Fixed Income Boutique
When famous Austrian writer Stefan Zweig published Brasilien, Ein Land der Zukunft (Brazil, A Land of the Future) in 1941, he was referring more to Brazil’s culture and civilization than to its economy. It is only decades after his death that cynical economists started to portray Brazil as a failed utopia, an immense hope that never delivers. This statement is over simplistic, however, it’s fair to say that betting on Brazil to deliver on its economic promises has often required bucket loads of patience and empathy.
Brazil’s problems are simple to explain but difficult to resolve; uniquely gifted in terms of natural resources, the country is too dependent on agriculture and commodity exports which have relatively low value added and economic inclusiveness. This is aggravated by shocking disparities in income, wealth, and education, inherited from the colonial period and resulting in poor labor productivity and little incentive to invest in infrastructure.
The only period in Brazil’s history that achieved a high level of wealth accumulation were the five decades following the crash of 1929. Over this period, the compound growth rate of GDP per capita exceeded 3% p.a. compared to less than 2% p.a. in the USA. That period, known as the “Developmentalist Era”, was marked by a partial, although significant, shift of the country’s economic model away from agriculture and commodity export businesses, toward protectionism and import-substitution industrialization (an economic policy of favoring domestic production over imports).
Of course, there were a lot of ups and downs and it would be unfair to paint too rosy a picture of that period, which was also marked by extended cycles of fiscal irresponsibility and monetary instability, not to mention two dictatorships. The worst part of this unprecedented period of prosperity was that it failed to structurally address social, ethnic, and regional inequalities. The Developmentalist Era was followed by two lost decades of deindustrialization and hyperinflation that fostered a political culture steeped in corruption, clientelism, and patrimonialism1.
The 2000s brought some hope. First, the economy was put back on a healthy track by the Plano Real and President Fernando Henrique Cardoso’s austerity policies from the mid-late 1990s. Second, China accessed the World Trade Organization to literally turbocharge the demand for commodities and global trade momentum in general. From 2003 to 2011, President Luiz Inácio Lula da Silva was in a position to pursue pragmatic economic and social policies that resulted in more inclusive prosperity. However, most of the government policies aimed at boosting demand rather than developing the ailing infrastructure. If a country is unable or unwilling to invest in infrastructure when the economy is booming, it will never do so, and the busts following the booms will be even more painful.
The following decade (2010s) was a slow descent into hell, with the end of the commodity super cycle and the complete failure of the Nova Matriz Econômica economic model, which was a set of growth-oriented economic measures including interest rate cuts, voluntary currency depreciation, tax exemptions for industry, energy subsidies, and a reduction of public investments compensated by an expansion of private credit offered by public banks. This led to the most severe economic recession since the Great Depression of the 1930s. The crisis was aggravated by the largest ever corruption scandal (Petrolão) involving national oil champion Petrobras and construction giant Odebrecht. The action of the unpopular President Michel Temer, who succeeded President Dilma Rousseff after her impeachment in 2016, had the merit of stopping the self-fulfilling spirals of unsustainable fiscal and monetary policies. Temer’s most important accomplishment was probably the passing of the constitutional amendment freezing public spending in real terms for 20 years.
Then came President Jair Messias Bolsonaro, elected on an anticorruption/populist platform as a side effect of the Lava Jato (Car Wash) operation that uncovered the Petrolão corruption scandal. Financial markets obviously cheered the market-friendly economic agenda of Economy Minister Paulo Guedes, including a deep reform of the pension system and a broad agenda of privatizations.
However, the grand plan of Paulo Guedes to boost the economy with Reaganomics-inspired recipes found itself jammed after the initial success of the pension reform passing. In Brazil, no ambitious reform agenda can progress without the support of the Congress where Bolsonaro’s majority coalition is entirely based on pork-barrel politics (maybe in Brazil’s case a more appropriate meat metaphor would be Picanha politics), including the infamous toma lá, dá cá practices (give and take) that Bolsonaro himself had promised to suppress.
But pork-barrel politics only works as long as wooed politicians stay confident their support won’t put their own re-election at risk. And the least we can say is that the rhetoric and the behavior of Jair Bolsonaro became extremely controversial in 2020 after the start of the Covid-19 pandemic. With over 600,000 fatalities, Brazil has the second highest Covid-related death toll in the world after the USA. People did not forgive him for having waited until January 2021 to launch the much-needed mass-vaccination campaign. The latter was so successful in stopping the pandemic that his denial to recognize its necessity damaged his popularity.
What do populist leaders do when they lose popularity? They blame others and they spend. And spend he did. Bolsonaro put the responsibility on the states’ governors and launched an expensive welfare program of stipends. Helping the neediest in the midst of a crisis is obviously laudable but doing it irresponsibly at the expense of fiscal sustainability and price stability is more questionable. All the more in the context of a nascent post-Covid economic recovery. The bill came due earlier this year, catching the central bank off guard and forcing it to embark on an aggressive tightening of monetary policy to fight double-digit inflation, dissipate the fears of fiscal dominance, restore positive real rates, and stop the relentless depreciation of the currency.
What do populist leaders do when their popularity continues to fall despite the spending programs? They double down and promise to spend even more . For markets, the straw that broke the camel’s back was last week’s government announcement that it would breach the spending cap rule to extend and expand the current welfare program, and even offer compensation to truck drivers for the increases in the price of diesel. This triggered a wave of resignations in the Ministry of Economy, including well-respected Special Secretary of the Treasury and Budget, Bruno Funchal, and Secretary of the National Treasury, Jeferson Bittencourt throwing in the towel.
The headlines sent local equity and rates markets into panic mode, only the currency managed to depreciate in an orderly manner thanks to the intervention of the central bank.
We were not expecting the spending cap rule to be under attack at this point, but we do believe valuations have now overshot fundamentals. Even the most adverse scenario now seems priced in. In other words, we see the risk-reward as sufficiently attractive to support the Brazilian real and local rates. In FX, we believe the Brazilian real is now undervalued by approximately 25% versus the theoretical equilibrium level that would be consistent with the country’s economic fundamentals. As for local rates, we prefer to stay cautious at the short end of the curve, but we do like the current term premium offered by the long-term nominal rates over their risk-neutral levels. This is probably enough to absorb more bad news and has the potential to perform well, should the flow of negative headlines run dry. In the best-case scenario, we even see a possibility of the spending cap breach to be rejected by the Congress.
Looking towards next year’s presidential election, we do not rule out that a loss of Bolsonaro’s popularity could result in the emergence of a centrist candidate like Rio Grande do Sul state Governor Eduardo Leite. This off consensus (and not base-case) scenario would, in our view, be celebrated by the markets, which are suffering from a case of populism fatigue.
1. Clientelism: social order dependent on patronage. Patrimonialism: authority based on personal power exercised by a ruler.