Brazil: Macro Headwinds Are Strengthening

Invesco Fixed Income’s outlook on Brazil as a sovereign credit is deteriorating. Downside risks to growth have increased given the country’s deteriorating fiscal position, rising interest rates, lower commodity prices, global growth headwinds, water and electricity shortages, among other challenges. The key for markets, in our view, will be the administration’s ability to deliver on promised fiscal adjustments.

Economic outlook: We expect growth to contract

Brazil faces a tough year of austerity and adjustments ahead, and we foresee growth contracting by 1.0% to 1.5% in 2015. In comparison, Brazil’s finance minister is forecasting flat growth, and in 2014 the country experienced meager growth of 0.15%.1

In November, economic activity recorded zero growth, and industrial production contracted. More restrictive rules governing public banks’ balance sheets are expected to impose an additional constraint on credit supply, and even more importantly, the labor market is set for its sharpest deterioration in a decade. Investment spending, which contracted 7% in 2014, is set to decline by 1% to 2% in 2015.2 On the other hand, positive net exports stemming from a more competitive exchange rate may offset the drop in investment spending.

Compounding the county’s economic issues, Brazil is experiencing a severe, multi-year drought that could cause electricity to be rationed. According to our estimates, a 10% cut in electricity supply would impact gross domestic product (GDP) by an estimated 150 basis points. At this point, we don’t expect rationing to be implemented, but this is something to monitor.

Fiscal outlook: The key for markets

Fiscal looseness has marked President Dilma Rousseff’s administration. Since she took office in 2010, the fiscal balance has gone from a deficit of 2.5% to 6.7% at year-end 2014.1 Gross debt has increased from 56.4% in 2006 to 63.4% of GDP at the end of 2014.1

Facing ratings downgrades, President Rousseff appointed former head of Bradesco Asset Management Joaquim Levy to the post of finance minister. He subsequently announced a series of tax increases that we believe could raise government revenue by 20.6 billion real, Brazil’s currency, in 2015. The new taxes on fuel, personal loans, imported goods and cosmetics went into effect on Feb. 1, 2015. In addition, the government is considering other revenue measures totaling 20 billion Brazilian real and the possibility of increasing returns on upcoming waterway, airport and road concessions to boost revenue and increase investment.

On the expenditure side, measures include reduced funding to the Brazilian Development Bank, increases in the TJLP3 and reduced subsidies on credit lines.

We believe that Mr. Levy, though well-intentioned, will be hard pressed to deliver on the primary surplus goal of 1.2% after recording a deficit of 0.6% in 2014. We believe he’ll fall short of this target by 40 to 50 basis points, but that the rating agencies will give him the benefit of the doubt.

While these measures are a welcome step, we believe the broader issues are not being addressed. Unemployment programs encourage an artificial unemployment rate of 5.1%, labor mobility remains rigid, and government payroll and social security benefits remain outsized, in our view. The current measures by Mr. Levy to adjust unemployment programs and labor reform are expected to face challenges in congress.

Over the medium term, we foresee the nominal budget deficit to be back toward 4% in two years, and gross debt to stabilize at current levels.

Monetary outlook: 2015 inflation target is a lost cause

The surge of inflation that Brazil experienced in January reflects the impact of higher regulated prices and drought-related food inflation, which we expect will continue to pressure inflation. We see the central bank hiking the Selic (the central bank policy rate) from its current level of 12.25% by 50 basis points at the next meeting, followed by another 25 basis point increase. The central bank faces a huge credibility issue given years of failing to get near its inflation target of 4.5%, and we believe policy will remain focused on fighting inflation. Policy goals going forward are intended to anchor 2016 inflation expectations. 2015 is considered a lost cause.

Our view on Brazilian bonds

Invesco Fixed Income believes downside risks remain on Brazilian sovereign bonds, given the effects of the deteriorating macro environment, political risks, the corruption investigation into Petrobras, the state-owned oil company, and weather-related shocks. At current levels, we prefer to be underweight hard currency and local currency debt instruments.

Given our negative view of sovereign bonds, we believe it is best to avoid many of the higher-quality Brazilian corporates that are most sensitive to sovereign bond movements. However, we are seeing a few areas of opportunity. Our next blog will examine our view on Brazilian corporate bonds.

1 Source: Central Bank of Brazil (BCB) 12/14

2 Sources: Central Bank of Brazil and Invesco

3 The TJLP is Brazil’s long-term interest rate target. The rate is used as the benchmark rate for loans from the Brazilian Development Bank to companies.

Important information

Issuers of sovereign debt or the governmental authorities that control repayment may be unable or unwilling to repay principal or interest when due, and the Fund may have limited recourse in the event of default. Without debt holder approval, some governmental debtors may be able to reschedule or restructure their debt payments or declare moratoria on payments.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

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