Fixed Income Boutique
The second round of the Brazilian presidential elections is taking place this Sunday. The race is now tight with polls showing Luiz Inácio Lula da Silva and Jair Bolsonaro in a technical tie despite the former keeping a small lead inside the error margin.
Local and foreign investors cheered the catch-up move, as markets typically take it for granted that right-wing governments are better at fostering economic growth while managing public finances responsibly. However, our base case still is that Lula da Silva will win by a small margin. Bolsonaro’s negative gap of 6.5 million votes in the first round must be closed by a massive transfer of votes – more than 70% – from the voters of Simone Tebet and Ciro Gomes, who ran in the first electoral round, or by a significant transfer of votes from invalid and blank ballots in favor of the current president. However, abstention, which is illegal in Brazil, and spoiled voting have always been stable in Brazil, so this is unlikely to change the game.
Economic reforms will probably advance under either administration because there is no other way to meet the expenditure limits imposed by the constitutional spending cap. Lula Da Silva would certainly be actively trying to repeal that cap, but the bar seems too high for his coalition to obtain a qualified majority for that purpose. This is especially true in the Senate, where the right-wing parties are dominant. Bolsonaro would also be keen on adjusting that constraint, but the political capital of his economy minister Paulo Guedes is not unlimited, and he will have to accept some trade-off among his main objectives.
The most urgent challenge for either winner must be the administrative and tax reforms. A Lula presidency would probably also try to reduce inequalities, boost investments in education and infrastructure, put the environment back in the agenda – including stopping the Amazon’s deforestation – and re-establish the role of the country in the international community. Instead, a Bolsonaro presidency would continue to work on reducing the role of the State in the economy, and improving the ease of doing business, while trying to restore a fiscal discipline that was undermined by the electoral campaign.
The privatization of state-owned companies, as well as the auctions of licenses to operate public infrastructures, are a core objective of Bolsonaro’s Economy Minister Paulo Guedes and will remain so if Bolsonaro wins a second mandate. In fact, that is the only card he can play to reduce the public debt burden when real interest rates are much higher than real GDP growth and given the big challenge of maintaining a budget primary surplus next year. On the other hand, large-scale privatizations face many judicial and political hurdles and take a lot of time to materialize. Specifically, the privatization of Petrobras would not only take longer than a presidential term but would also face reluctance, not to say opposition of Bolsonaro himself, whose populist playbook requires constant and active interventionism in the pricing policy of the company. In contrast, a Lula presidency would certainly put an end to privatizations of state-owned companies, but we do not believe re-nationalizations are on his agenda either.
We do not paint such a rosy picture of the economy in Brazil. Growth is present, but it is mostly the result of the post-Covid re-opening of the economy, multiple rounds of fiscal stimuli, and high commodity prices. All these factors are about to either be phased out or simply wane. Expectations for next year are a lot lower and barely in positive territory.
Headline inflation is particularly low now, but is primarily due to the tax cuts in energy products implemented last summer. Non-administered prices have been slowing down too thanks to the restrictive monetary policy, but core inflation is still at an elevated level, which is a cause of concern considering the tightening cycle is now over. In addition, we are concerned by the double-digit level inflation still prevalent in food and beverage because this category of goods is important for a large part of the Brazilian population.
Another cause of concern is the circa 1 trillion reais of non-performing consumer debt weighing on family finances. Almost 80% of Brazilian families are indebted and 30% of them are struggling to service their debt due to the extremely high levels of interest rates on private loans. For example, an auto loan costs around 2% per month (circa 27% p.a.) and a credit card overdraft, costs around 14% per month (circa 380% p.a.).
We believe caution is also warranted on fiscal policy. The good performance witnessed in fiscal revenues so far this year has been mostly allocated to tax cuts and subsidies rather than debt reduction or net capital formation.
On the debt sustainability side, after decreasing substantially last year thanks to the high nominal GDP growth, the gross debt over GDP is poised to resume its march higher in 2023. The net debt will be affected by the negative mark-to-market effect of the higher dollar rates on the forex reserves. Additionally, the cost of servicing the public debt is still quite high (almost 25% of government revenues) as more than 70% of the debt stock is indexed on either the monetary policy rate (via the Letras Financeiras do Tesouro) or on inflation (via the Notas do Tesouro Nacional – Série B/C). Therefore, there is little room for euphoria on that side too.
All in all, we are not overly alarmed, but we do not think the Brazilian real is particularly cheap and we are skeptical about the optimistic view that has been prevailing recently. We are more constructive on the duration side, where we see room for rates to compress in the run-up to the start of the monetary-policy easing cycle. Real (inflation-adjusted) interest rates are unsustainably high and that’s where we see the most compelling risk-reward at present.
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