Ms Rousseff’s political brinkmanship is depriving the Brazilian economy of a credible fiscal anchor, weakening the hand of the next administration – whoever wins October’s election. Meanwhile, the decade-long decline in Brazil’s unemployment rate may be coming to an end, aggravating the economy’s stagflationary dynamics. The recent strong performance of local financial assets has been driven by expectations related to October’s result; as we close in on the election, any further gains are likely to come with elevated volatility attached. Once political considerations move from centre stage, however, investors will need to shift their attention back to a challenging set of ‘initial conditions’: souring domestic fundamentals; Brasilia’s limited policy flexibility; and escalating external macro headwinds going into 2015. In this environment, positive market momentum will become increasingly difficult, if not impossible to sustain.
As we noted earlier this year, investors have been switching back into Brazilian financial assets, encouraged by the rising likelihood of a transition to policies that have a better chance of pulling the economy out of the stagflationary vortex in which it finds itself. The scenario market participants appear to be pricing-in is one in which the balance of incentives for the new government is skewed to delivering a more orthodox, market-friendly set of measures.
In this regard, S&P’s downgrade in March of the country’s sovereign rating to just a notch above ‘junk’ status has arguably made the incentive for Brazil’s next president to deliver even more compelling – whoever ends up winning. At the same time, the timing of this announcement effectively removed the threat of further rating action before October’s election, thereby allowing more room in the near term for the incumbent to concentrate on boosting her chances of electoral success.
A prolonged period of political uncertainty and resultant reform inertia is already doing no favours to Brazil’s fragile economy. But by opportunistically stepping on the fiscal gas pedal, Ms Rousseff may be pushing her luck a bit too far, putting the country’s economic prospects in jeopardy. The administration is effectively moving the policy mix back in the wrong direction, skewing the balance of risks further to the downside.
Fiscal discipline remains elusive…
While Ms Rousseff is still the leading candidate, the polls continue to indicate that the likelihood of an outright victory is getting progressively slimmer. Not only does a runoff now seem inevitable, but the incumbent’s chances are converging with those of her main rival, Marina Silva. The latest polls show that the two candidates are effectively tied for a second-round.
As the pressure builds, the incumbent has resorted to Chinese-style ‘fine-tuning’ stimulus measures aimed at winning votes, rather than pursuing policies consistent with this year’s ambitious 1.9% primary surplus target. Since the spring, she has announced higher welfare payments for low-income families, unveiled initiatives to support the manufacturing industry and promised a rise in next year’s income tax exemption threshold, to name a few. At the same time, the government continues to effectively conduct credit policy through state-controlled financial institutions in the hope of spurring domestic demand through more lending – although, in our view, treating the symptoms will not do much to address the real problem, which is waning demand for credit rather than lack of supply.
We have already expressed our skepticism about the administration’s ability to deliver on some R$45 billion in announced discretionary spending cuts this year. Unfortunately, the latest official data seem to confirm our fears. In July, Brazil posted a primary budget deficit for the third straight month, to the tune of R$5 billion, coming on the heels of a combined R$13 billion deficit for May and June. Growth in tax collection has been slow due to contracting economic activity while expenditures have surged across the board: subsidies, social spending and transfers to regional governments have all moved higher. With the year-to-date primary surplus now well under R$30 billion, fiscal performance in the first seven months of this year has been the worst since 2000, pushing the trailing twelve-month primary surplus to 1.2% as a share of GDP at a time when real interest rates have been on the rise.
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It should come as no surprise that last week Treasury chief Augustin effectively acknowledged that the administration is assessing whether to lower its fiscal target for 2014. This also makes it more likely that the state will need to rely, yet again, on extraordinary revenues in order to have any hope of closing in on fiscal objectives – the government’s latest budget review pencils in around 0.5% of GDP in one-off revenues over the next few months, coming mainly from oil/telecom concessions and private sector tax re-negotiations. Over and above the associated execution risk, this will compromise the quality of fiscal consolidation. But more importantly, budgetary slippage weakens the ‘initial conditions’ facing the new administration by undermining the credibility of Brazilian leaders in the eyes of investors, constraining policy flexibility, crowding out private investment and amplifying the economy’s vulnerability to shocks.
Against this backdrop, while Brazil’s sovereign debt dynamics remain relatively benign, they may be getting nearer to an inflexion point. Public debt-to-GDP is still at low levels, but it has been on the rise this year as low nominal growth and weak budgetary contributions have failed to offset elevated debt-servicing costs. As a result, net consolidated public debt increased as a share of GDP by 1.5 percentage points to 35.1%, and gross general government debt by 2.3 percentage points to 59%, in the seven months to July. The ratings agencies are certainly keeping a close eye on the evolution of these dynamics, rendering the new government’s task of articulating a convincing economic strategy all the more pivotal. Last week, Moody’s – which still rates Brazil two notches above non-investment grade – put the sovereign on negative credit watch and said the economy was unlikely to rebound in the short term, raising the possibility of a downgrade to ‘junk’ status down the road.
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…while the economy is in stagflation mode
Meanwhile, Brazil remains in stagflation mode. GDP growth has been below trend for some time and the economy even entered a technical recession during the second quarter, while leading indicators continue to point downwards. Elevated political uncertainty has caused economic activity, particularly business investment, to stall. Hampered by high inventory levels and political uncertainty, momentum in industrial production has fizzled, registering a contraction of 3.6% in the twelve months to July. Capacity utilization remains on a downward trend, private sector confidence has been sagging for some time and retail sales growth has decelerated sharply, as depicted in the charts below. As a result, expectations for GDP keep getting ratcheted down. Banco Central do Brasil’s latest weekly survey of market economists recorded yet another reduction in the consensus forecast for this year’s growth to 0.48%, while the consensus for growth in 2015 stands at a mere 1.1%.
