Financial markets in Brazil have outperformed most global and other emerging markets since the start of the year. In particular, the Bovespa index of equities has rallied by about 10% in local currency terms while the currency, the Brazilian real, has delivered a total return of almost 12% against the US dollar.

It is never easy to pin down the exact drivers of markets, but there appear to be at least three key reasons why Brazilian assets have found favour with investors.

What is behind the strong year-to-date performance in Brazil?

1) Valuations.

Perhaps most obviously, after underperforming for much last year, valuations had become more appealing.

2) Covid-19.

There have been fewer negative headlines regarding Covid-19 and the political outlook. As it happens, new Covid-19 cases have risen sharply in recent months, reaching a peak of almost 200,000 new infections on a 7-day rolling average at the end of January.

That is almost three-times the peak that was reached in June last year. However, the successful roll-out of vaccines has so far meant that higher infection rates have not translated into worse health outcomes, raising hopes that Brazil has found a way to live to Covid.

3) Inflation.

The central bank has finally caught up with rampant inflation, helping to allay fears that policymakers are behind the curve. Late last month the monetary policy committee at Brazil’s central bank, known as COPOM, raised its policy Selic rate by 150bps to 10.75%; taking it above the annual rate of inflation for the first time in over a year. The move brings total policy hikes to 875bps since Brazil’s central bank began tightening rates in March last year.

Is Brazil out of the woods with regards to inflation?

Investors got a reminder last week that Brazil's inflation battle is not over yet. The headline rate rose to 10.4% year-on-year (y/y) in January, from 10.1% y/y in December, largely due to a small uptick in food inflation and a larger increase in the core, ex energy and food, rate.

That raised question marks about whether or not the apparent peak in inflation, at 10.7% y/y in October was a false start. Indeed it has led to some reassessment of the outlook for short term interest rates after the minutes from January COPOM meeting were more hawkish than expected.

We expect inflation to trend down during the course of this year. Leading economic indicators remain consistent with some further decline in food inflation in the months ahead. That said, the risk of higher global commodity prices and disruption cause by local droughts can’t be ignored.

We use futures prices to forecast the UN Food and Agriculture Organization food price index, a monthly measure of actual food prices, and have converted to Brazilian reais in the chart below. These figures point to a deceleration in annual food prices this year.

And an absence of strong demand pressures should ultimately ensure that core inflation falls back.

Much like in the rest of the world, core inflation has overshot expectations in recent months. This is as bottlenecks in global supply chains, coupled with frictions as the domestic economy reopens, have fuelled price pressures.

This has the potential to run for a while longer. However, the economy does not appear to have rebounded much from recession in the middle of last year. This is evidence that demand conditions are not strong. Meanwhile, higher interest rates typically feed through to weaker economic activity with a lag of about two quarters. This is shown in the chart below. All of this suggests that core inflation will fall back in the months ahead.

What does this mean for investors?

A decisive peak in inflation, coupled with an underwhelming growth outlook should support further gains in the local bond market as investors reassess the outlook for monetary policy. And policies to reinvigorate Brazil’s economy are likely to take centre stage during the campaign ahead of the general election that is due to take place in October.

After all, despite huge political upheaval in recent years, Brazil’s economy is only marginally bigger than in 2011.