Why Brazil’s Economy May Be Headed for Recovery

By Allison Fedirka

For months, mainstream headlines have been painting a negative picture of the Brazilian economy and yesterday’s headlines were no different. The Central Bank announced that economic activity in May fell by 0.51 percent compared to the previous month. This means economic activity decreased 16 of the last 17 months – the exception being April, when it increased by 0.07 percent. Despite this negative economic performance, growing anecdotal evidence indicates investors still maintain a strong interest in Brazil. Much of this steadfast interest can be attributed to the economic reforms promised by interim President Michel Temer.

In our Mid-Year Report Card, Geopolitical Futures identified Brazil as one of the key countries for our forecast that there will be increased foreign direct investment (FDI) in South America this year. This forecast stems from the fact that the Western Hemisphere remains stable compared to Eurasia, as well as the anticipation of a regional shift to more center-right, market-friendly policies. According to the U.N., Brazil received about 57 percent of all FDI destined for South America in 2015. The tracking of this forecast relies on anecdotal evidence since there is a general lack of data for running FDI totals and quarterly or annual statistics often publish months after the fact. For example, complete 2015 FDI figures for the region were not released by the Economic Commission for Latin America until June 2016. For this reason, when we observe anecdotal evidence of interest in Brazilian investment, we take special note.

This week, two leading financial media outlets – Bloomberg and Valor Econômico – published articles highlighting increased investor confidence in Brazil. In one article, Bloomberg noted that BlackRock, the world’s largest money manager, increased Brazilian holdings in their portfolio from 46 percent to 57 percent in the last six months. In a separate article, the outlet noted that nine out of 12 funds surveyed by Reuters included Brazilian bonds. And London’s Finisterre Capital has enjoyed positive returns on its purchase of Petrobras bonds in February. The bonds initially traded at $0.75 on the dollar but now trade at around $0.93.

Valor Econômico detailed the market expectations for Brazil’s leading asset management firms for 2016 and 2017. In particular, asset managers from AZ Quest, BNP Paribas, BTG Pactual and Santander Asset Management Brasil expressed an optimistic outlook for the second half of the year and highlighted signs the Brazilian market will start to recover.

This anecdotal evidence also aligns with Brazil’s Central Bank estimates for the year. Since late April, there has been a steady rise in the Central Bank’s expectations for direct investment into the Brazilian economy this year. At the start of 2016, Brazil’s Central Bank’s weekly bulletin, Focus, reported the expected aggregate median market estimate for direct investment was $55 billion. In the last week of April, this figure crept up to $58 billion and in the most recent edition of Focus published on July 8 it increased to $63.5 billion.

In general, one of the first things evaluated for potential investment locations is the macroeconomic environment. The objective is to understand whether the broader performance, on the whole, is up or down. To make the most profit, investors ideally invest when the economy has bottomed out.

With the Brazilian Senate’s decision on May 12 to open an impeachment trial against President Dilma Rousseff came the opportunity to reform Brazil’s economy. Many investors, including from the companies listed above, view economic reforms proposed by Temer as a turning point for the Brazilian economy. Furthermore, major credit rating agencies – including S&P and Moody’s – have noted their earlier downgrades did not factor in Temer’s planned economic reforms, making any future downgrades this year and next unlikely.

Markets also responded positively to the promise of reforms in the interim Brazilian government. Brazil’s stock market Ibovespa gained this week for the sixth consecutive session. At this point in the year, Ibovespa is the best performing major stock market in the world. The Brazilian currency, the real, also has gained 20 percent against the dollar this year and is one of the currencies that has made the largest gains in the world. Lastly, the cost to hedge against losses in Brazil’s bonds with credit default swaps has dropped by almost a third in the past six months.

Temer’s reforms focus on reducing the government’s fiscal deficit and keeping the government solvent primarily through austerity measures. One of his first acts in office was to redefine the 2016 budget, which included a new deficit target of 170.5 billion reais ($52.4 billion) for 2016 and roughly 139 billion reais for next year. The priority for the current government is to amend the constitution so that the government can cap public spending to an increase no more than the previous year’s inflation rate. Ideally, this spending cap will be in place by 2017 and will lower government spending by 80 billion reais.

There is also discussion of raising about 10 different taxes by a small amount in localized areas, rather than increasing personal income tax or taxes on very general items like fuel. Pension reform has also been discussed but is currently on the back burner due to its controversial nature. The desired side-effects of these changes include lower inflation and interest rates, as well as renewed investor confidence.

At this time, the general consensus and perception is that Temer will remain in office through 2018 as Rousseff is expected to be found guilty at her impeachment trial in late August. The most recent tally of impeachment votes by the Estadão newspaper show 38 senators in favor, 18 against, 19 undisclosed and six undecided. Fifty-four votes are needed to be impeached. Temer will still need to work closely with Congress to ensure he has enough support to move his measures through. This will be a difficult but not impossible task.

Markets frequently have difficulty distinguishing between cyclical and structural shifts. Brazil has many structural problems but nonetheless enjoyed high growth during the administration of President Luiz Inácio Lula da Silva. There is a tendency to forget that after periods of growth, no matter how large or small, the opposite will follow and markets will contract. This is a necessary corrective and a natural part of the economic cycle that helps force inefficiencies out of the market. It was inevitable that Brazil would experience a contraction, which was further aggravated by underlying structural problems. Inevitably, many have seen this as a failure of the Brazilian economy rather than a natural corrective phase.

The current recession has helped correct distortions and inefficiencies in the Brazilian economy. Parallel to this, the government has raised investors’ confidence by laying out vital economic reforms. The recession has been painful at times and may not be entirely over yet. However, as indicated by the growing anecdotal evidence, writing off Brazil would be a mistake.