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The inflation picture has become somewhat more stable following a cumulative 375 basis points of hikes in the policy rate since April 2013. Annual headline CPI now rests just above the 6.5% upper bound of the central bank’s comfort zone, while inflation expectations have stabilised somewhat. But overall price pressures can be expected to remain sticky, keeping the central bank on high alert and interest rates elevated for the foreseeable future. First, non-regulated prices are still running at 7%, driven by strong pressures in the services sector. Second, artificially suppressed administered prices – which make up around a quarter of the CPI basket – should continue to rise on an annual basis well into next year due to base effects; particularly if the next administration embarks on a normalisation of subsidy policy, as widely expected. Third, if prolonged budgetary slippage triggers a loss of investors’ faith in Brasilia’s ability to enforce fiscal discipline, the currency will come under pressure, volatility will rise and inflationary pressures will get amplified as a result.
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…and the labour market no longer is such a bright spot
Against a weak macro backdrop, it was only going to be matter of time until Brazil’s labour market – arguably one of the few economic bright spots available to Ms Rousseff in her campaign for re-election – began to show signs of stress. So far, unemployment has remained well-contained in spite of the slowdown in economic activity. It has been trending down for the last ten years and, at a non-seasonally-adjusted rate of 4.9%, remains one of the lowest in the world, underpinned by a robust services sector. At the same time, real wage growth has stayed positive and is likely to remain so – Ms Rousseff has explicitly vowed to keep increasing the minimum wage by more than inflation, which goes some way to explaining the stickiness of CPI. However, this benign employment picture is starting to look somewhat tenuous.
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From a cyclical perspective, the combination of souring fundamentals and restrictive monetary settings is starting to bite. Job creation has become more sluggish. The twelve-month moving average of new ‘formal’ (i.e. government-registered) jobs, as reported by Brazil’s Ministry of Labour, has resumed its decline this year and is heading to levels last seen during the Great Recession, pulled lower by manufacturing. And as the boost from the World Cup subsides, the relatively positive momentum in the services sector could soon wane. In turn, this has been exerting downward pressure on real wage gains, which slowed to 2.6% in the twelve months to April (the latest month for which there is available data) – down a full percentage point since the start of the year and tracking the deceleration in GDP.
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Perhaps more worrying is the fact that labour market tightness has been underpinned by a sustained contraction in the labour force – potentially a harbinger of weaker trend GDP growth and a higher structural deficit. Both the numbers of the unemployed and those either in employment or actively seeking work have been shrinking: the so-called ‘economically active’ population contracted by 0.8 percent in the year to April, posting its seventh consecutive monthly fall and marking the most sustained contraction in more than a decade. Moreover, this could be more than a temporary phenomenon. Brazil’s workforce has been adversely affected by a declining fertility rate, down by some 30% in the last two decades to 1.8 children per woman, according to World Bank data. Also, an increasing proportion of the young population (18-24 age bracket), which makes up around one sixth of the labour force, has been opting out – in line with Ms Rousseff’s push to get more people into university or training. As a result, Brazil’s labour participation rate has fallen significantly.
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Weak macro to weigh on markets once investors shift their focus away from the politics
Positive sentiment on Brazilian assets has been pinned on high expectations for an improved economic strategy by the new government. While there may well be further gains in the near term, they are also likely to come with elevated volatility attached, in view of how close the presidential race has become. As an illustration, when last week’s polls indicated a pick-up in Ms Rousseff’s popularity the Bovespa fell by 6%; and implied volatility in the Real has bounced meaningfully during the last couple of weeks, as the chart below illustrates.
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Over and above the short-term jitters, however, investors need to remain alert to a disheartening macro backdrop, characterised by a challenging combination of souring domestic fundamentals with escalating external macro headwinds going into 2015 – not least as Fed policy is set to move closer to a phase of rate normalization. As such, the sustainability of positive market momentum for Brazilian assets beyond the near term appears increasingly tenuous, particularly as Brasilia’s policy flexibility is relatively constrained at this juncture. First, further fiscal indiscipline would raise the likelihood of a sovereign downgrade, with severe repercussions across the board. Second, a lower policy interest rate would risk another flare-up in inflation, and in its latest Minutes the central bank indeed indicated no interest rate cuts are on the cards for the foreseeable future. And, third, meaningful structural reforms remain on hold in view of the upcoming election, holding back much-needed investment spending.
Conclusion
Credible fiscal targets form the linchpin of any policy mix that has a chance of success in putting Brazil’s economy back on a virtuous path. They are essential for anchoring the currency, paving the way for sustainably lower interest rates and inspiring investor confidence. With Brazil’s credit rating standing marginally above ‘junk’ status, policymakers’ room for manoeuvre is limited. Ms Rousseff knows full well that what the economy needs is neither opportunistic fiscal props nor distortive interventionist practices, but putting in place the reforms that will drive an increase in domestic savings, improve productivity, enhance competitiveness, inspire private sector confidence and address supply-side bottlenecks which hamper investment, keeping a lid on potential GDP growth.
If fiscal discipline remains elusive, reform inertia persists, the employment picture takes a decisive turn for the worse, and the health of the financial sector is threatened by asset quality impairment, Brazil’s economic fortunes will continue to deteriorate. Moreover, there are significant external macro risks lying ahead. China’s slowdown could still escalate to a hard landing, leading to further erosion in Brazil’s terms of trade; and sentiment on emerging markets could soon succumb further to the potential onset of tighter US monetary settings. Then the Brazilian economy’s back could actually come close to breaking.
This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.
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