BRL is Cheap, But Not Yet a Buy

Summary

• Petrobras CEO’s dismissal could signal the start of a populist spiral ahead of Brazil’s 2022 presidential election.
• The BCB will hike in March from a record low to avoid further BRL depreciation amid rising inflation.
• Risks have elevated, but BRL looks cheap compared with the improved balance of payments.

Market Implications

• Neutral FX: Investors should wait for more clarity or favour optionality exposure.

Risk of More Interventionism

Brazil’s financial markets have tumbled this week tumbled after President Jair Bolsonaro’s 19 February decision to fire the head of state-controlled oil company Petrobras following clashes over fuel price hikes. It is the fourth time this year that Bolsonaro has criticized the company for rising fuel prices, and he introduced a two-month reduction in federal diesel taxes from 1 March. Hikes in fuel prices are usually the final straw that leads to public outcry. And with Bolsonaro’s popularity falling after the expiry of pandemic aid, the move is likely an attempt to shore up his popularity ahead of the 2022 elections.

However, Bolsonaro’s unilateral decision concerned investors. The risk is rising that the government takes a more interventionist approach and avoids making difficult decisions to control the fiscal situation. History suggests that leaders in Latin America tend to turn populist as presidential elections near. In the 2019, Argentinians opted to take back Christina Kirchner and punished incumbent Mauricio Macri, who chose steady reforms after 12 years of free-spending populism.

Since 2018, Brazil’s economy minister Paulo Guedes has struggled to implement his ambitious reform agenda. The economy remains one of the most protectionist in the world, and industry lobbies are very powerful. The key question now is whether Bolsonaro will risk backing Guedes ahead of the presidential election. The dismissal of Petrobras CEO – who was a close friend of Guedes – is a negative signal.

Brazil’s Biggest Issue Is the Budget

The overwhelming macro issue in Brazil remains the fiscal situation. Brazil has accumulated macro imbalances since the commodity cycle peak and the populist policy round from 2008 to 2014. However, the unwinding of the unsustainable policies exacerbated the 2014-16 recession (GDP fell by 7.3% in two years).

In 2018, the newly elected economy minister, Guedes, promised a path toward a market-driven economy with structural reforms. Although he succeeded in passing a reform of the pension system, he failed to implement his ambitious reform agenda. Meanwhile, public debt rose from 50% in 2010 to 90% in 2019 – one of the worst fiscal deteriorations among emerging markets.

With Covid-19, Brazil has been facing another deep recession before having normalized its fiscal trajectory. Brazil recently hit 10 million Covid cases, and the national vaccination campaign has gotten off to a shaky start with concerns over supply. The speed of vaccination rollout will determine the need for additional fiscal stimulus. Indeed, since the pandemic’s start, the government has undertaken a very aggressive fiscal response. The fiscal deficit is expected to come in at 10% of GDP last year, much higher than Mexico’s 1.6% deficit, in line with advanced economies.

A new fiscal stimulus bill is now expected to be voted on, while the Senate president urged Guedes to implement the emergency aid as quickly as possible. Therefore, the government will likely break the spending ceiling for a second consecutive year. At this stage, fiscal tightening has unfortunately become economically and politically unviable.

BRL Looks Cheap

Since 2017, BRL has massively underperformed other EM currencies: -45% vs MXN, -30% vs COP, -35% vs CLP, -40% vs ZAR, -30% vs RUB. This is probably more related to the fall in interest differentials than the fiscal situation, as the five-year CDS improved from 240bps to 180bps. The Selic rate decreased from 14.25% in October 2016 to 2% today, while the Banxico interest rate remained close to 2017 levels at 4%, after rising to 8% in 2019.

Since the start of the crisis, BRL has underperformed its peers by 20% on average. Credit growth, a very important indicator for EM, accelerated again in 2020 and could possibly hit 25% in 1H21. Meanwhile, credit aggregates in most other EM countries are far stabler. As we saw in Turkey, a massive rise in credit growth can pressure the currency via a deterioration of the balance of payments. Moreover, Covid-19 hit Brazil harder than its peers (50,000 cases per month vs 16,000 in Mexico). But most importantly, the fiscal response was far more aggressive than its peers, exacerbating the fragile situation.

The BRL’s cheapness, the import compression due to the 2014-16 and Covid-19 recessions, and the rise in commodities prices (soybeans up 60% YoY) have boosted the trade balance. Meanwhile, the current account deficit in January was the smallest in 13 years. Also, FDI remained stable from 2014 to 2019, which led to a significant improvement of the basic balance of payments – close to a 10-year high at 2.5% of GDP. The gap between the improvement of the balance of payments and the weak exchange rate is yet to normalize.

Moreover, institutional investors are probably still underweighted Brazilian assets. Equities and fixed-income flows have been weak since 2017, amid lower real rates, while outflows have worsened during the pandemic. Foreign ownership of public debt is back below 10% from a peak of 20% in 2015.

The Market Is Pricing a Hike in March

The minutes of the last BCB policy meeting removed the forward guidance introduced in August, which was conditional on inflation expectations and the maintenance of the fiscal regime. However, inflation expectations are now sufficiently close to the inflation target, while the headline rose to 4.6% YoY in January. The post-Covid recovery pressured food prices, while the 25% weakening of the BRL and the rise in commodities prices drove tradable prices up.

Moreover, some members explicitly commented about starting a process of ‘partial normalization’, likely reflecting their discomfort with the record low level of the Selic rate at 2%. The current carry is probably too low to support Brazilian assets given the lingering political uncertainty and concerns about the fiscal situation.

Unsurprisingly, the market is currently pricing a hike of 40bps in BCB’s March meeting. The central bank will probably have to act strongly, despite the struggling economy, to prevent the BRL from depreciating further. We expect a 50bps hike at the March meeting. However we will wait for positive price action before turning positive on BRL, as investors may not be ready yet to anticipate much higher rates amid continuous negative news flow.