A mere 12 months or so ago, Brazil was in the middle of the Lava Jato (‘car wash’) corruption scandal. The market was obsessing about when, with a budget deficit approaching 10% of GDP, the Brazilian government would be likely to achieve a primary surplus and have any prospect of reversing the deterioration of debt-to-GDP numbers.

Fast forward to today, and the issue is barely of concern to investors. Since January 2017, there have been strong positive flows into emerging-market bonds, driven by a steady uptick in the global economy and an upward revision for growth in China, a major consumer of commodities.

But Brazil’s budget deficit remains sizeable. Barring a slashing of government expenditure, a primary surplus won’t be achieved any time soon, and debt fundamentals will continue to deteriorate. The country’s debt-to-GDP ratio is likely to breach 80% in 2018.

 

All eyes on the 2018 election

 

Fiscal sustainability is impossible without social spending reform. Brazil certainly has the propensity to disappoint investors regarding pension and social-security reform, both pre and post the 2018 election; a major pillar of fiscal discipline must be an expenditure ceiling. Brazilian politics are all about the individual and rarely a collective effort for the good of the country. This is likely to mean a fragmented centre ground at the next election, which could open the way for a populist candidate to make it to the second round of voting. Such an occurrence would panic investors, and threaten fiscal consolidation.

Conversely, falling inflation (which may well persist given 13% unemployment and a large output gap), should make it possible to continue reducing domestic interest rates and boost domestic credit, demand and consumption. We should also not be unappreciative of the significant reforms already enacted by the Temer administration.

 

Imminent default unlikely

 

With 95% of government debt denominated in Brazilian real, and US$370bn of foreign-exchange reserves which could easily cover US dollar-denominated government debt, Brazilian state development bank (BNDES) debt and other quasi-government US-dollar debt, an imminent default is very unlikely.

While the music of a benign external environment plays a bossa nova beat, we may as well make our way over to the dance floor. Recent 10-year Brazilian government US-dollar issuance at around 240 basis points over US Treasuries still represents value – especially versus select, much less diversified and fundamentally weaker single B-rated issuers. The local bond curve may still benefit from rate cuts and a reduction in the required level of real-yield compensation after the recent Taxa de Longo Prazo (TLP) reforms to the BNDES’ standard subsidised lending rate. We could reasonably expect a greater allocation towards Brazilian equities from domestic pension funds, should rate cuts persuade locals to exit the lower-yielding bond markets.

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