Last week I posted some thoughts on Brazil, which I concluded by mentioning that I am optimistic on the outlook there, without getting too deep into the weeds on what that meant, given the combination of a volatile political situation, a strong rally in asset prices, and fair to strong positive expectations already baked into the market. Frequent contributor Johno rightly posited a few questions--questions I should have dealt with in the initial post. Without further ado:

  1. I see Meirelles saying a pension bill would generate 75% of savings originally planned while a doubter like CSFB sees 30%. A big spread! Any view where in that range a bill passes?  

I mentioned the pension reform as a potential game-changer. As Johno mentions, the problem is how watered down this thing gets.  The initial proposal would have been a good fix, but Temer administration already offered to water it down in May, and that was before he was caught on tape signing off on bribes, and subsequently accused of outright corruption. Looking back in my notes, JP Morgan expected a reform to be passed with 70% of the initial April. So go ahead and fade that number to anywhere between the bearish 30% CSFB figure and, let's say 50%. That said, to the extent the current congress can break this taboo would still be a positive--especially after the election.

  1. The DI curve sees about 125-130bps of cuts in the next year and then >100bps of hikes the following two years. You alluded to value in (fading) that steepness. Curious how you think about that. A call on prolonged slow growth, or structurally lower inflation and maybe lower real rates?

The terminal rate is currently around 7.5%, with some steepness going into the election, and a return to double digit rates as we move into 2019.

The forward curve shows a couple of interesting points--first is the steepness implying hikes throughout 2018. That aggressive in an election year without a bounce in inflation--while this is possible, I don’t think it is a certainty so long as taxes are going up, fiscal policy is tightening and BRL is strengthening. Certainly the latter could easily change by 2018, but who knows.

The second point is the continued steepness to what appears to be a “neutral” level near 11%. If one were to assume a long-term inflation rate of 5%, which is 1% over the center of the central bank’s target mandate, that is a real rate that is still nearly 6%.

I hear you thinking, “hold on there hombre, wasn’t it just last week you were talking about the central bank’s low credibility and lousy inflation targeting credentials?”

Yes, that’s true, and certainly warrants a term premium. But you can see in the inflation history that CPI bounced around 6% in an era of unprecedented commodity prices, fiscal profligacy and monetary irresponsibility during the reign of the Lula/Dilma/Tombini axis (read this brilliant article by former MS Latam economist Gray Newman to learn more about this era in Brazilian economic history). With a center-right president, chastened congress, a more orthodox central bank board and governor, tighter fiscal policy, and lower commodity prices, medium term rates of  6% real on 5% breakeven is way too high if you buy into the reform story, which would clear the logjam of red tape and bureaucracy that has held down Brazilian productivity for generations.

If structural reforms pass, long-term breakevens and real rates will fall.  Simple as that. And the Jan19/Jan21 flattener is a great risk reward if the central bank doesn’t cut quite as aggressively as the market thinks right now, but then leaves rates in the basement during 2018 which we can’t rule out quite yet.

  1. How worried should we be about Lula?

This is really the fulcrum around which the rest of the long Brazil thesis rests. I think Lula has been strong in polling thus far because of a) name recognition, which goes a long way anywhere, but especially in Brazil, and b) he’s still the leftist flagbearer, despite his recent conviction and subsequent prison sentence due to corruption charges.

But I don’t think he is going to win, in fact, he may not even get to the starting blocks. He will have to win an appeal to even run, which may or may not happen before the election. But as Johno mentioned, while he is polling in the high 20s-low 30s, this is a block of people that have supported him for the past thirty years and would continue to support him even if he showed up on TV wearing a sportsuit made of gold and holding a suitcase full of cash. The rejection rate is the key thing for Lula--there is probably a bare majority of the electorate that wouldn’t vote for him under any circumstances.

In the end, it is indeed not unlike Le Pen in France--even if he is eligible to run, he will suck the oxygen out of the leftist movement, despite being unelectable. As such, his candidacy is if anything a positive--and would likely turn up a few buying opportunities along the way, just as we saw in France earlier this year.

What does that mean for the rest of the field of presidential candidates? One “name” is Marina Silva, another leftist but more of the “green” variety. She doesn’t have the political machine or the money to make significant waves nationally. Same goes for other candidates from the left like Ciro Gomes, who will still struggle to get away from the legacy of the PT.

On the right, there is Jair Bolsonaro. He has been rising in polls lately but is probably unelectable due to some views that are, erm...let’s just say “old school”.

Bolsonaro's rise in popularity illustrates the strengthening hand of Brazil’s conservative movement. This will play into the hands of two center-right candidates from the PSDB, João Doria and Geraldo Alckmin. Unlike Aecio Neves, they have managed to steer clear of the Car Wash scandal, are center-right known quantities and will be cheered by investors, yet don’t have the baggage of a guy like Bolsonaro. Despite the filth of the political system at large, the PSDB money and machine will be of great importance--there just isn’t much breathing room for an insurgent candidate.

If one of those candidates wins in 2018, he will have the mandate to push through stronger reforms and tighter fiscal policy. So while there are certainly landmines in the next 12 months, I don’t see a candidate that is likely to reverse or sandbag the reforms that are necessary to put the country back on a sustainable growth path--in fact it is quite the opposite--there is likely to be a supportive government, a more reform-minded congress, and an orthodox central bank. That is a combination that Brazil hasn’t seen since, well….forever. The market is still trying to wrap its hands around that.

To sum it up--we could also spend some time drilling into the relative value between Brazil and similar credits, equity valuations, or recent performance of BRL relative to high beta EMFX. At the end of the day Brazilian assets have performed well over the past year, but not dramatically better than the rest of the asset class given the massive tailwind for EM. There is plenty more to go if the politicians can deliver.