Brazil has been one of the hardest hit countries by the pandemic, with the second-most fatalities and third highest number of infections globally. Despite severe criticism over the level of health management, the economy rebounded sharply in the second half of 2020, with sound fiscal and monetary support driving the recovery. After a massive economic contraction of 9.6% in Q2, GDP rose by 7.7% QoQ in Q3 and points to a continued, although slower, recovery in the last quarter of the year.
To aid the recovery, the central bank cut interest rates to a record low of 2%, while stepping aside from quantitative easing to oust investor concerns about potential monetary financing.
On the fiscal front, the enactment of the “State of Calamity” freed the federal government from its fiscal rule, leading to an aggressive fiscal stimulus package of nearly 12% of GDP in 2020. Altogether, the measures managed to cap Brazilian borrowing costs, while simultaneously boosting domestic demand.
Brazil’s fiscal support during the pandemic crisis outstood among major peers
However, BRL’s price action during the pandemic’s aftermath didn’t live up to the pace of the economic recovery itself. The real was amongst the worst performing currencies in 2020, having lost half of its nominal value against the dollar at the peak of the pandemic, recovering only 8% since then. Looking ahead, the currency outlook remains mixed and is poised to face yet more periods of severe volatility amid a challenging panorama. With ample losses to pare back to return to pre-pandemic levels, the real might gain attention due to an early hiking cycle from the BCB this year as inflation expectations grow. However, major risks to the economic outlook from a second wave of the pandemic remain, especially given the current constraints around the fiscal policy. The main debate for the real will be dominated by the fiscal outlook in an environment of both economic and political stress, with the balance of risks hanging on whether or not the spending cap is threatened yet again.
Monex Europe’s BRL forecasts as per our February Reuters submission
THE MACRO OUTLOOK REMAINS HIGHLY SENSITIVE TO THE FISCAL POLICY
The sharp economic rebound in Q3 after two previous quarters of contraction was largely driven by a strong rebound in domestic demand. Private consumption, which accounts for nearly 2/3rds of GDP, rose by 7.6% QoQ from an 11% collapse in Q2, despite the drag of a weak labour market and restrictions to services.
Crucially, government cash handouts to vulnerable households made up for the impact a weak labour market had on consumption, filling the gap between slow wage growth and higher overall consumption.
Government spending was key to the strong outperformance of the Brazilian recovery in the second half of 2020, with a record primary deficit of nearly 9% of GDP in the year to November. Gross capital formation also grew at a fast 17.9% in Q3 on top of a 22.8% contraction in Q2, driven by the pick-up in demand and record-low borrowing costs. Net exports inflicted a 2.1% drag on quarterly real growth despite favourable terms of trade due to the currency depreciation, reflecting the impact of the challenging global environment caused by the pandemic.
Decisive fiscal support places Brazilian sovereign debt into sky-rocket levels
Looking forward, risks to the economic recovery are tilted to the downside as crucial fiscal aid vanishes and the pandemic worsens into its second wave in Brazil. With last year’s support package coming to an end in December and public debt levels nearing 100% of GDP, a tapered fiscal outlook compared to 2020 remains our base case scenario. So far the government has pledged to stick to the constitutional spending cap in 2021, which means that federal expenditure will be about 20% lower in real terms compared to last year. Even if some extra-budget gets approved considering the mounting pressure for funding, public spending should hardly compare to 2020’s relief support. That doesn’t bode well for an economy that is some 4.1% lower than pre-pandemic levels, with consumer spending 6.4% below the 2019 baseline. Momentum for private consumption is weighed down by record-high unemployment of over 14% and a shrinking workforce participation rate, which was 6 percentage points lower in October compared to the start of the year. Combined, these factors pose downside risks to both consumer spending in the short run and long-term economic growth.
POLITICS WON’T MAKE THINGS ANY EASIER
While the domestic fiscal outlook is yet again the main game for Brazil, a tense political background underpins the complex panorama. Breaching the spending cap once again could lead to the departure of Economy Minister Paulo Guedes, triggering a confidence crisis like the one in 2015-2016 and potentially ousting Bolsonaro ahead of time. But even when public finances are so stretched, there is substantial political pressure to deliver some form of emergency aid next year. Bolsonaro himself could lean towards providing extra fiscal support in the short run, in an attempt to boost his profile ahead of the 2022 elections. The President’s popularity has been undermined by widespread criticism on the management of the domestic outbreak and vaccination agenda. Several political observers and public demonstrators have recently shown outrage at Bolsonaro’s “disastrous” views on coronavirus, which elevates the prospects for immediate impeachment. Both the Brazilian economy and currency couldn’t bear with such a political crisis at this juncture. However, the consensus view indicates that most political circles want to avert a presidential impeachment process while focusing on efforts to overcome the pandemic emergency, rendering this a tail risk to our BRL outlook.
