Brazil’s Flight of the Chicken

The market has bid up Brazilian assets in anticipation of economic reforms, but the optimism should be well measured and individual securities well picked.

Over the last 12 months, capital markets have generally chosen to focus solely on Brazilian President Jair Bolsonaro’s economic platform, avoiding discussion of his social views or more recent broil with French President Emmanuel Macron over the conflagration in the Amazon. Optimism about Brasilia’s ability to awaken a high potential—but lately stagnant—economy has propelled Latin America’s largest equity and fixed income markets considerably higher.

We are tempering our base outlook for near-term economic acceleration following recent meetings with corporate executives and government officials in Sao Paulo and Brasilia. In our meetings, we sought to better understand policy, business and macro momentum relative to our conclusions the last time we sat down with Brazilian corporates during the second quarter. It now appears difficult for the economy to gather real steam until later 2021 or perhaps 2022, even if economic reforms go as planned.

Local consensus on the buy and sell sides is being summed up on the ground in a Brazilian metaphor: “The flight of the chicken.” It refers to a chicken that runs hard, flaps its wings intensely and, leaping into the air, appears for a moment to have taken flight…only to fall back to earth.

Despite a slew of structural reforms in the pipeline, there are indications that the government’s 2020 economic forecast could come in below the market consensus of 2% to 2.5%. After many companies originally budgeted 2019 for more than 3% GDP growth, people are beginning to ask executives whether they will set 2020 budgets with sub 1% or sub 2% growth expectations, betraying worries about tepid near-term investment. Market consensus may soon be revised down as the timeline for policy implementation and hoped for investment flows becomes clearer.

Since the Bolsonaro administration took office at the beginning of the year, 2019 has been spent drafting reforms to the country’s financially onerous pension system and byzantine tax regime, along with creating plans for a host of privatizations of state-owned assets, infrastructure investment concessions and broader deregulation. The idea is to free up an economy that ranked 109, between Papua New Guinea and Nepal, on the World Bank’s latest  Ease of Doing Business  survey of 190 countries. A more dynamic economy should lower persistently high levels of unemployment, bolster a precarious fiscal balance and raise potential GDP.

Following 2019’s legislation, executive decrees, and privatizations, implementation should take place in 2020. The long-term positives should be less red tape and a more sustainable government budget. However, in the short-term we will probably see a headwind to growth from lower (inflation-adjusted) government spending, and because privatized entities are likely to see swift headcount reductions.

The government hopes these initiatives will pave the way for stepped up investment in 2021 by private companies on rising business confidence and lower domestic interest rates. Following a 2020 round of infrastructure-related requests for proposals (RFPs), winning bids should be announced in 2021, soon followed by shovels breaking ground. More public and private investment should in theory generate a multiplier effect. If things pan out as planned and unemployment declines amid rising consumption and investment growth, politicians supporting the Bolsonaro administration’s economic policies are likely to have bright prospects in the 2022 elections.

The government’s bet is that foreign exchange stability and lower interest rates keep the middle and upper classes spending in 2020-21 on improved confidence, even if they aren’t yet seeing real income growth. Stability can also help ensure passage of a long-awaited, and nearly complete, trade accord between the European Union and the Mercosur trading bloc, in which Brazil is the largest economy. That would spur consumption by lowering import tariffs and help domestic production by reducing E.U. tariffs on Brazilian exports.

However, there are a lot of “if-then” conditional statements for an economy in which consumption represents more than 60% of GDP, particularly with corporate confidence about end-market demand softening after economic growth downgrades this year.

Investors in Brazilian assets have already priced in quite a lot of reform. But threading the needle on structural reforms and trade pacts in targeted timeframes is no easy task. The legislative agenda can still get watered down, diminishing its impact. Policies also risk being delayed or undermined by the unexpected, such as an acrimonious dispute over Brazil’s handling of fires in the Amazon rainforest. Macron has already threatened to block the E.U.’s trade deal with Mercosur over the matter. Finally, Argentina’s recent surprise election results and currency correction show that if difficult economic reforms fail to quickly deliver the expected economic stability and growth, a one-two punch from voters and capital markets can result.

Brazil does need economic reforms for a more dynamic economy. But investors shouldn’t necessarily bank on the current slate of reforms either in terms of the anticipated timelines or impact. Securities of cyclical companies are more vulnerable to market disappointment than those exhibiting more consistent earnings and stronger balance sheets, or growing market share independently of the economic environment.

Although our expectations for the next 18 months have softened, we remain constructive. It’s true that chickens may only fleetingly take flight, but macaws are skilled at adaptation and comfortable flying whichever way the economic winds may blow.

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