THE YEAR OF ECONOMIC RECOVERY AMIDST RIGOROUS ADJUSTMENT
Addressing fiscal emergency as key macroeconomic priority in 2017.
Accelerated price stabilization fuels aggressive monetary easing.
Economic revival & improved terms of trade leads to currency stability.
Outstanding financial market performance will not be repeated this year.
The Brazilian economy remains in strict fiscal adjustment mode. The implementation of budget restraint is critical to place the public finances back on sustainable ground. The latest data showed that the consolidated public sector deficit closed the year near 9% of GDP, impaired by a primary shortfall (excluding debt service) of 2.5% of GDP (see graph on fiscal trends). The administration of President Michel Temer continues to voice its commitment to introduce changes to the tax framework and pension legislation to gradually reduce the structural rigidities of labour markets and thereby instill business confidence. The government is fully aware of the need to accelerate fiscal restraint in an environment characterized by increasing costs of international finance. Looking ahead, an ambitious infrastructure development plan might attract sizeable foreign direct equity capital inflows in the next 2 years.
The central bank has succeeded in reversing inflationary expectations more rapidly than originally envisaged, paving the way for a growth-driven monetary policy normalization phase (inverse to the direction to be adopted by the US Federal Reserve). The 12-month consumer price inflation at near 6.5% (y/y) by the end of 2016 is fuelling expectations that the Brazilian Monetary Policy Committee (COPOM) might speed up the process of reference rate reductions throughout 2017. In fact, the quarterly inflation report published last December points towards continuous reductions in the central bank SELIC reference rate in the year ahead. It is worth highlighting that lower demand-side pressures from persistently weak economic activity coupled with increasing rates of unemployment will likely contribute to the process of disinflation under way and lower interest rates.
Brazil remains subject to a profound macroeconomic adjustment which is delaying a rapid recovery in economic activity. On the grounds of a deep industrial recession, skyrocketing unemployment (near 12%), severe government spending contraction and profound confidence crisis, real GDP is estimated to have declined by 3.5% y/y in 2016. Industrial production alone has contracted by 7% y/y last year.
Nevertheless, business confidence indicators are showing modest signs of improvement and the external adjustment is proceeding successfully according to government targets. Indeed, the sharp compression in import activity as a result of the deep recession together with a mild recovery in exports has led to a steady narrowing of the current account deficit which closed last year at 1.1% of GDP down from 3.5% in 2015. The international trade surplus of US$50 billion is symptomatic of the deep adjustment undertaken in Brazil’s external sector.
Brazil has offered hefty total returns to global portfolio investors over the past 12 months that will not be repeated in the year ahead. Following a sizeable currency devaluation, the Brazilian real (BRL) recovered some of the value lost during the overshooting phase, appreciating by 25% vis-à-vis the US dollar (USD) over the past 12 months. The powerful combination of high domestic interest rates and a recovering local currency also helped direct capital flows to the high-yielding Brazilian securities markets (both equity and debt assets). Indeed, the default insurance cost implied in credit default swap (CDS) contracts declined from 500 basis points (bps) in early January to 250 bps last December.
The rebalancing of portfolios in emerging markets (out of Mexico and into Brazil) also contributed to the relative outperformance of Brazilian debt assets in 2016. Equity markets also experienced outstanding performance with the benchmark Ibovespa stock market index increasing by nearly 70% over the past 12 months.
Despite the positive financial market tone embedded in the country’s financial assets, all credit rating agencies downgraded Brazil’s sovereign debt ratings in 2016, and all maintain a “Negative” outlook on their ratings. Looking ahead, we are of the view that Brazil will adapt smoothly to the changes in US trade, monetary and foreign policies, and that rating agencies may become gradually more optimistic (in line with market forces) about the country’s creditworthiness.