24 September 2018
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Stéphane Monier, chief investment officer at Lombard Odier, comments on Brazil’s upcoming elections and the potential effects on lenders exposed to emerging markets.
Brazil’s voters go to the polls for the first round of general elections on 7 October in a race closely watched by investors looking for signs of fiscal improvement. High on the priority list for the eventual winner is the urgent need for pension reform to limit the country’s debt, which we consider an important risk in Brazil.
A tense and polarised election campaign offers Brazilian voters traditional left and right candidates as well as an extreme right-wing populist, with little clarity about the likely outcome. Recent corruption investigations, the so-called Lava Jato (Car Wash), have implicated a large share of the political class, destabilising projections as voters widely reject the historic choices.
Emerging market investors are paying attention because Brazil accounts for 9.5% of local currency debt in a universe such as the JPM Government Bond EM Broad Diversified index. Any sustainability crisis in Brazilian debt would have global repercussions, as it would make lenders already exposed to other emerging markets, such as Turkey, less willing to offer Brazil more debt. October’s vote may therefore hold one of the keys to the evolution of emerging markets over the coming months.
Paratrooper, ecologist, prisoner
The tense election campaign saw former president Luiz Inacio Lula da Silva abandon attempts to run for office this week. He is serving a 12-year sentence for corruption and money laundering linked to Petrobras. Lula’s vice-presidential candidate, Fernando Haddad, now replaces him. However, while August opinion polls placed Lula first with voters, only 9% of the electorate now say they support Haddad, putting him in fifth place according to polls from Datafolha on 10 September. A further complication is that Haddad faces criminal charges around 2012 campaign donations.
Attempts to poll voting intentions were thrown into confusion last week when the candidate leading polls in Lula’s absence, Jair Bolsonaro, was stabbed at a rally and hospitalised. Bolsonaro, a former paratrooper and far-right candidate, openly defends Brazil’s former military dictatorship. Despite being a member of congress for two decades, Bolsonaro is a marginal and highly divisive figure, with no experience of creating the political alliances needed to get things done. Poll data now shows him leading with 24% of the intended votes, however, no poll has given him a lead in any eventual second-round vote.
Second is Ciro Gomes with 13% of the vote, representing the centre-left Democratic Labour Party or PDT. Marina Silva, a former environment minister lauded internationally for her work against illegal deforestation, is making her third attempt at the presidency while Geraldo Alckmin, running fourth in the polls and a former Sao Paulo governor, is the only candidate considered business-friendly. Silva and Alckmin account for around 11% and 10% of the polls respectively.
The political perspective will be further confused this month as television campaigning starts and the influence of social media, which Bolsonaro will rely on, remains an unknown.
Urgent reform
Even if there were more clarity on presidential candidates, the prospects for changing the composition of congress are also uncertain. That will be important because reforms to the country’s pension system need a constitutional amendment backed by three-fifths majorities in both houses of congress. Unless that happens, government debt will continue to rise, hurting economic growth and lowering spending on other measures.
At first glance, Brazil’s macroeconomic health might look sound. Its economic recovery is in the early stages, it has an almost-balanced current account and inflation close to two-decade lows have allowed the central bank to more-than-halve its benchmark interest rate to 6.5% over two years.
Still, investors have punished the Brazilian currency. The real has fallen more than 30% since January due to the wider turmoil in emerging markets, rising interest rates in the US, a strong dollar, trade war between China and the US, and the heightened election uncertainties.
As a result, Brazil’s central bank has ended its interest rate cuts despite below-target inflation and weak activity growth. However, rates are likely to stay on hold rather than rise, unless falling investor sentiment pressures Brazilian assets and in turn fuels above-target inflation.
With a fiscal deficit running at 7.3% of gross domestic product, changes to Brazil’s complex pension system are becoming urgent. The world’s eighth-largest economy needs to contain its loss-making pension system that swallows one third of government spending before interest and 9.1% of gross domestic product. The country’s public debt-to-GDP ratio is already around 85% and without reforms may reach 100% within three years according to IMF forecasts. On the positive side, unlike Argentina and Turkey, a large proportion of Brazil’s debt is domestically funded.
“The current administration under (the unelected) President Michel Temer did manage a number of changes, but failed to reform pensions this year and striking truck drivers then brought the country to a halt in May, forcing government concessions over domestic oil price subsidies. The failures have further threatened the economy’s recovery and undermined investor confidence.
The yield on Brazilian government 10-year bonds rose as high as 12.04% on 5 September, its highest in two years. The credit default swap spread, a measure of investor confidence that an economy will repay its debts, widened to as much as 393.73 basis points.
Investment Implications
Brazil’s budget deficit will remain vulnerable to persistently rising US rates. Unless the country’s next government can overhaul the pension system, and in so doing narrow the country’s deficit, the weaker real may eventually trigger a new bout of inflation and in turn force the central bank into tighter policies sooner than expected.
Along with other commodity-dependent exporters such as Russia and South Africa, in the longer term Brazil needs to diversify its economic growth. The winner of next month’s general election will also need to be credible in the eyes of investors and politically skilful enough to forge a concensus capable of tackling the country’s debt burden. That would be a tall order even in less turbulent times.
