A mere 12 months or so ago we were in the middle of the Lava Jato scandal and the market was still obsessing about when, with a budget deficit approaching 10% of GDP, the Brazilian government would be likely to achieve a primary surplus and have any prospect of reversing the deterioration of debt/GDP numbers. Fast forward to today and it is barely of concern to investors.
The budget deficit remains sizeable. Barring a slashing of government expenditure, a primary surplus won’t be achieved any time soon, and debt fundamentals will continue to deteriorate. Government Debt/GDP is likely to breach 80% in 2018.
Fiscal sustainability is impossible without social spending reform. Brazil certainly has the propensity to disappoint investors regarding pension and social security reform, both pre and post the 2018 election, a major pillar of fiscal discipline must be an expenditure ceiling. Brazilian politics are wont to add to any noise and one risk to watch out for at the election would be a fragmented centre ground opening the way for a populist candidate to make it to the second round of voting, even if it is likely they would be defeated at this juncture.
Conversely, falling inflation, which may well persist with 13% unemployment and a large output gap, should make it possible to continue reducing domestic interest rates and boost domestic credit, demand and consumption. The BCB (Banco Central do Brasil) recently cut the SELIC interest rate by a further 75bp to 7.5% at the 25 October meeting and left the door open for further rate cuts, albeit at a ‘slower pace’ – ie, 50bps as opposed to the regular 75bp cuts. This means that the SELIC rate is likely to be 7% at the end of 2017, but with the BCB’s own inflation projections being below or approaching target levels up to 2020, there is a possibility that rates could near the 6% mark in the first half of 2018. We should not be unappreciative of significant reform already enacted by the Temer administration, but despite the progress made, the political and macro instability Brazil has recently experienced means that the market requires excessive real yields compared to its peers. With an election coming up in October 2018 we should view a SELIC rate of 6% as at the very low end of rate expectations.
However, with 95% of government debt denominated in BRL, and $370bn of FX reserves which could easily cover USD denominated govt debt, BNDES (National Bank for Economic and Social Development) debt and other Quasi govt USD denominated debt, an imminent default is very unlikely.
While the music of a benign external environment plays a bossanova beat we may as well make our way over to the dance floor, as recent 10yr Govt USD issuance at around 240bps over US treasuries still represents value, especially versus select, much less diversified, and fundamentally weaker single B rated issuers. The local bond curve may still benefit from rate cuts, and there is a possibility for a reduction in the required level of real yield compensation after the recent TLP reform. We could also reasonably expect a greater allocation towards Brazilian equities from domestic pension funds, should rate cuts persuade locals to exit the lower yielding bond markets.
Carl Shepherd is a fixed income portfolio manager at Newton Investment Management, part of BNY Mellon IM