Brazil Rally Likely to be Limited

Jair Bolsonaro won the first-round elections in Brazil but did not have the requisite 50% support. As such, he and Fernando Haddad will go to the second-round vote will be held on October 28. With the rest of EM remaining under pressure, we do not think BRL can rally much further. However, it could continue to outperform from a relative standpoint.

POLITICAL OUTLOOK

Jair Bolsonaro and Fernando Haddad will move on to the second-round vote for President. Whilst Bolsonaro did not win enough to avoid a second-round vote, his margin of victory over Haddad was so large (46.2% to 29.1%) that many observers see him as the next likely president.

Bolsonaro’s likely Finance Minister Paulo Guedes is seen as largely orthodox and free-market. With a Ph.D. in economics from the University of Chicago, this seems like a good bet. As always, the problem with pushing a free-market agenda in Brazil remains navigating a large and fractious congress. In this regard, there are some grounds for optimism. Why?

Bolsonaro’s Social Liberal Party (PSL) won 52 seats in the 513-seat lower house, up from 8 previously. Haddad’s Workers Party (PT) won 56 seats, losing 5 but remaining the biggest party. Center-right Progressistas (PP) came in third with 37 seats. Temer’s Brazil Democratic Movement (MDP) won 34 seats, as did the Social Democratic Party (PSD). Ex-President Cardoso’s Brazil Social Democracy Party (PSDB) won 29 seats, as did the Democrats (originally called the Liberal Front Party or PFL).

The big surprise was the overall rightward shift in the lower house. Not only did Bolsonaro’s PSL significantly increase its seat count, but the other center-right parties did better than expected. This came at the expense of the traditional left and center-left parties and supports the notion that Bolsonaro will be able to advance his pro-business agenda through congress.

As further evidence of the left’s decline, center-left PSDB presidential candidate Alckmin won less than 5% of the vote. This is the party’s worst showing ever in a presidential election. Looking at the other leftists, Ciro Gomes came in third with 12.5% while Marina Silva won about 1% of the vote, her lowest showing in three tries. Obviously, the key is how the supporters of Alckmin, Gomes, and Silva vote in the second round. Polls between now and October 28 will be key.

The Senate races were slightly more favorable for the center-left, but not by much. PSL won only 4 seats in the 81-seat upper house. MDP was the biggest winner with 12 seats, followed by PSDB with 8 seats and the Democrats with 7. PT won 6 seats, as did the PP and PSD.

 

A BRIEF HISTORY LESSON

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). Basically, Bolsonaro’s PSL came out of nowhere.

Voter fatigue with these traditional parties helps explain the rise of Jair Bolsonaro and his PSL. Interestingly enough, 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 this January. His stance as an outsider seemed to resonate with voters, as did his campaign against the culture of corruption in the country.

 

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. This was a temporary headwind, and Q3 data so far suggest some acceleration. Nevertheless, we see downside risks to the growth forecasts.

Price pressures are rising. IPCA consumer inflation rose 4.53% y/y in September, the highest reading since March 2017. This is above the 4.5% target but within the 3-6% target range. PPI rose 15.09% y/y in August, the highest since the series began in December 2010, while IGP-M wholesale inflation rose 10.0% y/y in September, the highest since September 2016. All the signs are pointing to significantly higher IPCA inflation ahead.

COPOM tilted more hawkish at its last meeting in September. 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. However, much will depend on the real and how it trades up until and after the second-round vote on October 28. Analysts see no hikes until 2019, while the CDI market is pricing in a 25 bp hike in October and a 50 bp hike in December.

The fiscal outlook bears watching. We saw a cyclical improvement in the budget numbers as the economy recovered 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. However, it rose to -7.45% in August. The Bloomberg consensus sees the nominal deficit at -7.2% at end-2018 and -6.5% at end-2019, which seem too optimistic.

The external accounts are worsening. The current account surplus 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 $380.7 bln in September, reserves cover nearly 16 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. With the real strengthening, we see no further swap issuance near-term.

 

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 -12% and is ahead of only the worst performers ARS (-50%), TRY (-38%), ZAR (-16.57%), INR (-14%), and RUB (-13.5%). 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 4.2135 before dropping to current levels. Today, it has gapped lower to trade at the lowest level since August 7 near 3.7120. The August low near 3.69 will offer some support, as will the 200-day moving average near 3.6050. With the rest of EM remaining under pressure, we do not think BRL can rally much further. However, it could continue to outperform from a relative standpoint.

Brazilian equities are now outperforming. In 2017, MSCI Brazil was up 21% vs. 34% for MSCI EM. So far this year, MSCI Brazil is -2.5% YTD and compares to -14% YTD for MSCI EM. Our EM Equity Allocation Model puts Brazil at VERY UNDERWEIGHT, and so we expect Brazilian equities to go back to underperforming.

Brazilian bonds have underperformed. The yield on 10-year local currency government bonds is +102 bp YTD. This is behind only the worst performers Turkey (+841 bp), Argentina (+698 bp), Indonesia (+216 bp), the Philippines (+192 bp), Hungary (+170 bp), and Russia (+129 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.