Risks in a low inflation Brazil


Rob Dwyer
Published on:

It is no understatement to say that the country is uncharted territory. The news is all good right now. But next year’s presidential election could return it to familiar, volatile territory.

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Do you remember the joke about central banking and trading that did the rounds when global quantitative easing was in full swing? 

There were variations around the theme that good economic news was positive for shares and so traders bought. And when data was bad, that led to expectations of further monetary expansion, which was positive for shares and so traders bought.

A similar thing is happening in Brazil with the central bank and expectations for rate cuts. The market sees any increase in the chance that the government will pass pensions reform as a positive for the country’s weighty fiscal problem and, as monetary policy won’t be alone in fighting inflation, that opens up scope for further rate cuts. 

Meanwhile, spikes in political risk lead to lower chances for big fiscal reform, which in turn will dampen the nascent recovery – and that economic weakness opens space for the central bank to make further rate cuts (in the short term, clearly the longer-term narrative for inflation and therefore rates is different).

People with just a passing interest in Brazil may not realize it, but the central bank has been waging a very successful war on inflation (helped by the country’s deepest recession in more than a century). In June, the monthly inflation index was actually negative for the first time in 11 years. After years of flirting with the top of its target band (6.5%), before leaping into double digits at the start of Dilma Rousseff’s second administration, annual inflation is now nearing the lower range (2.5%; in July the IPCA-15 price index hit 2.78%). 

Central banks president Ilan Goldfajn is in danger of having to write an open letter to Congress explaining why inflation has dipped below the lower boundary – a remarkably swift descent given the high degree of indexation still present in the economy. 

We do not yet know who will run. Lula may be prohibited from being a candidate but isn’t yet. So, if we don’t know who will run, we have no idea about who will win 

All this has sent economists scrambling to lower their predictions for where the floor will be for the Selic – or overnight – rate in this easing cycle. I was about to use BNP Paribas’ revised prediction of a 7% floor by March 2018 as the example of where a regularly-outside-consensus but often-right Marcelo Carvalho was pointing, when an email from Itaú dropped into my inbox matching this prediction. 

Think about that: Brazil with a 7% Selic in the first quarter next year – and with unheard-of-low inflation, meaning real rates are still between 4% and 5%.

To say this will be new territory for Brazil is an understatement. True, Brazil did see a 7.25% Selic in 2012, but this was artificially pushed down by a government that was dismissive of persistently high inflation and fiscal laxity. This made real rates negative and ultimately unleashed double-digit inflation and recession (and a 14.25% Selic).

Anticipating these changes will be the key to capitalizing on this rare window. The government has started. It is moving to change the interest rate that the national development bank BNDES levies for its loans from TLJP (a rate decided by committee) to one that is linked to the yield on inflation-indexed government debt. 

The government says it will still be below the market rate but it will end government subsidy (the TLJP rate was 7% when Selic was 14.25%, meaning the money lent to business was less than half the cost that the government needed to pay). 

The government has also increased taxes and made further cuts to government spending. This will help with the fiscal adjustment in the absence of broader reform and the lower interest rates will also help the government accounts by lowering the cost of its rising debt burden. 

Meanwhile, 7% to 8% nominal rates and real rates of between 4% and 5% are still going to be high enough for carry-trade momentum to continue (unless there are any surprises from the US Fed) – especially when the FX impetus is with the real and against the dollar.

Falling rates will also help the local economy by lowering the cost of debt servicing, freeing up space for renewed retail consumption and possibly corporate investment (although the bank spread remains punishingly high – as does unemployment). 

Global tailwinds

All in all, the near-term outlook for the Brazilian economy is positive. It should benefit from global tailwinds, see some important micro adjustments by the government and investors (both local and international) should be able to make some profitable investments by anticipating the lower rate environment. 

But… remember that jump in the Bovespa and the real in July when former president Luiz Lula da Silva was sentenced to nine-and-a-half years in jail? That revealed that while the markets shrug off the soap opera surrounding the current government (the Bovespa barely reacts to huge political shocks these days), investors are very much focused on the presidential election of 2018. 

We do not yet know who will run. Lula may be prohibited from being a candidate but isn’t yet. So, if we don’t know who will run, we have no idea about who will win. 

However, it seems a safe bet to say that at some point political risk could begin to drive Brazilian markets again and, if investors don’t like what they are seeing in the polls as the election nears (and it is certainly possible they won’t), FX and asset price volatility could come roaring back. 

So, timing an exit to the coming rally becomes key. If the 2018 election starts to spill political risk back into the markets, all positive bets will be off. And the money that remains exposed at that point could be lost in an instant.