Brazil entered 2023 with expectations for its economic growth to slow. A new administration was taking office, bringing a markedly different policy agenda, interest rates were close to seven-year highs, and several growth drivers were burning out. The valuation case for the Brazilian equity market remained compelling though, and inflation was expected to continue to moderate, allowing for interest rates to be eased. Even so, uncertainty prevailed.
Significant noise surrounded Brazil’s economy in the first quarter of the year, largely emanating from policy uncertainty. But uncertainty has turned to positive surprise. Q1 GDP growth of 1.9% quarter-on-quarter (q/q) exceeded expectations, supported by a booming agricultural sector, while the service sector was more resilient than anticipated. Unemployment has fallen to an eight-year low, while inflation is now sub 4%, enabling the central bank to kick off a rate cutting cycle. Meanwhile, policy concerns have eased.
The MSCI Brazil has returned 15% year-to-date, as at 9 August, well ahead of the 7% generated by the MSCI Emerging Markets Index. This masks the volatility seen earlier this year, with the market down -10% on 23 March; since then the market has rallied close to 30%. We recap the key changes in the outlook, and how the longer term picture and valuations have evolved.
Why the GDP growth outlook for 2023 has brightened
The economic outlook in Brazil since the start of the year has improved significantly, especially in the near term.
GDP growth expectations for 2023 have been revised up from just 0.8% in January to over 2% today. Looking into 2024, and despite stronger activity this year, expectations have remained comparatively stable, with an expansion of 1.3% still pencilled in.
A slowdown in the pace of GDP growth had been anticipated this year, as 2022’s growth was supported by various non-recurring factors, such as pre-election spending and the spike in commodity prices after Russia’s invasion of Ukraine.
The upgrading of forecasts came in the wake of a robust first quarter GDP growth print of 1.9% q/q, which came in well ahead of a 1.3% consensus expectation. A large part of this was attributable to agriculture, with output up 19%, while the services sector has been more resilient than expected in the face of high interest rates, and unemployment has fallen to 8%, from close to 9% in March. At the same time, policy uncertainty, which we will come on to, has eased, and with inflation continuing to fall, the central bank has commenced a rate cutting cycle, which should ease pressure on disposable incomes.
With inflation firmly down, interest rate easing is now underway
As in most other economies around the world, inflation accelerated sharply into the pandemic recovery, with further shock to energy and food prices stemming from Russia’s invasion of Ukraine. Brazil’s central bank has taken a proactive and orthodox approach in tightening monetary policy. Despite significant disinflationary trends in the second half of last year, it held policy tight at 13.75% until this month.
The headline rate of inflation fell to 3% in June, and sits comfortably within the central bank’s target range of 3.25% +/-1.5%. The core rate also came down further to 6.6% in June, from 7.2% the previous month. Against this backdrop the central bank cut the policy rate by a larger than expected 50bps. The accompanying communiqué indicated that further easing at a pace of 50bps per meeting is on the agenda.
In addition to falling hard inflation data, inflation expectations for this year have come down, as the chart below illustrates. The disinflationary trend this year will have helped, but policy developments have also played a part. In addition to a fiscal framework plan, which we will discuss below, credible central bank appointments and a commitment to maintain existing inflation targets were also well received. Brazilian real appreciation versus the dollar year-to-date of 8% has also been beneficial.
Policy concerns have moderated
The election of Luiz Inácio Lula da Silva in late October of last year was always going to herald a very different policy approach to his predecessor, Jair Bolsonaro.
There was much debate as to whether the new administration would be more moderate, as seen in Lula’s first term (2003-2007), or more interventionist, as in his second term (2007-10). The appointment of Geraldo Alckmin went some way to easing market concerns. Alckmin is a former governor of the state of Sao Paulo, and in 2018 was presidential candidate for the Brazilian Social Democracy Party; the main opposition party to Lula’s Workers Party during his previous terms. Another factor which alleviated market concerns was the Worker’s Party’s lack of a majority in congress.
After taking office in early January though, market fears picked up. The government appears to have been shrewd by expanding the cabinet to 37 ministries from 23 previously. Most of these appointments were given to opposition politicians, in effect building a wider coalition and gaining a slightly firmer hand in the legislative process. Changes have since been made to the State Owned Enterprises (SOE) Law; reducing a “cooling off” period for moving from a political party to a manager of an SOE from three years to 30 days. Meanwhile a transitional budget was approved which permits the government to lift spending for this year above the spending cap limit.
