Economy challenged by politics
At the start of the year, Brazil witnessed the beginning of Luiz Inacio Lula da Silva’s third term as president. Concurrently, the financial failure of a large retailer and subsequent credit events disrupted the market. In an environment of high interest rates, several medium and large companies have filed for bankruptcy or bankruptcy protection. Notwithstanding, the Central Bank of Brazil (BCB) assured the public that these events were one-off occurrences and the overall economic slowdown remained within the expected range due to the monetary tightening, preventing a credit crunch.
A notable point of contention of Lula’s administration has been the interaction between fiscal and monetary policy, with his government pressuring the BCB to cut interest rates as soon as possible. However, the BCB has remained steadfast in its commitment to independence. While President Lula maintains a combative stance against the monetary authority and against Campos Neto, Finance Minister Fernando Haddad and Planning and Budget Minister Simone Tebet have actively engaged in dialogue with BCB and the market through public statements calling for rate cuts. These two agencies are committed to addressing concerns by the market and the Monetary Policy Committee.
The presentation of the new fiscal regime reduced uncertainties regarding the trajectory of Brazil’s federal public debt, providing some relief to asset prices. However, analysts have expressed concerns about the complexity and enforceability of the new rules.
Inflation eases with resilient jobs sector
A set of economic indicators has confirmed a scenario of gradual deceleration of growth compatible with a contractionary monetary policy; however, the downturn has been slower than expected. Inflation remains above the target, although it has already cooled off from critical levels observed in 2021 and 2022. Despite that, the interest rate has been cut to 11.75 from 13.75 per cent, which is still contractionary to hold off further price spikes. The process of bringing inflation back to levels compatible with the inflation targeting system has proven to be challenging. The sharpest drop in annual inflation observed in the first semester carried a statistical bias from policies adopted last year while the end-of-year inflation is expected to be 4.49 per cent, above the government’s 3.25 per cent target.
Contributing to the scenario of moderation in activity, the credit market has slowly decelerated at the margin and household indebtedness has stabilized, although still at historically high levels. Industrial production has remained stable compared to one year earlier. Meanwhile, the labor market remains resilient with a relatively stable unemployment rate and a net increase in job creation. Real average income has increased strongly since last year and seems to be stabilizing at pre-pandemic levels.
One consequence of the resilience of the labor market is the strength of the services sector, with volumes only slightly below its all-time high. Retail sales also continued at high levels and exceeded expectations in the first quarter of the year, especially with the sales of vehicles and building materials. This is a point of attention for monetary policy since a consistent deceleration of inflation also entails a weaker labor market and services sector.
Lula’s fiscal framework coming
The final version of the fiscal framework – a bill mapping a strategy to balance public accounts and contain the growth of public debt relative to GDP – was approved in Brazil’s Lower House and Senate, which allowed for the materialization of lower market expectations for inflation and improved prospects for economic activity. Lula’s tax reform proposal, aimed at simplifying a highly complex Brazilian tax system through the implementation of a value-added tax (VAT), will also shape the country’s economic landscape for the long term. Analysts estimate that the VAT will increase tax collection efficiency and sectoral productivity and cause a 10 per cent increase in GDP in 15 years.
Although the BCB started a downward interest rate trajectory, long-term fixed income assets still offer historically high real rates. This presents an advantage for opportunistic investors. On the stock exchange, although uncertainty and volatility persist, patient investors with under-allocated positions in equities can potentially reap significant returns in the long term. The current level of volatility may affect portfolio performance, emphasizing the need for a cautious approach. However, although fixed income assets offer historically high real rates, equities should take off when investors become more confident in the downward trajectory of global interest rates. For instance, the Ibovespa index registered an impressive gain in November, the biggest monthly increase since November 2020.
Brazil’s economic landscape under President Lula’s third term has been shaken by a lot of controversial rhetoric, including issues on the interplay of fiscal and monetary policy, efforts to improve communication between the government and the central bank, and the introduction of new fiscal rules. Investors should look out for the finalization of Brazil’s fiscal framework and tax reform and how it will shape economic activity and inflation expectations in the months ahead. From there, they can adjust positions in high-yielding fixed income assets as well as the potential for long-term returns in the stock market accordingly.
