Global Macroeconomic Outlook and the Brazilian Elections - Paulo Leme 39º Convención del IAEF
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Global Macroeconomic Outlook
and the Brazilian Elections
Paulo Leme
39º Convención del IAEF
Mendoza, September 7, 2018Global Economy – Strong Growth and Low Inflation
• Global macro conditions: as good as it gets
• Global growth peaked to 4.1% in 1Q18, slowing to 4% in 2Q18 - 3Q18; and 3.8% in
2019
• Inflation rose from 1.7% in 2017 to 2.2% in 2018, stabilizing at that level in 2019
• Regional disparities: US economy (2.9%) accelerating and growing faster than EU
(2.2%) and Japan (1.0%) in 2018
• China: growth slowing from 6.9% in 2017 to 6.6% in 2018 and 6.4% in 2019
• Risks: tilted to the downside (trade war, tighter financial conditions, valuations and
financial market risks, completion of Brexit in March 2019)
• US watch: effect of mid-term election in November on the Trump administration
2US Elections: DEMs Take House REPs Keep Senate
Source: Goldman Sachs Investment Research
3A Positive Short Term Outlook for Commodities
Commodity Current 3m 6m 12m
WTI 69.80 74.50 69.50 69.50
LME Aluminium 2,125 2,300 2,200 2,000
LME Copper 5,975 6,500 7,000 7,667
Comex Gold 1,207 1,375 1,375 1,450
CBOT Soy 844 900 950 975
CBOT Wheat 545 500 500 475
Source: Goldman Sachs Investment Research and Bloomberg
4Central Banks Tightening Financial Conditions
• Gradual tightening of global financial conditions led by the US
• Significant increase in the “risk free rate” of return, favoring capital inflows toward the US
• Fed - 2 more hikes of 25 bp in 2018 (September and December), raising Fed Funds’ range
to 2.25% - 2.50% by December
• For 2019, FOMC likely to raise Fed Funds 4 x 25 bp to 3.25% - 3.50% by December 2019
• US Treasury Yield curve – upward-parallel shift more likely than inversion
• Risk– Fed being late at raising interest rates, given tight output gap, record-low
unemployment and more fiscal stimulus
• ECB – no rate hikes in 2018 and 2019; first hike only in 2020
• EM - with currencies being under pressure, several EM central banks are also tightening
monetary policy
5US Yield Curve in the Last 3 Months
Source: Goldman Sachs Investment Research
6FX – Strong USD; EM Currencies Under Pressure
• USD - while the bulk of its appreciation is behind us, fundamentals still favor a
slightly stronger USD
• US intervention in FX markets: unlikely and ineffective
• EUR is likely to continue to struggle in the near term because:
(a) tighter financial conditions and stronger relative cyclical position in favor of the
USD x EUR
(b) in Europe, political and fiscal risks (Italy) can weigh against the EUR
• EM FX: prone to high volatility and weakening due to trade war and mild contagion
from riskier countries (TRL, ZAR, BRL, ARS)
• The more Fed tightens, the larger is the risk for capital outflows in EM
• CNY – could weaken slightly to 7.10 in 6 months, stabilizing thereafter
7US Dollar Rally vs. CNY Depreciation
Source: Goldman Sachs Investment Research
8Flow of Funds: Out of EM and Europe into US
• In the year through August, EM equity funds received net inflows of US$15bn;
EM bond funds experienced net outflows of US$1.5bn
• In August, EM funds experienced outflows
• European equities and bonds experienced outflows
• Funds have moved to US bonds (net inflows of US$77bn YTD); US Money
Markets; and US equities (+US$5.4 bn YTD)
• For global markets, net inflows for equities and bonds amounted to US$116bn and
US$68bn YTD
• Global high yield funds experienced net outflows of US$46bn YTD
• Investors’ challenge: valuations and taking higher risks to receive lower returns
9Valuation – Low Risk Premia Across US Asset Classes
Source: Goldman Sachs Investment Research
