Brazil Quarterly Update Q3 2016

BRAZIL

Quarterly Economics Update – Q3 2016

Christian von Canstein, CFA,MSc

BRAZIL – QUARTERLY ECO

NO

MICS U

PDATE – Q3 2016

After going into its deepest recession since the 1930s, Brazil might be starting to see the light at the end of the tunnel.

While GDP is still expected to contract this year, Brazil’s economy might have reached a turning point, with the rate of contraction starting to decelerate. Inflation has slowed down as well, the current account deficit is shrinking and even the budget deficit is slowly moving in the right direction.

Positive developments on the political front have led to a sharp fall in Brazil’s 10 year yield and a considerable appreciation of the Real. Markets welcomed the impeachment and removal of Dilma Rousseff, whose interventionist stance and fiscal irresponsibility is largely attributed to turning what would have been a normal recession into a profound depression.

There is a risk that investors believe the new Michel Temer administration can make wonders happen and then get disappointed when realizing that Brazilian politics have not necessarily become simpler and more collaborative. Nevertheless, his newly appointed cabinet consists of well prepared technocrats who, unlike the previous administration, at least understand Brazil’s challenges and are wiling to put forward appropriate measures to tackle them.

Brazil’s tentative turnaround might thus be a combination of increasing investor and consumer confidence in its new administration and the slightly improved emerging markets outlook due to rising commodity prices (albeit Brazil’s economy is much less reliant on commodities than its neighbors).

2

Overview


NO

MICS U

PDATE – Q3 2016

Real GDP Growth (annualized) Brazil might get closer to the inflection point

3

After having gotten used to growth rates above 8% in the early 2000s, Brazil’s economy has been shrinking for the first time since the financial crisis over the last two years.

Construction and manufacturing have been particularly hard hit as the boom years were coming to an end. Much of the previous years’ growth was not overly reliant on commodity exports but more so on domestic consumption fuelled by lose credit conditions and redistributive policies.

During the boom, Brazil’s politicians did not make any effort to fix structural obstacles to growth, among them: high taxes and an archaic tax code as well as onerous regulations that create a hostile environment for business; poor and inefficient public services; a lack of infrastructure that keeps transport costs prohibitively high; entrenched protectionism which shuts exporters out of promising foreign markets and reduces consumer choice.

Another big issue is corruption. After mass protests erupted in 2013, corruption scandals surfaced over the last two years, involving state-owned oil mayor Petrobras as well as a large number of politicians from all political parties and several executives from large companies such as construction conglomerate Odebrecht.

There is reason to become cautiously optimistic, as its economy seems to have started to turn around. Growth is becoming less negative and the new government has started to implement the necessary structural and fiscal reforms that the country needs to return to a more sustainable path.

Real GDP Growth

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%3.47%

-4.45%

-3.78% -3.78%

30/09/201130/09/201530/06/201630/09/2016


NO

MICS U

PDATE – Q3 2016

CPI Inflation (year on year basis)

After rising briefly above 10%, inflation has fallen back into single digits again.

The Real, whose sharp depreciation in 2015 was an important inflation driver, has rallied over the first half of this year, which might have contributed to the easing of inflationary pressure.

However, excessive government spending amounting to almost 40% of GDP, which is very high for an emerging economy (Colombia is below 20% of GDP), is another important factor contributing to inflationary pressure. This is more difficult to reign in as much of it is enshrined in the country’s constitution. A constitutional amendment that would at least freeze government spending in real terms would already be a big step in the right direction and there is a chance that the new government might be able to push this through.

In the boom years, the country grew thanks to high commodity prices, easily available credit and despite the economic incompetence of the first Rousseff administration. Little structural measures to enhance economic growth were implemented and instead redistributive policies as well as a expansion of consumer credit were used to create an artificial sense of rising prosperity. Rapidly increasing demand through higher disposable income without commensurate growth in productivity fed into inflation as a consequence.