As a consequence, the first quarter was somewhat noisy from a policy standpoint, with comments regarding public policy unnerving markets; some of which raised concerns around central bank independence. This was evident in part through the movement of the 10 year bond yield through this period.
However, the policy outlook has moderated. This to some extent hinged on the proposal of a fiscal framework, which targets a balanced fiscal budget in 2024, moving to a 0.5% primary surplus in 2025 and a 1% surplus in 2026. A primary deficit of 1.1% is projected this year, but could be nearer 2% once additional spending is accounted for. The government plans to achieve these longer-term targets by limiting spending to 70% of the federal revenue growth recorded over the previous 12 months. The framework replaces a spending cap rule implemented by the Temer administration in 2016; it drew a firm line in the sand on spending, limiting the spending rise to be in line with the official inflation rate.
The Fiscal Responsibility Bill would also impose limits on the growth of government debt, as well as improvements to fiscal reporting, aimed at improving transparency and accountability. The proposal has so far been approved by the lower house and the senate, but amendments to the bill in the senate mean that a further vote in the lower house is required. Coupled to this new fiscal anchor plan are commitments to proposing higher taxes and to increase fiscal revenues. Other legislation is also on the agenda, most notably tax reform with a VAT mooted to replace local and state taxes, and corporate and income tax reforms to follow.
Fiscal sustainability remains crucial, with government debt-to-GDP at 88%, having picked up over the last decade. Approval of the bill is key to allaying concerns over fiscal sustainability, at least for now. Indeed, a major ratings agency recently upgrade Brazil’s sovereign debt citing its improved macro economic and fiscal performance. In addition, the cooperation between the finance ministry and congress in progressing this legislation is bodes well.
On the external side of the economy, Brazil has benefitted from a bumper harvest and a record trade surplus is projected for this year. This should help to bring down the current account deficit, which stood at 2.9% of GDP last year.
The combination of improving fiscal and current account outlooks, together with comparatively high real interest rates and an easing in policy concerns has supported the Brazilian real, which is up 8% year-to-date against the US dollar, as at 9 August.
Risks to the outlook
There are various risks to the outlook, positive and negative. As we have discussed, policy and the fiscal trajectory is an area to monitor, notably the passing of the new fiscal framework. Potential intervention in the economy cannot be ruled out and it may be that rhetoric seen in the first quarter continues, even if underlying policy remains somewhat more orthodox.
The external environment and commodity prices, in particular the outlook for China’s economy, are also important for the export side of Brazil’s economy. While a major stimulus programme in China is not our base case, this scenario would likely be positive for commodity prices, notably industrial metals, which have been mixed year-to-date.
El Niño is another factor to monitor, given potential implication for the agricultural sector and inflation. A pick-up in inflation could slow or delay the pace of monetary policy easing.
What do valuations look like?
Valuations for the Brazilian equity market in aggregate remain very attractive relative to history using a combined Z-score, which measures how far valuations are from their historical mean. This includes price-earnings, 12-month forward price-earnings, price-book and dividend yield (Since 2000).
In fact, on this basis Brazil is one of the cheapest markets in the MSCI Emerging Markets universe.
Looking at some of the individual measures, Brazil is particularly cheap on a dividend yield basis. However, the current dividend yield may not be sustainable, specifically high payouts from SOEs last year. On a trailing price-earnings basis, the market also scores as cheap, reflecting the strong performance of materials and energy companies in particular last year. The degree of cheapness is less on a 12-month forward price-earnings and price-book basis, but valuations are still low relative to history.
Against this backdrop it’s also important to delve further into sector and stock valuations. There is marked nuance at the sector level. Energy, materials, and banks look cheap, while consumer discretionary and healthcare are also more reasonable after a sharp de-rating. Interest rate easing ought to allow sectors under pressure to re-rate, notably the domestic sectors, though it may take time for earnings to recover.
Where do we stand on Brazil?
We continue to favour Brazil. The public policy outlook is improving, after deterioration earlier this year, and the central bank has begun to ease monetary policy from a high level. Meanwhile, aggregate market valuations in Brazil remain attractive.
We talked about Brazil being a rollercoaster market last year and we have seen a similar trend repeated in the first half of 2023. Despite this volatility, the market has rallied and comfortably outperformed wider emerging markets. While policy concerns may contribute to further ebbs and flows in volatility, the direction of travel remains positive, supported by the outlook for an interest rate easing cycle, together with low valuations.