Brazil Bolsonaro/Lula Matchup Wrestles Core Conviction

A year ahead of October 2022 elections, inflation is surging as Brazil endures the worst drought in nearly a century. The country’s nascent recovery from the pandemic will be derailed if power cuts begin. Annual inflation, nearly 10% in August, is being driven by food and electricity, about half hydropower. The central bank has hiked the benchmark Selic rate 350 basis points from its record low 2% in March and analysts expect further tightening of at least another 200 bps. by year-end.  The combination of Covid and inflation is hitting growth. The economy shrank 0.1% in Q2, although it expanded 12.4% on an annual basis given last year’s collapse. Analysts are downgrading growth forecasts, this year likely to be around the 4.1% it contracted in 2020 before slowing to less than 1% in 2022.

As Brazil’s congress debates next year’s budget, investor interest is also focused on the 2022 election. President Bolsonaro’s approval rating is less than 25%, the lowest since he took office in 2019.  His administration’s handling of the pandemic and attacks on the Supreme Court, which authorized probes of the president and his allies based on allegations they had attacked Brazil’s democratic institutions, hurt popularity. Bolsonaro has questioned the country’s electronic ballet system, and political tensions have nearly erased BRL gains for the year after it surged 16% against the USD in Q2.  Recent polls put former left-wing President Luiz Inacio Lula da Silva (Lula), imprisoned for money laundering before his release earlier this year, firmly in first place. A handful of governors are also gearing up to run for president, including prominent Bolsonaro critic Eduardo Leite who recently came out as gay and has won plaudits for budget trimming.  

Despite the ailing real and the stock exchange down 10% in USD terms on the MSCI Index so far this year, the IPO market is booming.  Through mid-September 44 companies have raised more than USD 11 billion and another two dozen are in the pipeline.  The wave of offerings was dominated by tech and smaller companies. Rising inflation and the falling currency resulted in several cancellations of planned offerings on the USD 1 trillion market which lists nearly 400 companies.

Investors are closely monitoring debate over the 2022 budget which targets a primary deficit of 0.5% of GDP.  There is rising concern that the administration may not adhere to the constitutionally mandated spending cap that prevents an increase above the inflation rate. The draft does not provide an explanation of how to pay for a 50% increase in a revamped pandemic cash distribution program for the poor as debt/GDP nears 90%. The primary fiscal deficit in the 12-months through June stood at 3.8% of GDP, with the government optimistically projecting it will narrow to 1.8% by year-end.

The hefty trade surplus recorded earlier this year will continue to narrow on China policies and slowdown. China has been Brazil’s biggest trading partner for over a decade, with bilateral trade topping USD 100 billion in 2020. Brazil suspended exports of beef to China – it accounts for 40% of China’s beef imports – after mad cow disease was found, soy exports are falling due to drought, and iron ore prices are down 60% from the record May high. Foreign exchange reserves remain healthy at nearly USD 340 billion, covering more than 17 months of imports. 

Inflation, next year’s budget debate, impact of severe drought, and the presidential race will continue to dominate investor attention in the months to come. At the same time, analysts will continue to monitor Brazil’s commitment to climate change.  While Bolsonaro told the UN General Assembly that the country’s environmental laws should serve as a model, deforestation of the Brazilian Amazon has risen sharply since he took office.  The central bank, for its part, announced new rules for lenders to incorporate climate change-related risks in reporting and next year plans to launch its own environmental stress tests for the banking sector.  As the risk events unfold over the next 12 months, the BRL and stock market will roller-coaster until the re-elected or next president is firmly in charge of the dizzying Carnival ride.