Lack of fiscal sustainability drives projections for a stronger U.S. dollar and higher interest rates

12/02/2024

The long-awaited announcement of Brazil’s fiscal measures, which had been seen as a potential stabilizer for domestic assets amid worsening conditions in global markets, has instead fueled further deterioration in local prices. Experts warn that higher levels for the U.S. dollar and a steeper Selic policy rate hike may be necessary to mitigate the impact on inflation and market expectations.

For Drausio Giacomelli, chief strategist for emerging markets at Deutsche Bank, the recent sell-off in Brazilian assets reflects concerns over fiscal measures that could worsen the country’s financial outlook, compounded by the expansion of income tax exemptions.

“It was confirmation that there is no meaningful fiscal adjustment on the horizon, with debt nearing 80% of GDP and a fiscal deficit close to 10% of GDP—figures typically seen in wartime economies,” he said. Of the R$70 billion in projected savings for 2025 and 2026, only about R$40 billion is likely to materialize, as much depends on social program audits and Congress refraining from diluting the measures, Mr. Giacomelli added.

This sentiment is echoed by Ricardo Cará Monteiro, chief investment officer at EQI Asset. “After a year of government measures focused mainly on increasing taxes, there was great expectation for a spending-focused adjustment plan,” he said. “Investors grew impatient as the government lost credibility, exacerbated by clashes between the president and the market, which raised the risk premium. Now, instead of measures addressing fiscal concerns, we got more exemptions and more taxes. It was a bucket of cold water,” he said.

Mr. Giacomelli warns that further deterioration in Brazilian markets is still possible, even with future interest rates stabilizing around 14% and the exchange rate per U.S. dollar at R$6. “There is still room for things to get much worse. In crises, investors look to historical references. Without anchors for exchange rates and debt, the currency and interest rates lose benchmarks,” he said. “R$6.5 would not surprise me.”

Luiz Eduardo Portella, partner and manager at Novus Capital, noted that the market had hoped for signs of debt stabilization but instead saw a government already focused on the 2026 elections. “This will lead to a new, worse equilibrium for the market,” he said.

Mr. Portella said the “floor” for the dollar has risen again, increasing the likelihood of further exchange rate deterioration. “Previously, if the market calmed, the dollar could fall back to R$5. Now, seeing the dollar below R$5.80 is difficult,” he added.

Alexandre Silvério, CEO of Tenax Capital, avoided setting a ceiling for the exchange rate but said he would not bet on the real until fiscal and monetary policies align to provide clearer visibility on public debt dynamics.

The weakening real is expected to fuel inflation further, potentially requiring higher interest rates. “The Central Bank has become a passenger at this point but must remain firm in its communication, as Gabriel Galípolo has been doing,” Mr. Portella said.

Novus had maintained bullish positions on interest rates and equities, expecting the fiscal package announcement to mark a positive turning point. “But after the disappointment, we closed those positions. We are now long in U.S. equities, holding small short positions on Brazilian stocks, and betting on interest rates and the dollar,” Mr. Portella said.

For Mr. Giacomelli, of Deutsche Bank, the new scenario may require Brazil’s Central Bank to adopt a “shock treatment” to prevent inflation from spiraling out of control and posing a greater risk to financial stability. He expects the Monetary Policy Committee (COPOM) to raise the Selic rate by 75 or 100 basis points at its December meeting. “I’m leaning toward 100 basis points,” he said.

“We must prepare for a substantial increase in the neutral interest rate and inflation. It’s not an exaggeration,” Mr. Giacomelli said, referencing the term structure, which now projects a Selic rate between 14.5% and 15% by the end of the tightening cycle next year.

Congressional role

As the constitutional amendment (PEC) and related bills progress through Congress, Mr. Portella of Novus said some reversals might signal a more positive trajectory. “But Congress won’t act unless the government leads,” he said.

To reverse the sharp deterioration in domestic assets, Mr. Silvério of Tenax emphasized the need for the economic team to regain control of the fiscal adjustment process. “It’s increasingly clear that [Finance Minister Fernando] Haddad is losing influence. Both the content and presentation of the package show the political wing has dominated the economic wing,” he said.

While fiscal issues remain a major concern, Mr. Silvério highlighted the appointment of Nilton David to the Central Bank’s monetary policy board as a positive development. “Nilton reinforces the perception of the Central Bank’s strong independence. It doesn’t resolve the fiscal challenge but eliminates fears of a looser monetary policy worsening inflation expectations,” he said.

Mr. Silvério also noted that the current environment has created opportunities to increase positions in local equities, citing attractive valuations and improving microeconomic conditions for companies in terms of profit growth and business resilience, particularly in the utilities and shopping mall sectors. “Stock prices are at levels where we don’t need to take risks on highly leveraged companies,” he said.

Even if the income tax exemption is not approved, Mr. Cará Monteiro of EQI Asset doesn’t foresee an improvement in risk perception. “The market remains poorly supported. The government missed an opportunity to re-anchor fiscal credibility, and chances of reversing the exaggerated risk premium have vanished,” he said.

EQI Asset has reduced its exposure to Brazilian equities to almost zero, cut its interest rate positions to 20%, and maintained no exposure to Brazil’s real. “We have no appetite. We’re staying out and watching from the sidelines, which is likely what many are doing,” Mr. Cará Monteiro said.

*By Gabriel Roca, Gabriel Caldeira, Bruna Furlani e Arthur Cagliari— São Paulo

Source: Valor International