Despite Market Optimism Around Bolsonaro, Brazil Fundamentals Telling A Different Story

The market euphoria in Brazil since the election last fall of right-wing populist President Jair Bolsonaro does not mask the fundamentals of economic weakness and the investment risks that accompany it.

But the clean break from the past that Bolsonaro and his University of Chicago-trained economy minister Paulo Guedes represent is not lost on long-time observers.

“To someone who has been following Brazil for three decades, the huge rightward shift is simply amazing,” Win Thin, global head of emerging market strategy with Brown Brothers Harriman, said. “And in a very direct snub to so-called leftists, Bolsonaro even withdrew invitations to his inauguration from Cuba and Venezuela.”

Guedes, a co-founder of investment bank BTG Pactual, has identified three pillars for improving the country’s public finances: pension reform, privatization, and tax reform. He has pledged to drastically cut pension costs, sell off some state assets and simplify the tax code.

Bolsonaro also designated Banco Santander executive Roberto Campos Neto to succeed Ilan Goldfajn as central bank president.

Pension Vow

While details on the pension plan are incomplete, raising the minimum retirement age is a given. Bolsonaro claims the support of 300 out of 513 deputies in the lower house, a clear majority but short of the two-thirds needed to amend the constitution as required for pension reform.

“We are going towards a market-driven economy,” Guedes asserted in a February 10 Financial Times article. He said that a pension reform plan that will save the country the equivalent of $350 billion over 10 years will be approved “within five months.”

Investors’ optimism is reflected in record highs on the Bovespa exchange, while the currency, the real, rose since the second round of voting on October 29, 2018.

“Yet we cannot help but think that investors have gotten overly bullish on Bolsonaro and his reform prospects,” Thin stated.

Reviewing Bolsonaro’s appearance in January at the World Economic Forum in Davos, Switzerland, Ryan C. Berg of the American Enterprise Institute said the new president made a “moderately good” first impression. “His honeymoon could end quickly,” Berg wrote, “once the new Congress begins in February and investors turn to scrutinizing both the stability of Bolsonaro’s congressional coalition and his prospects for passing pension reform.”

Modest Growth Rates

The International Monetary Fund expects GDP growth of 2.4% in 2019 and 2.2% in 2020, up from the estimated 1.4% in 2018. The third quarter 2018 rise was only 1.3% year-over-year, and some analysts see downside risks in the forecast.

With slow growth and inflation below target, markets do not see a tightening cycle in Brazil before mid-2019. Data shows the nominal consolidated budget deficit was -7.1% of GDP in November and reflects a primary deficit equal to -1.5% of GDP.

The OECD sees this narrowing to -6.5% in 2019 and -6.1% in 2020. In addition, foreign reserves dipped from nearly $383 billion in May 2018 to $374.7 billion in December. That is the lowest since December 2017 but still covers nearly 15 months of imports and is equivalent to nearly 9 times short-term external debt.

Outpacing Emerging Markets

The real has turned around after two years of underperforming, which Thin expects will continue.

The MSCI Brazil index, which fell 8% in 2018 while MSCI EM as a whole dropped 17.5%, is up 16.5% in 2019 versus a 4.5% gain for MSCI EM.

“With growth likely to remain sluggish, we expect Brazil equities to start underperforming, as suggested by its very underweight within our emerging market equity allocation model,” Thin explained. “Also, the country’s bonds are seeing brighter days, coming in behind Argentina’s in second place of emerging market performers.

“With inflation likely to remain low and the central bank on hold for much of this year, we think Brazil bonds will continue to outperform,” Thin added.