High rates of inflation are still a heavy burden on Brazil’s economy. On one hand, a higher risk premium on Brazilian debt will push up the cost of capital for government and business alike. This, in turn, increases inflation again – a vicious circle. At the same time, consumers will see their real income being eroded which puts a strain on demand.

A decade of unconstrained public spending and lack of central bank independence is now coming back to haunt Brazil.

Inflation back in single digits

4

CPI Inflation0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

7.31%

9.49%

8.84%8.48%

30/09/201130/09/201530/06/201630/09/2016


NO

MICS U

PDATE – Q3 2016

Unemployment

As a consequence of the downturn, unemployment has reached its highest level since the first quarter of 2010, when Brazil had just weathered the global financial crisis although it appeared to be stabilizing now.

Due to tight labor regulations that impose heavy costs on both hiring and firing of workers, Brazil’s employers initially seemed to have been holding on to their workforce, hoping a recession could be avoided in the end. However, as Brazil entered recession in the end, companies have started to shed labor. This has led to a steady increase in unemployment over the last two years.

The Rousseff administration seemed to be completely ignoring economic fundamentals, as the last budget that was finally approved in December 2015 further burdened employers with a more than 10% rise in the minimum wage.

Those employers whose products enjoy inelastic demand (i.e. consumers demand reacts little to price increases) will probably pass on the higher wages to consumers which only adds further to already high inflation.

For those companies that operate in more competitive markets with substitute goods available, competition from overseas or selling discretionary consumer goods, price increases might not be passed on entirely. Therefore, seeing their wage costs rise without being compensated through higher productivity, such companies might decide to reduce their labor force or go out of business.

Unemployment stabilizes but remains high

5

Unemployment0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

6.00%

7.50%

8.20% 8.20%

30/09/201130/09/201530/06/201630/09/2016


NO

MICS U

PDATE – Q3 2016

10 Year Yield Government Bond Yield

Over the year, yields on Brazilian government debt dropped considerably, as investors became increasingly positive about political changes and a more independent central bank, committed to bring down inflation.

Even though the country was downgraded by all rating agencies last year, the new government’s commitment to fiscal responsibility and more orthodox economic policies is making a default now less likely, as the unsustainable fiscal situation that was largely ignored by the previous administration is now being taken seriously.

Having said that, there are still clear limits on what can be done. In the short run, much of Rousseff’s disastrous budget from last year cannot be unwound. In the long run, a constitutional amendment would be required to reduce entitlement spending. This will be politically difficult, given the “cradle to crave” mentality that has been indoctrinated since the country’s return to democracy. Brazil’s pension system for example, is one of the most generous and thus also most unsustainable systems in the emerging world and current beneficiaries form a powerful lobby to fend off any reforms.

Rising taxes would also be counterproductive. First of all, tax rises are the last thing the country needs while still being in a recession and second, taxes in Brazil are already as high as in many “developed” countries.

Hence, even if Brazil’s cabinet is well aware of these problems, it does not necessarily have all the tools available to fully tackle them.

Risk Premium for Brazil has fallen sharply

6

0.00%

200.00%

400.00%

600.00%

800.00%

1000.00%

1200.00%

10 Year Yield0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

12.61%

15.40%

12.06%11.58%

30/09/201130/09/201530/06/201630/09/2016


NO

MICS U

PDATE – Q3 2016

Rising commodity prices and recovering Real reduce current account deficit

Belt tightening is necessary but will it happen?

Brazil will need to rebalance quickly

As most of the regional economies, the commodity downturn has pushed up the current account deficit. Over the year, Brazil’s terms of trade have started to recover, as the value of its commodity exports increased while imports became cheaper again, due to the strong recovery of the currency. The result has been that Brazil’s current account deficit has started to shrink considerably. Brazilian exporters should seize the opportunity to expand into foreign markets which would help the country rebalance. The traditionally protectionist stance of Brazil might make this difficult. With the political changes seen not only in Brazil, there is a good chance that the continent might start to turn less protectionist in the future. Especially within the region, there is still plenty of unrealized potential as many Latin American countries still trade more with the rest of the world than with each other.

