Brazil keeps spending as presidential race gets underway

When Mr Bolsonaro was elected in 2018, Brazil’s economy was emerging from a deep contraction. The Covid pandemic then set Brazil’s economy back significantly as it recorded the second-highest number of Covid-related deaths after the US, and more than one-tenth of the reported total globally. In 2020, as Covid hit, the economy shrank by almost 4% compared with a year earlier, according to World Bank data, and then grew by nearly 5% in 2021. Still, more than a decade of stop-start growth leaves the economy no bigger than in 2009. We see the economy slowing in the second half of 2022, to take growth to 1.5% for the full year.

The economic agenda has become the election’s key issue. As the world’s 12th-biggest economy by gross domestic product (GDP) has slowed under a rapid monetary hiking cycle to fight inflation, the government is offering households support.

Positive rates, fiscal spending

Since March 2021 the central bank, Banco do Brasil (BCB), has increased the country’s interest rate, known as the Selic, 12 times from 2%. Its benchmark rate reached 13.75% on 3 August, taking it close to its expected peak of 14% in September. The BCB may begin lowering borrowing costs, in steps of 25 basis points, as soon as the second quarter of 2023 (see chart).

Inflation, close to a two-decade high, fell slightly in July to 10.1% compared with a year earlier, leaving real or inflation-adjusted rates among the highest of the world’s major economies. The BCB is far from its annual inflation target of 3.5% (with a margin of 1.5% either side) for 2022. In addition to monetary policy, the country has also tried to lower inflation through a series of tax breaks including on electricity and petrol, as well as fuel-price freezes and public transport subsidies. Although inflation has kept real wages relatively lower, unemployment has declined and in the second quarter was below pre-Covid levels at 9.3%.

Nearly all local government tax revenues and one-fifth of federal tax revenues in Brazil depend on global commodity prices and the exchange rate. Higher global demand for agricultural produce and oil, the country’s largest exports, boosted Brazil’s balance of payments to a record surplus in 2021. That looks set to continue as the global economy demands more bulk and soft commodities. As commodity supply chains and prices stabilise, we would however expect these revenues to decline, reducing the budgets available to spend on supporting households. There remains some margin, thanks to the recovering economy, as Brazil’s government debt-to-GDP ratio fell to 93% in 2021, from 99% in 2020, according to International Monetary Fund data.

We see little danger of capital flight abroad as most of Brazil’s debt is within domestic hands, its current account deficit is under control, and it has a positive interest rate differential with the US.

Rival candidates, rival programmes

Four years ago, the presidential campaign focussed on corruption and far-right candidate and eventual winner Jair Bolsonaro was stabbed. The ex-army captain has historically expressed his approval for Brazil’s former military dictatorship that ended in 1985. As his four-year term ends, Mr Bolsonaro has cast doubt that the election will be free from fraud. Opposition politicians fear that if he loses, there may be efforts to create an environment justifying a coup. Mr Bolsonaro now faces federal police charges of criminal negligence for his handling of the pandemic during which he disparaged public-health measures such as mask wearing, and said that vaccines were dangerous.

The current president is now trailing his political nemesis in opinion polls. Recent polls point to Lula winning 44% of first-round votes, while Mr Bolsonaro may get 37%. The other main presidential candidates, Ciro Gomes (Democratic Labour Party or PDT) and Simone Tebet (Brazilian Democratic Movement party or MDB), are polling at 6% and 4% respectively. 

Lula, the Workers’ Party (Partido dos Trabalhadores or ‘PT’) candidate, served as president for two terms and eight years until the end of 2010. In 2017, he was sentenced to 12-years in prison for money laundering and corruption as part of what became known as the ‘car wash’ or ‘Lava Jato’ scandal that implicated swathes of Brazil’s political class. Lula denounced his conviction as a conspiracy, and after 19 months in jail, was released when Brazil’s Supreme Court ruled that evidence against him was tainted. His opponents dispute that verdict.

Despite their political differences, both Bolsonaro and Lula have promised to leave in place a 50% increase in welfare spending, totaling as much as BRL 70 billion (USD 13.5 billion) a year. That is due to finish at the end of 2022, and would breach the country’s spending cap, requiring an exemption from Congress. Mr Bolsonaro says that he would increase the salaries of government workers and adjust income taxes. Lula wants to scrap the country’s two-decade old spending cap, replacing it with a fiscal mechanism that allows for a higher minimum wage, and increase spending on welfare and infrastructure. Lula has chosen Geraldo Alckmin, a former governor of Sao Paulo, considered sympathetic to business and markets, as his vice-president. Mr Alckmin lost the second-round of the 2006 presidential race to Lula.

Whoever wins, one complication is that budget details for spending in 2023 must be negotiated before the end of 2022. That three-month period, in which the country’s legislators are in flux between the election and the new government taking office on 1 January, may prolong political volatility. That suggests that the fiscal relief measures already in place may be extended, especially if Lula wins the presidency and can count on more allies in the new Congress. Although Lula remains the frontrunner, the leadership race may narrow as consumers benefit from the recently-approved cash transfers.

Managing exposure to Brazilian assets

Brazil accounted for 10% of the JPM Government Bond EM Broad Diversified Index at 1 July, so any worsening in the economic outlook may have broader repercussions and make investors already exposed to emerging markets less ready to extend more debt.

We initiated exposure to Brazilian local currency debt in late February, based on its advanced position in the monetary policy cycle, and its benefit from higher commodity prices with lower geopolitical risks, along with an undervalued currency. However, given the expected volatility surrounding Brazilian assets in the run-up to the elections, we believe that it is now tactically prudent to take profit from our exposure. We therefore sold our position in Brazilian government debt to lock in a profit of 5%. We will look for new opportunities once this current politically charged period is past. Any eventual improvement in the outlook for Brazilian government debt, driven by higher commodity prices, would support the country’s currency, which we see trading at 4.8 reais per dollar, 12 months from now.

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