Brazil: Lula II — Firebrand or Pragmatist?

2 November 2022

Indeed, Brazil’s election result was historic. Not only was former President Lula da Silva returned to power (by an unexpectedly narrow margin), but Jair Bolsonaro’s defeat was the first by an incumbent since the country returned to democracy. Despite earlier threats to challenge the election outcome, President Bolsonaro and his supporters appear willing to accept the result; hopefully, paving the way for a smooth transition in January 2023.

What may Lula’s second presidency look like? His distractors suggest he is a socialist, and will ruin the economy. Meanwhile, his supporters expect potentially expansive policies aimed at reducing poverty and dealing with climate change. The Charts illustrate that Brazilian markets are cheap. For example, the Real (BRL) appears to be up to 15% undervalued (Figure above). Likewise, Brazilian inflation-adjusted 10-year bond yields are amongst the highest in the Emerging Markets (next Chart). Both Charts indicate financial markets have discounted lots of bad news regarding President-elect Lula’s post-election policy direction. Are markets correct or does Brazil now represent an attractive opportunity for global investors?

Lula II: Party Like It’s 2003?!

Despite his reputation as a firebrand union leader, President Lula defied his critics during his first presidency (2003-2010) by implementing macro-policies aimed at stabilising Brazil’s economy. As is often the case, only a left-wing leader who enjoys the trust of workers (and the poor) can successfully pursue such an orthodox macro-strategy. The Chart above illustrates that Lula’s first government — along with an inflation-targeting central bank (BCB) — was able to tame Brazil’s chronic runaway price growth.

Similarly, the Chart above illustrates Lula’s earlier willingness to reduce the government budget defict by 50%. Unfortunately, the proflicacy of his successors have now left Brazil’s public sector debt on an unsustainable path, which narrows the incoming Lula government’s options if it’s to avoid a UK-like market meltdown.

Likewise, the Figure above shows the earlier Lula government’s macro-strategy successfully eliminated Brazil’s habitually bloated current account defict, which had led to a sizeable buildup of external debt.

Not surprisingly, financial markets celebrated these achievements. The earlier Chart indicates the undervalued exchange rate soared, the stock market surged (sharply outpacing gains in the rest of the world), and bond yields with the USA narrowed signicantly.

Lula II: Domestic and Global Factors Limit Policy Options

However, President-elect Lula again will inherit many difficult problems, and the global environment and domestic situation will limit his room for maneuver. Between 2003-2010 Brazil’s economy (as well as the current account surplus and financial markets) benefited from high/rising commodity prices and a steadily growing global economy (Chart above).

In 2023, however, world-wide growth will be tepid, with the developed economies likely to slip into recession. As a result, commodity quotes are likely to decline from currently lofty levels. In the earlier period, likewise, financial markets’ appetite for risk-taking reached their peak (remember the Great Moderation and Global savings glut themes?). Currently, investors remain more risk averse, although this attitude may change after the US Federal Reserve pivots, and signals a cap in US interest rates.

In addition, the Brazilian economy confronts formidable domestic headwinds. GDP will struggle to grow 1% in 2023. In particular, high food and energy prices are constraining consumer spending, as highlighted by the recent slump in retail sales (Chart above). While inflation appears to have peaked, recent declines largely reflect lower government-administered prices. With core inflation still running at 8.5%, monetary policy will need to remain tight for a considerable period before CPI increases decline towards 4.75% (the top of the 2023 inflation target range). Further BCB rate hikes are possible, but interest rates are at/near their peak.

On the other hand, of the many competing long-term structural issues, economic stability must be President Lula’s top priority, as it was in 2003. However, pandemic spending and the proflicacy of his predecessors have left public finances in a perilous condition. To be sure, President Bolsonaro’s pension reform and change to the government spending rules were considerable accomplishments. Nevertheless, in order to stabilise the debt/GDP ratio, fiscal policy would need to be tightened by roughly 6% of GDP.

Given President-elect Lula’s campaign pledges to reduce poverty and inequality, stabilising the government debt ratio is unlikely in the near term. Therefore, mapping out a credible medium-term strategy will be important to maintaining financial market confidence. Nevertheless, while Brazil has reduced poverty considerably in recent decades, the level remains 3X higher than in Chile and Uruguay (Chart above). Likewise, while income inequality has improved in recent years, the situation remains one of the world’s worst. To be sure, President Lula will confront significant demands to increase government spending in coming years.

During his first presidency, Lula da Silva’s efforts to stabilise the macroeconomy were far more successful than his reforms at the micro level. To be sure, Brazilian GDP benefited from high commodity prices and strong global growth. After these tailwinds subsided, however, Brazil’s structural weaknesses became more evident. Indeed, Lula’s and his successors’ failure to pursue firm-level reform aggressively has left Brazil’s long-term GDP growth potential amongst the weakest in the G20 (next Chart).

The list of needed reforms is extensive (and well known): reducing corruption, opening trade, judicial reform, improving the educational system, etc. etc. However, the ultimate aim is to remedy Brazil’s woeful productivity performance (following Chart). Without improving efficiency, government efforts to stablise the debt level, reduce povery, generate long-term economic growth, and improve living stadards will remain illusive.

Policy and Market Considerations

  • The Brazilian Real is 10-15% undervalued. If President-elect can convince financial markets that he will be as pragmatic as during his first presidency, the BRL could test USD4.5 during the next year, especially if US interest rates peak soon. However, declining commodity prices, reflecting deteriorating global growth prospects, may become a headwind.
  • Inflation may have peaked, but reducing core inflation towards targeted levels will require that monetary policy remain tight for an extended period. BCB interest rates, however, may have peaked, reflecting weakening domestic spending (especially consumer outlays).
  • Brazilian real bond yields reflect considerable concern about Lula’s future policy stance. If he proves pragmatic, 10-year bond yield spreads could narrow 75-100bp relative to the USA in the next year.
  • Opposition political gains in both Brazil’s National Congress and in state governor elections may increase the likelihood that President Lula adopts a pragmatic policy program.
  • Brazil faces may challenges. The immediate priority is to produce a credible medium-term strategy to stabilise the government debt ratio. To achieve this aim without unacceptably draconian measures, however, Brazil must unlock its long-term growth potential. Overdue micro-level reforms are essential to boosting productivity: a precondition to reducing poverty and raising living standards, especially amongst the poorest and most vulnerable citizens.