Including interest payments, Brazil’s fiscal deficit is still in double digit levels while its gross debt to GDP ratio is close to 70%, which is very high for an emerging economy. What makes it difficult to consolidate the budget is the fact that up to 90% of public spending is enshrined in the constitution and thus not discretionary. Tax increases, on the other hand, would come at a bad moment, given that taxes are already much higher than in comparable emerging countries and would only exacerbate the recession. At the same time, even the new government would probably lack legitimacy amid the various corruption scandals and tax increases would therefore be ill received. For these reasons, it is difficult to see how Brazil’s fiscal situation can improve over the medium term.

7

Current Account

-4.50%

-4.00%

-3.50%

-3.00%

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

-2.03%

-4.09%

-1.67%-1.46%

30/09/201130/09/201530/06/201630/09/2016

Fiscal Balance

-12.00%

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

-2.39%

-9.16%-9.98% -9.64%

30/09/201130/09/201530/06/201630/09/2016


NO

MICS U

PDATE – Q3 2016

Policy Rate

Brazil has many strong institution such as the judiciary that is currently investigating endemic corruption in politics and state-run enterprises. One institutional weakness, however, is the lack of central bank independence.

As part of the Ministry of Finance, the central bank governor is a minister who reports directly to the president and can be removed from his post at the president’s discretion. Therefore, monetary orthodoxy is very much dependent on the current president and the temptation of letting the economy overheat during an election year is great. Alas, printing money does not create wealth but it creates inflation instead.

Inflation was indeed let lose to finance public spending for the election year in 2014 and went above the target of 4.5% and even the upper limit of the target range (2.5% - 6.5%).

There are some encouraging signs that the new government is moving towards central bank independence. The newly appointed central bank governor is a respected technocrat and seems to be able to use his discretion.

Whether this will survive the next electoral cycle though, remains to be seen. Years of meddling with the institutions have engrained a mindset in Brazil that suggests that interest rates are somehow part of government policy and it will thus be very difficult to move away from this.

Is Brazil’s central bank becoming more independent?

8

Policy Rate10.50%

11.00%

11.50%

12.00%

12.50%

13.00%

13.50%

14.00%

14.50%

12.00%

14.25% 14.25% 14.25%

30/09/201130/09/201530/06/201630/09/2016


NO

MICS U

PDATE – Q3 2016

Exchange Rate (BRL/USD) – Official Rate

The Real has been going through a rollercoaster ride over the last year, mirroring Brazil’s economic downturn and recent tentative signs of recovery , changing commodity prices, the increased inflation risk and regularly changing expectations of when the Federal Reserve will continue with interest rate increases.

Over the last five years, the value of the Dollar against the Real has doubled. In theory, this should create massive opportunities for Brazilian exporters if the country’s legislators were as keen on free trade as those in neighboring Colombia. Instead, the country remains stuck in the protectionist and poorly integrated Mercosur. Former finance minister Guido Mantega’s argument five years ago that “currency wars” led to an overvalued Real, inflicting damage on Brazil’s industry, seem to have little foundation now.

The sharp depreciation in 2015 has been driven by markets reacting to Brazil’s downgrade. Due to the loss of its investment grade rating, many institutional investors were forced to sell Brazilian debt which weakened the currency.

Over the year, the Real has rallied, recovering much of the losses it suffered over the previous year. Markets seem to be pricing in a more benign outlook and at the same time a much slower pace of interest rate increases by the Federal Reserve.

It should also be mentioned that Brazil is in a much better position than it was during its 2002 crisis. With foreign reserves more than 10 times the amount it had then and a strong willingness to pay, a sovereign default by Brazil remains highly unlikely.

Real rallies over the first half of the year

9

Exchange Rate (BRL/USD)0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1.8793

3.9475

3.213 3.2624

30/09/201130/09/201530/06/201630/09/2016


NO

MICS U

PDATE – Q3 2016

Equity Market

After losing almost 18% since 2010, the Bovespa has made a remarkable comeback over the year.

