Post-U.S. election relief fades as currency, interest rates, and stocks remain pressured; Finance Ministry’s fiscal package in spotlight
11/11/2024
The post-U.S. election relief that buoyed Brazilian assets last week has now faded. As the government delays announcing the spending cuts promised by the Ministry of Finance, concerns about fiscal risk continue to mount, compounded by an increasingly challenging global backdrop. Early signs indicate that the Trump administration may adopt more protectionist trade policies, which, alongside recent disappointments in Chinese stimulus, is creating a harsher environment for emerging markets, pushing Brazilian assets to maintain high risk premiums.
The currency’s volatility illustrates the recent market instability. Last week alone, the exchange rate ranged between R$5.63 and R$5.83 per dollar, closing Friday in the middle of that band. Now that the post-Trump-election technical adjustment has passed, the market faces an adverse external outlook. Paired with Brazil’s unresolved fiscal issues, these factors are driving higher risk premiums for domestic assets.
The delayed release of Finance Minister Fernando Haddad’s fiscal plan, aimed at maintaining the country’s fiscal framework over the coming years, has fueled market uncertainty. Expectations that some previously expected programs may be dropped from the package add to investor unease.
“The government must understand that the current debt-to-GDP trajectory is completely unsustainable. A primary deficit that appears small but is maintained through temporary measures will only lead to a massive nominal deficit,” said Bruno Marques, partner and co-manager of XP Asset Management’s multimarket funds. For Mr. Marques, the government should focus on more structural solutions to reduce debt levels. The external backdrop, marked by a strengthening dollar and rising interest rates, complicates matters further.
The potential for the Trump administration to adopt a protectionist stance is already affecting financial markets. The possibility of Robert Lighthizer’s return as U.S. trade representative has raised concerns that the threat of tariffs, a hallmark of Donald Trump’s first term, could once again become reality.
“If tariffs are imposed on Europe, China, and Mexico, this will strengthen the dollar and impact currencies worldwide,” said Fernando Fenolio, chief economist at WHG. He added that rising external pressure calls for a reduction in the domestic risk premium, which is currently a primary factor in the Brazilian real’s depreciation.
“If we don’t see improvement locally while global risks rise, the exchange rate will continue to depreciate, pushing beyond recent highs,” Mr. Fenolio warned. “With the global environment under stress, investors will demand clearer and more stable local policy,” he said, noting that even an increased interest rate differential between Brazil and the U.S. may not be enough to sustainably support the real.
Last week, expectations were high for an announcement on the spending cuts package. Despite numerous meetings, the government failed to reach an agreement between the economic team and ministers from social sectors, who have resisted cuts to their budgets. Market concerns are growing over the likelihood of a watered-down spending reduction plan.
“We’re entering a phase where fiscal dominance is becoming a concern. In such cases, no interest rate can stabilize the currency because market players start doubting the government’s ability to repay its debt,” Mr. Fenolio explained. Typically, an interest rate hike would lead to currency appreciation, but in times of crisis, this relationship can reverse, as seen in 2014 and 2015. “Since March, we’ve seen this reversed correlation, with interest rates rising alongside a depreciating currency,” he said.
By the end of last week, Brazilian assets reflected high risk premiums across the board, even with expectations of an increased interest rate differential. The exchange rate hovered around R$5.73 per dollar, mid- and long-term interest rates neared 13%, and long-term inflation-linked bonds (NTN-Bs) remained above 6.5%.
“We hope the package is announced soon. Overall, we expect the government to aim for the original fiscal framework’s intent by implementing rules and restrictions to limit government spending growth to around 2.5%,” said Tiago Berriel, chief strategist at BTG Pactual Asset Management and a former Central Bank director.
In his monthly scenario review, Mr. Berriel noted that some elements being discussed are politically difficult to implement, such as changes to social spending. “The initiative is good, but we’ll need to see if Congress will back it and if it’s politically sustainable. It’s quite challenging,” he added.
A favorable fiscal package could trigger a relief rally in Brazilian assets, “but any rally is likely to be temporary,” said Paulo Clini, chief investment officer at Western Asset in Brazil. He noted that the strength of the U.S. economy and the outlook for higher long-term rates dampen foreign appetite for emerging markets, including Brazil. Without foreign investors, a sustained domestic rally seems unlikely.
“Global investors are holding back, and they typically drive the yield curve term structure. This trend isn’t exclusive to Brazil but is impacting emerging markets broadly, including Mexico, Colombia, Chile, parts of Southeast Asia, and Eastern Europe,” Mr. Clini said. Mr. Trump’s policies, which could increase inflation and interest rates in the U.S., reinforce the concept of “American exceptionalism,” he added.
“With the ‘Republican wave,’ checks and balances are diminished. Trump holds considerable power, and a Republican Congress is unlikely to counterbalance his agenda,” Mr. Clini explained. Given local investor concerns over fiscal policy and limited foreign interest in emerging markets, “it’s hard to believe that the market will recognize any excess in the risk premium soon,” he concluded.
There’s also the chance that the government’s fiscal package may disappoint, cautioned Fernando Rocha, chief economist at JGP. “The market will scrutinize the details. If we see R$50 billion in cuts, but only through superficial adjustments, the reception may not be favorable.”
*By Arthur Cagliari, Bruna Furlani, Gabriel Caldeira, Maria Fernanda Salinet, Victor Rezende — São Paulo
Source: Valor International