggish economy. The IMF expects GDP growth of 2.5% in 2019 and 2.2% in 2020 vs. an estimated 1.4% in 2018. GDP rose only 1.5% y/y in Q3, and data in Q4 suggest a similar growth rate. As such, we see downside risks to these growth forecasts.

Price pressures are still low. IPCA consumer inflation rose 3.73% y/y in mid-February, a new cycle low. 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 below target and remains in the bottom half of the 2.75-5.75% target range.

Pipeline price pressures are still easing. PPI rose 9.07% y/y in December, the lowest since April 2018. IGP-M wholesale inflation rose 6.7% y/y in January, the lowest since May 2018. These readings suggest potential for even further deceleration in IPCA inflation.

The central bank will soon have a new president. Roberto Campos Neto faces a confirmation vote February 26. If he passes as expected, he takes over for Ilan Goldfajn and will be in place for the March 20 COPOM meeting. 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. There have been some minor grumblings about the next move being a cut, but we do not put much weight on this. Still, the CDI market does not see a start to the tightening cycle until end-2019. Next COPOM meeting is March 20, and rates are 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 December and reflects a primary deficit equal to -1.6% of GDP. The OECD sees the nominal deficit narrowing to -6.5% in 2019 and -6.1% in 2020, but we think much of this improvement is predicated on quick reform passage.

The external accounts are likely to deteriorate modestly. The 12-month total trade surplus has narrowed to its lowest level since January 2016. The IMF sees the current account deficit widening to -1.6% of GDP this year and -1.8% in 2020 from -0.8% in 2018. FDI inflows will more than cover this shortfall, however.

Foreign reserves have edged lower recently. Reserves peaked near $383 bln in May but fell to a cycle low of $374.7 bln in December before rebounding to $377 bln in January. This still covers over 14 months of imports and are equivalent to 6 times the stock of short-term external debt. Lastly, Brazil’s Net International Investment Position has fallen to only -28% of GDP, the lowest since 2015.

 

INVESTMENT OUTLOOK

Until this week, investors loved Bolsonaro. The Bovespa traded at record highs in early February, while the real on February 1 traded at 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. The recent price action suggests a bit of “buy the rumor, sell the fact” with regards to pension reforms.

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 up 3% and behind only the best performers RUB (6.5%), CLP (6%), THB (+4.5%), and COP (+4%). Our EM FX model shows the real to have STRONG fundamentals, and so we expect this outperformance to continue.

USD/BRL is giving up much of its recent gains. The pair is on track to test the February 14 high near 3.80 and then the January 22 high near 3.8160. Break above the 3.8265 area is needed to set up a test of the December 27 high near 3.9430. The 200-day moving average comes in near 3.8250 currently.

Brazil equities are still outperforming. In 2018, MSCI Brazil fell -8% compared to -17.5% for MSCI EM. So far in 2019, MSCI Brazil is up 17.5% vs. 10% 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 -33 bp YTD and is behind only the best EM performers Argentina (-197 bp), Turkey (-104 bp), Chile (-44 bp), Mexico (-42 bp), Russia (-37 bp), and Hungary (-33 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 Bolsonaro government proves its ability to push through pension and other structural reforms.