The poor performance last year was likely due to a sell-off in Brazilian markets amid the credit downgrades. The recent progress on the political front and the slight improvement in the macroeconomic outlook has created some positive momentum.

This should naturally be seen in the context that emerging market equities as a whole have done well over the year, as some optimism has returned to the region.

Also, on a relative basis, developed markets look increasingly richly valued, due to the distorting effects of monetary expansion. Emerging markets that were quite attractively valued might thus seem like a safer option for long term investors.

Investors seemed to have turned positive on Brazil again as quickly as they turned negative in 2015. As a word of caution; while the macroeconomic outlook is improving and a more competent government is now in place, it remains to be seen whether all these optimistic expectations will materialize as quickly as investors hope.

Stock Markets end the year with losses

10

Bovespa Index0

10000

20000

30000

40000

50000

60000

70000

52324.42

45059.34

51526.93

58367.05

30/09/201130/09/201530/06/201630/09/2016

APPENDIX: LONG-TERM STATISTICS

11


NO

MICS U

PDATE – Q3 2016

Stabilization in oil prices might be giving Brazil’s economy a small boost

12

9/30/0

1

3/30/0

2

9/30/0

2

3/30/0

3

9/30/03

3/30/0

4

9/30/0

4

3/30/05

9/30/0

5

3/30/06

9/30/0

6

3/30/0

7

9/30/07

3/30/0

8

9/30/0

8

3/30/09

9/30/0

9

3/30/10

9/30/1

0

3/30/1

1

9/30/11

3/30/12

9/30/1

2

3/30/13

9/30/1

3

3/30/1

4

9/30/14

3/30/1

5

9/30/1

5

3/30/16

9/30/1

6-7.00

-6.00

-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

0

20

40

60

80

100

120

140

160

GDP Growth and Oil Prices

Real GDP Growth (LHS)Oil Price (RHS)


NO

MICS U

PDATE – Q3 2016

Inflation and unemployment seem to be stabilizing

13

12/31/03

7/1/04

1/1/05

7/1/05

1/1/06

7/1/06

1/1/07

7/1/07

1/1/08

7/1/08

1/1/09

7/1/09

1/1/10

7/1/10

1/1/11

7/1/11

1/1/12

7/1/12

1/1/13

7/1/13

1/1/14

7/1/14

1/1/15

7/1/15

1/1/16

0.00

5.00

10.00

15.00

Inflation and Unemployment

CPI InflationUnemployment


NO

MICS U

PDATE – Q3 2016

Real has strengthened considerably since the beginning of the year

14

3/31/0

2

10/1/02

4/1/03

10/1/03

4/1/04

10/1/04

4/1/05

10/1/05

4/1/06

10/1/06

4/1/07

10/1/07

4/1/08

10/1/08

4/1/09

10/1/09

4/1/10

10/1/10

4/1/11

10/1/11

4/1/12

10/1/12

4/1/13

10/1/13

4/1/14

10/1/14

4/1/15

10/1/15

4/1/16

1

2

3

4

Exchange Rate (BRL/USD)

Exchange Rate


NO

MICS U

PDATE – Q3 2016

Real has strengthened considerably since the beginning of the year

15

3/31/0

2

10/1/02

4/1/03

10/1/03

4/1/04

10/1/04

4/1/05

10/1/05

4/1/06

10/1/06

4/1/07

10/1/07

4/1/08

10/1/08

4/1/09

10/1/09

4/1/10

10/1/10

4/1/11

10/1/11

4/1/12

10/1/12

4/1/13

10/1/13

4/1/14

10/1/14

4/1/15

10/1/15

4/1/16

50

70

90

110

Exchange Rate (Broad Basket vs BRL)