10Asset Allocation – Biased Toward US Equities
• Equities - despite high valuations, earnings and growth can support slight increases in
P/Es, raising the S&P moderately
• EM equities – the sell off offers interesting valuations for this asset class, particularly for
MSCI Asia Pacific ex-Japan
• US Treasury yield curve: a parallel shift is more likely than a bear flattener/inversion of
UST curve
• Yield curve puzzle: little inflation, term, and fiscal risk premium in the back- end of the
curve
• Credit – the most vulnerable asset class to higher UST rates
• US Investment Grade is in a stronger position than US High Yield
• EM Sovereigns and Corporates – bond yields are likely to continue to widen in the
short run
• FX – long USD; short CNY; EM currencies undervalued (ARS, BRL, TRL, MXN)
11Brazil – Next President will Face Difficult Macro Situation
• The Brazilian economy has 4 areas of strength:
- inflation: IPCA-15 index (4.3% yoy) remains close to the target
- strong external position: current account deficit is only US$20 bn (1% of GDP) and
international reserves are US$380 billion
- growth: after a deep recession, real GDP growth recovered to a modest 1% in 2018
- banking system: solid, with strong regulatory and prudential frameworks
• Brazil faces 5 major challenges:
- fiscal solvency – high stock of domestic public debt (88% of GDP); primary fiscal deficit of 2.4% of
GDP; some regional governments are insolvent
- total factor productivity is very low (0.5%), limiting potential real GDP to 1.5%-2.0%
- savings and investments are too low to generate growth (16.4% and 16.0% of GDP)
- unemployment is high (12.3%)
- infrastructure has depreciated and public services (health, education, security) are precarious
12Brazil – Selected Economic Indicators
2016 2017 2018 F 2019 F
Real GDP (% change) -3.5 1.0 1.0 2.0
Unemployment (%) 12.0 12.6 12.3 12.0
Exchange Rate (BRL/USD eop) 3.25 3.31 4.25 4.50
IPCA Inflation Rate (% yoy) 6.29 4.00 4.25 4.50
Primary Fiscal Balance (% GDP) -2.5 -1.7 -2.4 -2.2
Nominal Fiscal Balance (% GDP) -8.9 -7.8 -6.5 -6.6
Gross Public Debt (% GDP, IMF) 78.4 84.0 88.2 90.5
Trade balance (US$ bn) 48 67 50 30
Current account (US$ bn) -24 -10 -20 -45
Current account (% GDP) -1.3 -0.5 -1.0 -1.7
International Reserves (US$ bn) 365 374 380 370
Gross External Debt (% GDP) 37.2 32.5 32.0 30.5
13An Agenda to Restore Fiscal Solvency and Growth
• Reduce the size of the government: cut spending and privatize
• Primary fiscal adjustment required to reduce debt/GDP: 4.5%-5.0% of GDP in 4-5 years
(a) privatization revenues: 1.5% of GDP
(b) Buoyancy to growth of tax system: adds 1.0% GDP/yr in revenue (if GDP grows 3%)
(c) Eliminate tax exemptions (save 0.5%-1.0% of GDP)
(d) cutting primary spending (reduce subsidies and payroll) by 1.5% of GDP
(e) Eliminate wage indexation practices and deep social security and pension reform
• Structural reforms to boost productivity (TFP) to 2.0% from 0% - 0.5%
(a) open up the economy to trade
(b) tax reform (simplify tax system and reduce tax burden once D/GDP stabilizes)
(c) increase competition (anti-trust laws/regulatory agencies)
(d) boost credit growth: increase competition in the banking system, reduce reserve requirements, review
prudential regulation, eliminate earmarked credit, shrink size of federal banks
(e) new labor market reform to reduce unit labor costs
(f) Rebuild infrastructure funded with private and external financing
14Brazil - Understanding the October Elections
• General elections: President; 27 governors; all 531 house seats; 2/3rd of Senate (54
seats)
• Registered voters: 147 million (or 110 mn net of 25% null/blank)
• To win in 1st round (October 7) a candidate must receive the majority (50%, or 55mn)
of the valid votes, otherwise the election goes to a 2nd round (October 28)
