Brazil prospects brighten after rate hike

Financial markets in Brazil cheered the central bank’s larger-than-expected interest rate hike and hawkish rhetoric last week.

With the central bank now raising rates, and inflation likely to peak in the coming months, there appear to be attractive entry points into local assets after several months of underperformance.

That being said, investors will still need to tread carefully. The country continues to grapple with Covid-19, and there are uncertainties regarding next year’s general election.

Why Brazilian assets have underperformed recently

Brazil’s central bank raised its headline interest rate by 75bps to 2.75% last Thursday. This was larger than the consensus 50bps which markets had expected. The bank also dropped a heavy hint that it will deliver another three-quarter point hike at its May meeting, marking the culmination of a rocky few months for local markets. The move was one of a series of hawkish surprises in major emerging markets (EM) last week.

Government bonds, as measured by the JP Morgan Broad Brazil Index, have suffered a loss of 4.9% in local currency terms year-to-date. Meanwhile, as the chart below illustrates, Brazil’s currency – the real - has underperformed other EM currencies such as the South African rand, which has recouped the losses suffered in the first half of last year.

There are at least three reasons why Brazil has underperformed in recent months.

First, the Covid-19 pandemic has recently deteriorated in the country.

Second, there have been persistent concerns about the public finances after a large fiscal support package saw the government’s budget deficit balloon last year. According to the IMF, the government’s budget deficit is expected to have been around 17% of GDP, lifting gross debt to around 100% of GDP. This is one of the highest debt ratios of any major EM, as the following chart shows.

Third, a sharp rise in inflation has caught investors and central bankers off guard, and exposed Brazil’s extremely low policy interest rate, known as the Selic rate.

Is bad news now reflected in markets?

In our December Economic and Strategy Viewpoint we warned that rising inflation, mainly due to higher food costs, would unsettle the bond market and eventually force the central bank to raise interest rates later this year.

But the fallout has been even more severe than we had anticipated. The central bank has aggressively hiked rates just five months after reiterating its dovish forward-guidance in late October. That communique guided for inflation and rates to remain very low for a long time, and even hinted at the possibility of further policy easing.

Looking ahead, most of the bad news is probably now in the market with regards to inflation. Consensus expectations have increased steadily. And while food inflation may remain elevated for a while longer, and energy inflation will spike in the near term, both should eventually fall away as quickly as they rose.

Importantly, relatively subdued economic growth should ultimately keep a lid on underlying core price pressures and anchor headline inflation in the long-run. We note that the consensus growth expectation has been moving down towards our forecast for GDP to expand by 2.8% and 2.5% this year and next.

The monetary policy committee, known locally as Copom, clearly signalled that rates will rise further. Nevertheless market expectations for rates to climb towards 8% next year seem far too hawkish in our view and we suspect the Selic will settle closer to the 5.5% consensus in the central bank’s FOCUS survey of 100 economists.

Where are the risks to the outlook?

All other things being equal, this ought to be a good time to enter the bond markets. And we also see plenty of opportunities in the equity market. However, there are still lingering concerns for investors about Covid-19 and the outlook for fiscal policy that cloud the outlook.

As we previously noted, the fact that Brazil’s economy has a large services sector means that it should be one of the main beneficiaries in EM from vaccination against Covid-19. However, the roll-out of vaccines still hasn’t reached its full potential, in part due to supply constraints. And Brazil is currently suffering a second wave of infections, with local restrictions re-imposed in many parts of the country. These could be tightened further if new cases continue to rise, adding further pressure to the health system until vaccination rates accelerate.

There was some relatively good news on fiscal policy earlier this month after congress approved a fairly conservative $8 billion of additional emergency aid; significantly less than the $50 billion deployed last year. The size of the package, and the fact that it respected Brazil’s public spending caps, soothed some fears about the government’s commitment to fiscal discipline.

However, the announcement that former president, Luiz Inácio Lula da Silva, has had his convictions for corruption preliminarily quashed by a supreme court justice has taken the limelight somewhat. Time will tell if he will contest next year’s presidential election against the incumbent, Jair Bolsonaro; the full supreme court could yet overturn the decision. But there is a risk that the prospect of a tight election race could alter expectations with regards to the pace of economic reform. At the very least, the re-emergence of Lula is likely to lead to bouts of market volatility.