Exchange Rate Broad Basket


NO

MICS U

PDATE – Q3 2016

Twin deficit is still unsustainable but there are signs of improvement

16

3/31/0

2

10/1/02

4/1/03

10/1/03

4/1/04

10/1/04

4/1/05

10/1/05

4/1/06

10/1/06

4/1/07

10/1/07

4/1/08

10/1/08

4/1/09

10/1/09

4/1/10

10/1/10

4/1/11

10/1/11

4/1/12

10/1/12

4/1/13

10/1/13

4/1/14

10/1/14

4/1/15

10/1/15

4/1/16

-12

-11

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

Current Account and Budget Deficits

Current Account DeficitBudget Deficit


NO

MICS U

PDATE – Q3 2016

Ten Year Year yield has fallen dramatically as sentiment improves

17

3/31/11 10/1/11 4/1/12 10/1/12 4/1/13 10/1/13 4/1/14 10/1/14 4/1/15 10/1/15 4/1/169

10

11

12

13

14

15

16

17

10 Year Government Yield

10 Year Government Yield


NO

MICS U

PDATE – Q3 2016

Equity Market are still close to 2009 levels

18

3/31/03

10/1/03

4/1/04

10/1/04

4/1/05

10/1/05

4/1/06

10/1/06

4/1/07

10/1/07

4/1/08

10/1/08

4/1/09

10/1/09

4/1/10

10/1/10

4/1/11

10/1/11

4/1/12

10/1/12

4/1/13

10/1/13

4/1/14

10/1/14

4/1/15

10/1/15

4/1/16

5000.00

10000.00

15000.00

20000.00

25000.00

30000.00

35000.00

40000.00

45000.00

50000.00

55000.00

60000.00

65000.00

70000.00

75000.00

Bovespa Index

Bovespa Index


NO

MICS U

PDATE – Q3 2016

Industrial production has picked up recently

19

3/31/0

4

10/1/04

4/1/05

10/1/05

4/1/06

10/1/06

4/1/07

10/1/07

4/1/08

10/1/08

4/1/09

10/1/09

4/1/10

10/1/10

4/1/11

10/1/11

4/1/12

10/1/12

4/1/13

10/1/13

4/1/14

10/1/14

4/1/15

10/1/15

4/1/16

-20

0

20

Industrial Production

Industrial Production


NO

MICS U

PDATE – Q3 2016

Inflation forces the Central Bank’s hand so credit conditions remain tight

20

3/31/0

2

10/1/02

4/1/03

10/1/03

4/1/04

10/1/04

4/1/05

10/1/05

4/1/06

10/1/06

4/1/07

10/1/07

4/1/08

10/1/08

4/1/09

10/1/09

4/1/10

10/1/10

4/1/11

10/1/11

4/1/12

10/1/12

4/1/13

10/1/13

4/1/14

10/1/14

4/1/15

10/1/15

4/1/16

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Credit Conditions

Policy Rate


NO

MICS U

PDATE – Q3 2016

Contact & Disclaimer

21

In preparing this report, I have relied upon publicly available data supplied by third parties. Although reasonable care has been taken to gauge the reliability of this data, this report carries no guarantee of the accuracy or completeness and I cannot be held accountable for misrepresentation of data by third parties involved. This report is an opinion piece and for private information and is for discussion purpose only. This report does not constitute financial advice and should therefore not be used as a basis to make any decisions. This report is based on data and information available at the date of the report and takes no account of subsequent developments after that date. It may not be modified without my prior written permission. Under no circumstances do I accept responsibility for any consequences arising from any third party relying on this report or the opinions expressed therein. This report is not intended to form a basis of any decision by a third party to do or omit to do anything.

This report has been written in private capacity and any opinions expressed therein should not be associated in any way with my current or previous employers or any professional organizations I belong to.

If you have any questions or comments on this report, please feel free to contact me.

Third Party sources that have been used are Banco Central do Brazil and Bloomberg.

Christian von Canstein, CFA, MSc

Email: [email protected]

Documents

Brazil Quarterly Update Q3 2016