The political agenda is yet more complex, as any legislation debate is temporarily frozen until Congress gets reconvened with both Speakers’ vote in early February. After the country’s top court ruled out a new term for incumbent Speakers Rodrigo Maia (House) and Davi Alcolumbre (Senate), new candidates are lining up. The Speakers hold great influence over the government’s agenda as they decide which bills go to a vote and when. The elected candidates will be key to oversee crucial reforms on the budget deficit and the tax system during Bolsonaro’s remaining tenure in office. Endorsed by Maia, runner Baleia Rossi seeks to mitigate Bolsonaro’s influence in the lower house while favouring more support for low-income families hit by the pandemic. His opponent Arthur Lira, the government´s favourite candidate, pledges to protect Brazil´s spending cap rule in a more market-friendly fashion. Lira holds more than the 257-vote majority needed so far. In the Senate race, Bolsonaro’s preferred candidate, Rodrigo Pacheco, is also set to win, with some 46 senators on board compared with the 33 supporting his opponent Simone Tebet. Regardless of the outcome, the next set of speakers will have to handle growing pressure for increased fiscal spending as the country faces a sluggish economic recovery.
THE SECOND WAVE OF INFECTIONS AND SLOW VACCINE PLANS WEIGH FURTHER ON THE ECONOMIC OUTLOOK
Brazil has seen a resurgence of Covid infections in the past few weeks, with an aggressive outbreak taking place in Manaus, the largest city in the Amazon rain-forest. The sharp increase in daily cases has been fuelled by a more contagious strain of the virus hitting the country, which has led to the collapse in hospital capacity in Manaus, Sao Paulo and other main economic areas. Social distancing measures have been tightened as a result, further dampening the already slow recovery in services. With broad restrictions likely to remain in place for the time being, the severe health situation poses significant downside risks to the economic outlook looking forward, especially limiting buoyant consumer spending seen previously.
Brazil is hit by a severe second pandemic wave
Daily Covid Cases (7-day MA in the blue line)
Daily Deaths (7-day MA in orange line)
Although vaccinations offer a path out of the health crisis, politicised programmes and logistical challenges have left Brazil in a lagging position in the immunisation race amid Latin American peers, with only 2.2 vaccinated people per 1000 by the end of January.
Brazil has already granted emergency approval to the Oxford/AstraZeneca and Sinovac shots, with the latter being the only one available in the country at the moment. However, local labs Fiocruz and Instituto Butantan, which are set to produce AstraZeneca and Sinovac doses domestically, keep reporting delayed production plans. Meanwhile, talks with Pfizer and other pharmaceutical companies have not yielded any agreements to date. The government’s agenda to immunise the most vulnerable people was originally set for the next four months. However, as issues regarding access and deployment of vaccines carry on, it seems increasingly likely that most severe restrictions will remain in place until at least the end of Q2 and possibly beyond.
MONETARY POLICY IS HANGING IN THE BALANCE FOR THE BRL OUTLOOK
The Brazilian real recently enjoyed a short-lived rally as the Brazilian Central Bank moved swiftly to drop its forward guidance and open up some space for potential interest rate hikes ahead of time. These signals bring special attention to the currency as markets search for high-yielding assets amid the global economic recovery. The potential move by the BCB also comes at a time where monetary normalisation isn’t due for some time across most advanced and emerging economies. An interest rate hike from the record low 2% level would render positive gains for the real since the currency remains extremely cheap compared to both historical nominal levels and fair values. We argue, however, that a path towards potential policy normalisation will only have a marginally positive effect on the currency, as factors justifying the rate hike will be weakly linked to better economic fundamentals. Instead, increasing concerns over the fiscal outlook will drive inflation expectations higher, neutralising the boost in real yields while forcing the central bank to reduce its support to the recovery in real activity.
The removal of previous guidance over sustained monetary accommodation was mainly due to the positive dynamics of inflation and inflation expectations. Specifically, the Copom stated that “inflation expectations, as well as inflation projections for the baseline scenario, are now sufficiently close to the inflation target over the relevant horizon for monetary policy”. Given this, the BCB will follow the usual assessment of the balance of risks for future inflation when deciding on policy tweaks as the inflation projections are set to meet the target at present. In another hawkish tweak, the Copom will now seek to anchor inflation expectations to the 2022 target of 3.5% – a downgrade from the previous 2021 target of 3.75%. As previously stated, inflation dynamics are already reaching this lower target, meaning the bar is now lower for the BCB to recalibrate policy accordingly with tighter monetary policy. This is especially the case if fiscal stimulus remains supportive throughout 2021.
While the BCB acknowledges that the recent inflation upshot is still expected to be temporary, thus reducing the need for immediate rate hikes, the balance of risks to the path of prices remains tilted to the upside. Due to this, markets have revised their implied expectations for policy changes, pricing in an earlier normalisation cycle and more front-loaded set of interest rate hikes. Markets are currently betting on the first hike in the next 3 months and an overall increase of more than 3 percentage points over the next year. Back in September, investors priced in a normalization path starting 3 months later and an overall rise of 1.3% in the year ahead.
Markets price in an early front-loaded hiking cycle for the Brazilian economy
Author: Olivia Alvarez Mendez, FX Market Analyst