Markets Underestimating Brazil COPOM’s Need to Tighten in 2019

Brazil COPOM meets Wednesday amidst a worsening domestic and global backdrop. We think there is a growing case for rate hikes sooner rather than later. Coming on top of planned fiscal tightening via pension reforms, headwinds on the economy are likely to grow.     

POLITICAL OUTLOOK

President Jair Bolsonaro personally delivered his pension reform proposal to Congress. 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. So far, so good.

The pension reform bill recently passed a lower house committee, signaling some progress. The bill passed by a 48-18 vote in the lower house Constitution and Justice Committee and will now proceed to another debate in special committee before going to a full Congressional debate. The first lower house floor vote could come in the first half of June, where 308 votes out of 513 are needed to pass. A second lower house floor vote could come in the first half of August. Then it goes 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 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.

 

ECONOMIC OUTLOOK

Bolsonaro inherited a sluggish economy. The IMF expects GDP growth of 2.1% in 2019 and 2.5% in 2020 vs. 1.1% in 2018. GDP rose only 1.07% y/y in Q4, and data in Q1 suggest a similar growth rate. As such, we see downside risks to these growth forecasts.

Price pressures are rising. IPCA consumer inflation will be reported Friday and is expected to rise to 5.0% y/y, the highest since January 2017. 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 nearing the top of the 2.75-5.75% target range.

Pipeline price pressures are rising too. PPI rose 8.6% y/y in April, the highest since November. IGP-M wholesale inflation rose 8.07% y/y in March, the highest since December. These readings suggest potential for even further acceleration in IPCA inflation. We believe rate hikes are on the table in H2, something the markets are not prepared for currently. This is especially true if BRL continues to weaken.

The central bank has a new president. Roberto Campos Neto took over for Ilan Goldfajn earlier this year. He is more of a markets person than an academic. This does not mean he is better or worse, but just different. He will surely be tested by the markets this year. Bolsonaro pledged to establish central bank independence within his first hundred days, but that deadline has come and gone.

With growth sluggish and (until recently) inflation subdued, markets have pushed out tightening expectations until Q1 2020. Next COPOM meeting is this Wednesday May 8, and rates are expected to be kept steady at 6.5%. However, we believe it should deliver a hawkish hold that recognizes the deteriorating inflation outlook. One analyst inexplicably looks for a 50 bp cut to 6.0%.

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 March and reflects a primary deficit equal to -1.4% of GDP. The OECD sees the nominal deficit narrowing to -6.5% in 2019 and -6.1% 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 have been contracting y/y three straight months through April, though this has been offset by collapsing imports. Overall, 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 at record highs. At $384.2 bln in March, reserves cover fourteen and a half 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 -27% of GDP, the lowest since 2015. All in all, Brazil’s external vulnerabilities remain relatively low.

 

INVESTMENT OUTLOOK

The real has been underperforming for three 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 behind only the worst performers ARS (-50.5%), TRY (-28%), and RUB (-17.5%). So far in 2019, BRL is -3% and is ahead of only the worst EM performers ARS (-16%), TRY (-14%), RON (-4.5%), and KRW (-4.3%). Our EM FX model shows the real to have NEUTRAL fundamentals, and so we expect this underperformance to ebb a bit.

USD/BRL is currently trading near the year’s highs. The pair is on track to test the March 28 high near 4.01. Break above the 4.0 area would set up a test of the August/September highs near 4.21. After that is the all-time high near 4.25 from September 2015.

Brazil equities are underperforming after outperforming last year on optimism regarding Bolsonaro. In 2018, MSCI Brazil fell -7.7% compared to -17.4% for MSCI EM. So far in 2019, MSCI Brazil is up 6.4% vs. 11.4% for MSCI EM. With growth likely to remain sluggish, we expect Brazil equities to continue 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 -41 bp YTD and is behind only the best EM performers Russia (-55 bp), Mexico (-55 bp), and Peru (-47 bp). With inflation likely to rise further and the central bank likely forced to tilt more hawkish, we think Brazilian bonds will underperform more in the coming weeks.

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 incoming Bolsonaro government demonstrates its intent and ability to enact significant pension and other structural reforms.