Alberto Matellán, Chief Economist in MAPFRE’s Corporate Investment Area explains the key behavioral drivers of Brazil’s economy
Up to mid-June the Brazilian real depreciated circa 12% vs the USD and 6% vs the EUR since the end of March, with lows on June 7th, just before the intervention of the BCB. Admittedly, this quarter has been quite adverse for emerging markets. MSCI EM currencies index depreciated 4% in such period, led by the Turkish Lira and the Argentinian Peso, but since May, some other markets started to feel some contagion, like Mexico or Chile. This suggests there are global factors in play.
But also idiosyncratic dynamics still make investors differentiate, which we regard as a positive development, since it prevents a full blown EM crisis. In Brazil, as global factors start to fade, or at least stabilize, we should start to pay more attention to internal issues.
Liquidity in US dollars is the main global factor impacting EM.
Global factors in play
The single most important factor seems to be the squeeze in USD liquidity since the start of this year. The combined actions of the Fed2 and the US Treasury led to an unexpected, abrupt and protracted shortage of dollars in international markets. At the same time, growth outside the US disappointed, whereas it kept quite solid inside. So, the expectation of investors turned towards a wider divergence of monetary policies between the Fed and the rest of the world. All of this led to a quick appreciation of the USD, something which is usually related to widespread weakness in EM currencies and economic activity3.
The contribution of the US Treasury to the liquidity squeeze was probably motivated by the second factor, the expected expansion of the US fiscal deficit. Between January and May, the Treasury increased its cash holdings from USD 100 Bn to USD 400 Bn (see Chart 1). In other words, it drained about USD 300 Bn that would have been available to invest and/or lend otherwise. At the same time, the expectation of a larger deficit by itself may lower the flow of funds to emerging markets, both via financial channels and via exports.
The third factor in play has been the escalation of the trade wars rhetoric. What seemed just an aggressive negotiation technique by President Trump is now perceived by investors as a true will to harm Chinese industry, along with that of other countries, at the risk of triggering a full blown trade war. We cannot be sure whether this perception reflects reality or not, but, as long as is seizes investors’ minds, risk aversion will stay high, and sensitive to news. And this risk aversion towards EM is mainly based on the fact that a trade war would harm emerging exports the most, as well as their ability to finance themselves.
Finally, though less relevant than the above, risk aversion intensified in late May due to geopolitical tensions in Middle East and the political turmoil in Italy. This may not trigger a volatility spike by itself, but reinforced the other three factors.
The most important of these, the USD liquidity squeeze, seems to be coming to an end. This should relieve pressure on EM and, and namely on Brazil. But it’s not enough by itself. The other are still in play, and their future developments are very uncertain, especially that related to trade wars. But at the same time, correlations show that, for the last month, local factors have played a more important role in Brazil recent movements. So, probably, it’s time to focus more on local factors.
Up to April, macro conditions were benign.
Idiosyncratic factors: macro and politics
The macro assessment is positive in general, but it has deteriorated rapidly since April. Slow but steady improvements in growth, unemployment and net exports kept the country attractive to most investors during 2017 and the first weeks of 2018. At the same time, the external balance was virtually nil and at its lowest in nearly ten years. This added up to the fact that the BCB had it highest historical amount of reserves (seven times short term external debt) and the aggregated balance sheet is less vulnerable to external shocks now than five years ago. So summing up, growth was back to positive after a long and deep recession and inflation stayed well below the target. So, until April, Brazil was one of the brightest spots inside the EM space, despite the adverse global context in place since the start of the year. This suggests the relevant role of idiosyncratic factors that developed later.
In May the country suffered a rapid shift in conditions, not only due to the USD but especially to internal shocks. When the corruption scandals were still being felt, the truckers’ strike arrived. Its initial assessment by investors was certainly gloomy, not only because of its economic impact, but also due to the political inability to handle it properly in the middle of the run up to elections. Earliest figures seem to confirm a tough impact in the industrial sector and in the food distribution industry (the latter should mean a serious but short lived effect on inflation). But retail sales seem more solid.
It’s virtually impossible to anticipate the election outcome.
The large fiscal deficit has been the darkest point of Brazil’s recent macro outlook. The Temer administration was able to focus investors away from such risk for a while, on the hopes of new legislation towards fiscal discipline. That disappeared with the corruption scandals that ended such administration, about a year ago. Now, with growth slowing, fiscal revenues are set to the downside. At the same time, before October election, there won’t be any political will to control it; on the contrary, incentives are for more expense. And, if a populist government wins the election, this outlook will be even gloomier. In this sense, the main message from the truckers’ strike is the existence of an underlying but widespread demand for populist measures or, at least, a generalized rejection of the current policies, identified as “pro establishment”.
Ahead of the election, uncertainty will prevail, mainly because of the large pool of “undecided/none” voters in recent polls (33% as of June 18th). This instability, together with economic tensions, also favors extreme outcomes. But at the same time there is some room for hope since the probability of a second round between non-populist candidates is remarkably high: simulations based on polls point to around 40% chance. This should allow for better prospects on fiscal control and a significant improvement in market perception.
Summing up, the macro scenario for Brazil, which was relatively optimistic at the start of the year, turned gloomy since April. The external position is the brightest spot, whereas the large fiscal deficit is the weakest issue. But the big risk ahead is the election in October; until then a very tense calm is guaranteed. Unfortunately, the outcome is highly binary: a populist government may unleash a “politics become policy” style crisis, but a more serious administration could start a recovery. In this sense, the odds for a “pro establishment” second round are high. If, during the next four months, external factors stabilize, this could favor the victory of a non-populist candidate. These latter two facts make us assign a slightly higher probability on a benign outcome.
In the meantime, the currency stabilization provided by the BCB seems to be working well, not only via FX swaps but also supported by the large amount of reserves and the solid message of not overreacting; anyway, a full blown crisis is not our scenario, but it could be worth to hedge the currency exposure as long as it is relatively cheap.