Some Thoughts on Brazil Ahead of COPOM Meeting

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COPOM meets tomorrow and is widely expected to deliver another 100 bp cut.  While the economy is recovering slowly, the fiscal numbers remain poor as June data out at the end of the week should underscore.  Add in political risk and we see reasons for investors to remain cautious on Brazil.

POLITICAL OUTLOOK

The political landscape remains unsettled for a variety of reasons.  President Temer remains under a cloud of suspicion after recordings were released of him apparently giving the OK to hush money payments.  He faces a lower house vote on August 2 for the case to be heard by the Supreme Court.  Temer seems likely to survive this vote but he risks serving out the remainder of his term as a lame duck.

On the other hand, former President Lula was recently sentenced to nearly 10 years in prison after being convicted of corruption.  Lula remains free on appeal but would be unable to run for president in 2018 if upheld.  He has vowed to fight the charges but recent polls suggest that Lula’s support may be eroding.

The next national elections will be held in October 2018.  Polls have former President Lula in the lead.  Yet virtually all of the frontrunners from the major political parties remain at risk from the ongoing “Carwash” investigations.  Will this bring on a rise in a non-establishment candidate?

Recent press reports suggest the government is discussing changes to the 2017 fiscal targets.  This in turn has triggered rumors of Finance Minister Meirelles resigning in opposition to such a move.  We think this is unlikely but acknowledge that tensions seem to be building.  Other reports suggest Meirelles is mulling other measures, putting him at odds with those that wish to change the fiscal targets instead.

Structural reforms are desperately needed.  Brazil scores very low in the World Bank’s Ease of Doing Business rankings (123 out of 190 and down from 121 in 2016).  The worst categories are paying taxes (181), starting a business (175), and dealing with construction permits (172).  Brazil does slightly better in Transparency International’s Corruption Perceptions Index (79 out of 176 and tied with Belarus, China, and India).

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF at 0.3% in 2017 vs. -3.6% in 2016, picking up to 1.3% in 2018.  GDP contracted -0.3% y/y in Q1, the “strongest” rate since Q4 2014.  Monthly data so far in Q2 suggest a return to outright growth and so we some modest upside risks to the growth forecasts.

Price pressures remain low but bear watching after recently announced fuel tax hikes.  IPCA consumer inflation decelerated to 2.78% y/y in mid-July, the lowest since March 1999.  This is below both the 4.5% target and the 3-6% target range.  There are some upside inflation risks after the government recently announced a fuel tax that would raise BRL10.4 bln ($3.3 bln).  Overall, however, there does not appear to be any demand-pull forces at work.

The data support the case for lower rates and we believe COPOM will cut 100 bp to 9.25% at its July 26 meeting.  Looking ahead, markets are pricing in a 75 bp cut to 8.50% at the September 6 meeting followed by a 50 bp cut to 8.0% at the October 25 meeting.  The weekly central bank survey shows end-2017 and end-2018 SELIC expectations at 8.0%.  With inflation running so low, we see downside risks to the SELIC forecasts and potential for a dovish surprise at the December 6 meeting.

Fiscal policy has been tightened several times.  Besides the fuel tax hike, the government will also freeze spending by BRL5.9 bln in an effort to meet its fiscal targets.  The primary deficit was -2.5% of GDP in May, at the cycle highs.  The nominal budget deficit came in around -9% of GDP in 2016, down from over -10% 2015.  It stood at -9.2% of GDP in May and is expected to end the year around –8.2% of GDP.

The external accounts continue to strengthen.  Low commodity prices have hurt exports, but the sluggish economy has helped reduce imports.  The current account deficit dropped below -1% of GDP in both May and June.  The gap was -1.3% of GDP in 2016, and is expected by the IMF to remain at -1.3% in 2017 before widening to -1.7% in 2018.  If the economy picks up faster, the external accounts may come in slightly worse.  However, the gap will likely continue to be covered entirely by FDI inflows.

Foreign reserves continue to rise steadily near record highs.  At $377 bln in June, they cover over 16 months of import and are 7.5 times larger than the stock of short-term external debt.

INVESTMENT OUTLOOK

The real has done much better after an awful 2015.  In 2016, BRL rose 22% vs. USD and was the top EM performer.  So far in 2017, BRL is up 2.7% YTD and is near the middle of the pack.  Our EM FX model shows the real to have NEUTRAL fundamentals, so this year’s “so so” performance is likely to continue.

Since the beginning of Q2, USD/BRL had traded largely in a 3.10-3.35 range.  Indeed, the 3.10 area has proven to be a tough level to break and the current bounce may have some room to go.  Retracement objectives from this month’s drop come in near 3.1950 (38%), 3.22 (50%, and 3.2465 (62%).

Brazilian equities are underperforming EM after a strong 2016.  In 2016, MSCI Brazil surged 57% vs. 7% for MSCI EM.  So far this year, MSCI Brazil is up 11% YTD and compares to 24% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Brazil at a VERY UNDERWEIGHT position.

Brazilian bonds have outperformed recently.  The yield on 10-year local currency government bonds is about -128 bp YTD.  This is behind only Argentina (-266 bp) and well ahead of the next best Indonesia (-97 bp) and Peru (-78 bp).  With inflation low and the central bank likely to ease further, we think Brazilian bonds can continue outperforming for now.

Our own sovereign ratings model showed Brazil’s implied rating steady at BB+/Ba1/BB+ after a one notch improvement last quarter.  Actual BB/Ba2/BB ratings still have modest upgrade potential.  The economic outlook is poor, but we see scope for further improvement in Brazil’s implied rating if the cyclical recovery picks up as we go into 2018.