While 1Q16 GDP contracted less than expected, the Brazilian recession continues to get deeper. Since 1Q14, GDP already contracted 7.1% – the worst recession in Brazilian economic history – and recent data assures us that there will be an additional retreat this quarter. Note that domestic demand is falling even more and tax collection is collapsing on the back of falling activity.
As described earlier this year (see Brazil: the good, the bad and the ugly), public expenditures are largely rigid and therefore the severe fiscal deterioration – which triggered the country’s downgrades last year – continues steadily. Recent adjustments suggest that the primary fiscal deficit could further widen to 2.7% of GDP this year from an already very high 2% in 2015. Debt dynamics remain on an unsustainable path and should surpass 70% of GDP (which is untypically high in emerging markets) this year. To further complicate the situation, this problem can be fixed only through a series of constitutional amendments since most of the mandatory expenses were specified in the Constitution.
In view of this, it would be very hard to justify the outstanding performance of Brazilian assets year-to-date: BRL gained 16% vs USD (the best performance among EM currencies); local equities 21% in USD, and long dated local bonds 33% in USD. It is true that the end of the “long USD” trade and more constructive view about China and commodities underpinned risk assets and EM trades in particular, but Brazilian assets clearly outperformed among EM high beta names.
Enter politics: the possibility of impeachment of President Dilma Rousseff and of a reformist administration triggered the rally in Brazilian assets early this year. And in May, the impeachment trial was finally approved in the Lower House and Senate with more than two thirds of congressmen, forcing President Rousseff to step down in mid-May for 180 days or until the final impeachment judgment in the Senate.
Subsequently interim President Michel Temer announced a credible cabinet including experienced politicians to gain the necessary political support for a reform agenda, and high-calibre technocrats in key positions of the economic team. As the impeachment trial already got more than two thirds of the votes, a strong case could be made that the new administration could get the required three fifths of the votes required for constitutional amendments.
In recent weeks, however, it is becoming clear that this political transition will prove more turbulent than initially expected for two reasons: 1) votes in favor of Dilma’s impeachment may not translate easily into votes in favor of unpopular expenditures cuts, higher taxes or social security reform; and 2) the uncertainty generated by ongoing judicial investigations (where many congressmen are being investigated) may hurt the new administration’s capabilities to articulate the agenda in Congress. Note for instance that in twenty days in office, acting President Temer already lost two Ministers over recordings suggesting they sought to interfere in a corruption probe; and two Senators that voted in favor of the impeachment trial are now saying that they may change their votes in the final judgment in the Senate.
Brazil’s politicians are at a critical crossroads. Opting for the virtuous cycle has a very clear path: the approval of a minimum reform agenda with more sustainable fiscal trajectory, which boosts business confidence and anchors inflation expectation, allowing the Central Bank to finally reduce interest rates (policy rate is still at an amazing 14.25% despite the sharpest recession ever!), which should further support economic growth. Brazil has already experienced the vicious cycle in 2015, and with that in mind we believe that Congress will eventually opt for the virtuous path to be selected. However, as recent weeks have shown, it will remain a very bumpy road.