Brazil Macroeconomic Brief

Lula Da Silva will be the next president. Although he did not present a specific economic program during his campaign, he said he would focus his government plan on fighting indebtedness and inflation (mainly food, energy, and fuel prices). He aims to resume public investment in infrastructure and housing so as to promote sustainable and stable economic development. Unlike Bolsonaro, and with a markedly statist bias, Lula has even promised to use Petrobras as a vehicle for national development. On the other hand, a key point is a fiscal issue. He plans to repeal the spending cap required by the Constitution, which might be translated into a deeper fiscal deficit. The reaction of the markets will depend on Jair Bolsonaro's response to the results obtained and on the fiscal policy signals of the leader of the workers' party, as well as the appointment of his advisers.

Brazil has been dealing with a stagnant economy for a decade. Nonetheless, this year is showing the best performance since the crisis of 2014, driven mainly by investment. In addition to the fact that unemployment hit a 7-year low, consumption growth accelerated in Q2 even though real wages fell (8%). Meanwhile, export growth was driven by rising Terms of Trade. Despite the electoral cycle and an early, aggressive monetary policy tightening, Brazil is performing a strong fiscal consolidation in 2022. Regarding price dynamics, inflation reached 12.1% YoY but it is already cooling down thanks to tax cuts, mainly on fuels and energy.

Activity

Brazil's economic activity fell in August after showing two months of acceleration (June +0.75%; July 1.67%). Although the Central Bank Economic Activity Index (IBC-Br) continues to show positive YoY values ​​(+4.86%), it suffered the largest monthly fall since March 2021 (-1.13%). Simultaneously, industrial production fell 0.6% monthly, offsetting the 0.7% increase in services. That said, it has accumulated a decline of 1.3% so far this year, remaining 1.5% below the pre-pandemic levels. Results reflect the obstacles faced by the sector, mainly due to the increase in production costs and the limitations on the availability of inputs and components for the production of the final good. The inflation peak of early 2022, in combination with rising credit costs, slowed down activity. Although growth expectations have improved so far this year (from 0.3% in January to 2.7% in September), the slowdown in the economy is beginning to show up. As a result, a moderate growth rate is expected for 2023 (+0.6%).

Inflation

In September, the Brazilian consumer price index IPCA-15 fell 0.29%, the third decrease in a row. Inflation reached 7.17% YoY, below the peak of 12.1% in April. The figure was driven mainly by the drop in transport prices due to lower fuel prices, as a result of the tax reduction policy. After three months of deflation, market expectations began to gradually decline from June's peak. Although inflation of 5.6% YoY is expected for this year, it continues above the ceiling of the 5% inflation target.

Monetary Policy

The remarkably aggressive monetary policy tightening began in mar-21, before any other country in the region. Aiming to alleviate the high levels of inflation, the Brazilian interest rate suffered one of the fastest increases in its history, going from 2% in Mar-21 to the current 13.75%. That said, it is positioned as the country with the highest nominal rates after Argentina. The COPOM has announced that it will maintain rates at 13.75% to contain inflation in the face of an adverse, volatile scenario, with negative revisions to world growth and greater volatility in financial assets. The hawkishness of Brazil's monetary policy has made it the only large economy in Latam with positive real interest rates, at an effective annual rate of 7.8%.

FX & Markets

Brazilian Real proved surprisingly resilient to the growing uncertainty around the election until the days leading up to the first round. The year began with a Real Exchange Rate at a 20-year low, around 20% above the 2003 previous low but 30% more depreciated than the 10-year average. This weak Real was underpinned by an aggressive monetary policy. Nonetheless, the day after the elections (Oct 2) the Brazilian currency strengthened by 3.8% after Lula's partial victory with a lower-than-expected margin. However, amid the dispute between the two candidates, the Brazilian currency fell sharply last week as political tension increased after Roberto Jefferson, a supporter of the president, went to two policemen when he resisted an arrest ordered by the Supreme Court of the country. In addition to this, international pressure on the Chinese economy also weighed.

So far in 2022, Brazil's equity (EWZ, +12% YTD) has outperformed Latam (ILF, +8% YTD ) by 612 bps. It's high exposure to Energy and Materials sector allowed it to capture the gains of the commodity price rally during Q1-22 (DBC +22.3% QoQ). Moreover, its long position in Financials is key in a rising interest rate environment. Nonetheless and while it is still early to determine the impact of Lula's victory on the markets, since the peak reached on October 21 the EWZ has fallen -7.8% and the dollar soared.

Also, selling pressures from global fixed income markets (BNDX -12.6%, AGG -15.3%, EMB -23.8% YTD) are being more benevolent on Brazilian bonds (EMBI Brazil JPM Total Return Index -9.98% YTD). Its bond yields validate the timing and aggressiveness of its central bank, which has led to a slowdown in inflation. In late Oct-22, its risk premium trades at 265bps (-230bps vs Latam), -205 bps below the peak of Mar-20, during the initial stages of the pandemic.

Fiscal

Despite the electoral cycle, Brazil strengthens fiscal consolidation in 2022. That said, it is showing the first fiscal surplus since 2014. Brazil's federal tax revenue reached another monthly record in September, even though the growth rate slowed down compared to previous months. The tax collection increased by 4.07% YoY in real terms, driven by a higher collection of both Corporate Income Tax (IRPJ) and Social Contribution on Net Income (CSLL). As a result, so far this year collection grew by 9.52% compared to the same period in 2021.

Nevertheless, this result is not expected to continue: next year's budget sent to Congress projects a deficit of R$ 63.7 billion, which has several inconsistencies and is expected to be even higher. The constitutional reform of 2015 and the high levels of indebtedness put a cap on spending that will contain fiscal mismanagement. In this regard, Lula da Silva plans to repeal the spending cap required by the Constitution, the country's fiscal anchor that states that spending cannot increase more than inflation, but says the administration would be fiscally responsible. With Lula elected again, the focus will be on the fiscal route to follow to guarantee control of public accounts and reduce debt, which represents more than 75% of GDP.

Trade & CA

Since June 2020, amid the health crisis, the terms of trade have been increasing until peaking a year later (+14.9% vs. June 2020) and then begin to decrease. So far this year, in March there was a 6.4% rise compared to the end of the previous year, due to the conflict in Ukraine that increased a large part of Brazil's export prices, but today it stands at 6.7% below that peak. On the other hand, as a consequence of the positive shock of commodities and the hiking rates environment, the reality shows a notable appreciation so far this year (+4.6%), being the most appreciated currency in the region.

Despite this, the country faces a slight but persistent current account deficit, even with a positive trade balance. The fall in the international price of iron ore and the increase in the price of fertilizers and oil meant that, even though the trade balance showed a positive result, the surplus was reduced compared to previous months (-9.3% vs. September 2020). In September, exports grew by 18.8% annually, while imports did so at a faster rate, growing by 24.9% compared to the same period of the previous year.

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