• Exit polls released only after the ballots close (8m) but vote count is fast
• There are 13 presidential candidates, but only 5 are viable: Bolsonaro, Haddad,
Marina, Alckmin, and Ciro
• TSE did not allow Lula to run, so PT has until September 10 to replace him with
Haddad
• Keys to outcome: (a) transfers of votes from Lula to Haddad (or Marina/ Ciro); (b)
undecided votes; (c) TV campaign; (d) role of social media
15Economic Team and Policies of the Viable Candidates
Candidate (party) Chief economist Policy orientation
Geraldo Alckmin (PSDB gov SP) Persio Arida (Real plan of 1994, finance) Orthodox, reforms, negotiator
Jair Bolsonaro (PSL - Congressman) Paulo Guedes (Chicago PhD, finance) Army, hard liner, pro reforms
Fernando Haddad (PT) Marcio Pochman (PhD Unicamp) Heterodox/ return to crisis
Marina da Silva (Rede, Senator) Eduardo Gianetti (economist, academic) Leftist background; hesitant
Ciro Gomes (minister, governor CE) Mauro Benevides (PhD Vanderbilt) Leftist and populist
16Votes for the Left & Right: ½ to ¾ of Total
Datafolha Poll August 22 (in percent)
45
40
35
30
25
20
15
10
5
0
w/ Lula w/out Lula
LULA BOLSONARO MARINA CIRO ALCKMIN HADDAD A DIAS OTHER NULL/VOID DONT KNOW
17Ibope Poll Sept 6 2018 – Bolsonaro Leads
First Round Presidential Elecion in %
25
20
15
10
5
0
FIRST ROUND
BOLSONARO MARINA CIRO ALCKMIN HADDAD A DIAS OTHER DON’T KNOW BLANK/NULLIbope – Second Round – Bolsonaro Weakened
Second Round in %
50
45
40
35
30
25
20
15
10
5
0
Ciro vs. Bolsonaro Alckmin x Bolsonaro Bolsonaro x Marina Haddad x Bolsonaro
1 2A Polarized Election; Alckmin not Doing Well in the Race
Alckmin
vs Alckmin
Bolsonaro
Alckmin
vs Haddad
1st Round October 7 Haddad
w/out Lula Bolsonaro
Bolsonaro
vs
or Haddad
Haddad
Bolsonaro
vs Marina
Marina
20Four Scenarios for the Next Government
• Bullish – Alckmin – not priced in, large upside for Ibovespa and BRL
• Strongest economic and political teams – likely to deliver a good portion of the required
adjustment & reforms in Congress
• Bearish – Haddad – end of Lava Jato and largest market downside
• Return of heterodox policies and spending, pushing fiscal toward insolvency
• Bolsonaro – buy the rumor and sell the news – markets may like initial effort by
Guedes, but would sell off afterward
• Main concerns about Bolsonaro: governance and ability to build consensus
• Marina – economic program is in the right direction but it’s not strong enough
• Marina may have a hard time to build an effective coalition in Congress
• Skewed distribution of outcomes: neutral to bearish scenarios 3 to 4 times more likely
than the bullish scenario
21Brazil: Effect of the Elections on Asset Prices
Alckmin Bolsonaro Marina Haddad Ciro Current E(X)
Probability
20% 35% 15% 25% 5%
5-yr CDS bp
180 350 425 800 700 305 457
IBOVESPA
91,452 70,113 67,065 57,158 64,779 76,210 70,418
(% change)
20% -8% -12% -25% -15% -7.6%
BRL
3.40 4.35 4.50 5.00 4.75 4.13 4.37
SELIC
6.25 6.50 6.75 9.00 8.00 6.50 7.19
22Conclusions
• The global economic outlook is good: strong growth/low inflation
• Financial markets: volatile, stretched valuations, and prone to slide into a bear
market in 2019
• Main downside risks for global scenario – Fed tightens faster; US government makes
policy mistakes; trade war intensifies
• EM: interesting valuations but tighter financial conditions, protectionism, and
external/fiscal fragilities undermine the asset class
• Brazil: growing risk that next president will not be market friendly
• Best case – Alckmin – candidate remains weak in the polls
• Worst case – Haddad (PT) wins and debt dynamics becomes unstable
• Intermediate cases (Marina or Bolsonaro) – gain time but fail to restore fiscal
solvency and growth
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