The beginning of 2021 was clouded by a deterioration in the Covid-19 pandemic globally. Brazil was no exception, seeing an acceleration in daily new cases, despite already having a high number. This led to concerns both in relation to the impact on growth and the need for additional fiscal support, which would add further to Brazil’s government debt burden.
Other headwinds included a sharp uplift in inflation, a rise in political uncertainty given the emergence of former president Luiz Inácio Lula da Silva as a potential candidate in Presidential elections in 2022, and questions about the government’s commitment to reform.
However, the market environment and sentiment have improved markedly in recent months. As the chart below shows, Brazilian equities are now outperforming wider emerging markets year-to-date.
So what’s changed?
The pace of vaccinations has picked up
The rate of vaccinations has accelerated after a slow start, as illustrated below. Deliveries are set to increase further in coming months. Just over 35% of the population has received at least one dose as of 30 June and this should rise to more than 40% by the end of August. Daily new cases of Covid-19 recently hit a record high, but have now begun to improve. Hospitalisations have been falling and the vaccination of older and more vulnerable people means that the country may be past its worst point in the pandemic. Rising vaccination rates give hope that Brazil transitions out of the pandemic through the second half of the year.
Economic activity has positively surprised, aided by commodity price strength
The economic recovery in Brazil is underway, despite temporary headwinds from partial lockdowns in March and April. This is reflected in the pick up in high frequency activity indicators and company earnings.
GDP growth was stronger than expected in both Q4 of 2020 and Q1 of this year, aided by stronger commodity prices. The rally in global commodity prices - from iron ore to coffee - has been a tailwind for Brazil. This has benefitted the external accounts and provided support to Brazil’s currency, the real.
As a result, GDP growth expectations have been revised up. The Schroders economics team now forecasts growth of 4.7% this year, up from 2.8% previously.
The central bank has reacted to higher inflation
The central bank has responded to the pick up in inflation, which has jumped to 8.1% year-on-year in May from 4.6% in January, taking its policy rate up to 4.25% from 2% at the start of the year. It has also pledged to increase the pace of rate rises from 75bps to 100bps at the next meeting, if required.
In combination with stronger commodity prices and an improved GDP growth outlook, the central bank’s commitment to contain inflationary pressures has supported the real.
We expect the headline interest rate to reach 6.5%. Inflation is expected to peak in the near term – base effects will diminish as we move through the year and recent currency strength will have a beneficial negative passthrough to inflation. Real rates are therefore to be positive by the end of the year.
The budget has been approved, easing near term fiscal concerns
Disagreement over spending between congress and the executive delayed the approval of the 2021 federal budget. This largely centred on the need to balance pandemic-related support, congressional spending demands, and mandatory outlays without breaching the spending cap rule.
Enacted under the leadership of President Temer back in 2016, the spending cap rule imposes a limit on additional spending at the previous year’s inflation rate. It is the cornerstone of the government’s fiscal framework in terms of anchoring confidence in its commitment to reducing the deficit and overall debt.
Agreement was found and the budget passed, though the pandemic-related support for this year will be excluded from the spending rule. This amounts to a budgeted BRL 122 billion, far less than the BRL 551 billion deployed last year. However, the scale of spending in the budget is higher than expected at the start of the year.
The recovery in nominal growth is leading to a reduction in Brazil’s gross debt to GDP ratio from 89% at the end of 2020. Nonetheless, it is still one of the highest levels in emerging markets, hence fiscal discipline and reform are important to the performance of Brazilian assets. The fiscal deficit was close to 6% of GDP before Covid-19, but was on an improving path. The impact of the pandemic pushed this to 14% of GDP in 2020. The expected economic recovery and some reduction in spending versus last year means this should fall to below 8% of GDP this year.
Reform progress has picked up
After uncertainty earlier in the year, linked to unexpected management changes at state-owned enterprises, reform momentum has improved. In particular, the government’s strategy to reduce the state’s role in the economy has seen further divestment and asset sales. This includes the privatisation of state-owned enterprises such as Caixa Seguridade, the insurance arm of bank Caixa Economica, and most recently the announcement of the privatisation of utility company Eletrobras.
Minister of the Economy, Paulo Guedes, has masterminded the pro-market reform agenda with a focus on improving trend growth and ensuring fiscal discipline and fiscal sustainability. The government is now seeking to pass administrative and tax reforms but there is a relatively short window for their legislation given the political cycle – unless progress is made before the end of the year then legislation is unlikely before next year’s election.
What are the risks to the outlook?
The outlook for Brazil is not all plain sailing. Coronavirus cases are falling but remain elevated. That said, the roll out of vaccines is expected to support normalisation as we move into 2022.
Inflation too bears monitoring, and may surprise to the upside. Rainfall has been materially lower this year and drought conditions in central and southern Brazil have pushed reservoir levels down to 40% of capacity. As hydro power accounts for over 65% of the country’s overall energy mix, there is a risk that water and energy rationing or tariff hikes could be required later this year.
The upcoming presidential election in November 2022 is arguably the most important consideration for investors. Former president Luiz Inácio Lula da Silva - Lula - is expected to run and opinion polls currently imply a two horse race with President Bolsonaro. With two candidates at either end of the political spectrum and elevated government debt, policy uncertainty could drive financial market volatility. Furthermore, heightened political competition could lead to renewed concerns about both reform commitment and fiscal discipline as we move into an election year.
A brighter picture, though 2022 risks cannot be ignored
We continue to favour Brazil. Vaccine penetration should support an economic rebound through the second half of 2021 and into 2022. Valuations are reasonable and attractive versus other global emerging markets. The currency is cheap and supported by robust external accounts and monetary tightening. Success in reform would be a positive catalyst. However, structural challenges persist and political risk will be rising as we move into 2022 and election year.