By Scott Piper, Milltrust Latin America Fund, Oct 2017.

In Brazil we began the last quarter of 2017 in a slightly different context than the one portrayed in our last report. While the data published in recent months strengthen the thesis of a recovery of activity and the labor market, inflation indices continue to surprise analysts to the downside, thus creating room for a much more substantial degree of monetary policy accommodation than even the most optimistic analysts could have expected at the beginning of 2017. However, the political environment remains an important source of uncertainty. On the positive side we witnessed the successful passage through Congress of measures sponsored by the economic team, such as labor reform and the provisional measure that established the Long-Term Interest Rate (TLP). On a more negative note, we should mention the difficulties surrounding the negotiation of the provisional measure that deals with the new corporate tax renegotiation program – Refis – and the lack of progress on more controversial structural measures, such as pension reform.

However, the fact of the matter is that the cyclical recovery has continued to plough ahead, unabated by these political concerns. Both confidence indicators and those indices that seek to capture the behavior of the real economy suggest that gross domestic product (GDP) expanded slightly in the third quarter. This point of departure is consistent with a moderate expansion of activity in 2017, followed by more robust growth next year.

To transform this cyclical recovery into a longer-lasting one, it will be necessary to address our economy’s structural problems – especially the persistent fiscal imbalance. All indications are that the risk of not fulfilling the 2017 fiscal target has receded substantially in recent weeks. Thus, the auctions involving hydroelectric plant concessions and oil exploration blocks that took place at the end of September were an important source of relief for the short term.

The difficulties going forward, however, should not be underestimated, given that, although the spending ceiling constitutes an important fiscal brake, observing it will become an ever greater challenge, due to the high degree of rigidity of public spending and its expected future trend. In addition, we believe that the strong cyclical recovery of the economy forecast in our baseline scenario will not be sufficient to contain fresh increases in the public debt. All things considered, we expect the public debt to draw closer to 90% of GDP in coming years, which is very high for a developing economy.

Another risk facing this domestic activity acceleration process is the external economic situation, as it has been extremely benign for emerging economies. Although the prospects for the Brazilian economy have improved in recent months, we should remember that various structural challenges still exist, which should be reflected in our risk premium and Brazilian asset prices. Thus, we think that a possible deterioration of the external environment constitutes an important risk factor to be monitored in the months ahead. One should point out that this matter was also analyzed by the technical staff of the Central Bank of Brazil (BCB) in its last Inflation Report (IR).

The good news is that the balance of risks presented by the monetary authority gives us more reasons to expect interest rates to be kept below their neutral level in coming quarters than the opposite. The factors explaining this optimism include an extremely low level of current inflation, the anchoring of inflation expectations over the relevant horizon and results that are consistent with the inflation target pursued by the BCB in most of the scenarios presented to the Monetary Policy Committee’s (COPOM) directors.

It is in the difference between the BCB’s medium-term projections and ours that we find arguments to support our view that monetary easing has further to go than most market participants expect. If the assumptions used in our scenario are correct, the Broad Consumer Price Index (IPCA) will come in slightly below the lower bound of the inflation targeting regime’s range in 2017 and slightly above it in 2018 (2.8% and 3.2% in 2017 and 2018 respectively). This means that current conditions are extremely favorable for loosening monetary conditions, so we expect the Monetary Policy Committee (COPOM) to take the Selic rate down to 6.5% at the end of the current cycle. Given the output gap, this level of interest rates should provide an adequate degree of accommodation, and could be reversed over the relevant horizon if any risk (external or domestic) materializes.