Foreign banks show signs of concern with directions pointed by new government

01/09/2023

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After the noises emitted by the new government provoked days of high tension among local market players, foreign banks have now started to send messages of greater caution with the directions indicated by the Lula administration, worsening their projections for the trajectory of Brazilian assets.

Besides increasing the uncertainties about the performance of the local market, the move seems to give strength to the thesis that foreign players take a little more time to react to domestic political news.

For Morgan Stanley, the context of fiscal worsening and uncertainties about the framework that will discipline public spending in the coming years was translated into a worsening of the prospects for Brazilian assets. The American bank even cited in a recent report “echoes of the fiscal deterioration experienced in 2015 and 2016” in local markets.

“We reaffirm that, from the exchange rate point of view, the attractive spread [i.e., high-interest rates] will not be sufficient to avoid more significant depreciations if external accounts and the fiscal outlook continue to deteriorate,” stated the report. The bank’s strategy team reaffirms a pessimistic view of the real. “We believe that the BRL [real] should underperform emerging market peers due to the risks of political uncertainty and we have opened a short position against the South African rand.”

As for interest rates, the institution considers a process of falling rates unlikely, preferring to adopt a trend which gains from rising local rates. “We remain very focused on inflation expectations for 2024 and 2025, as further de-anchoring may lead markets to price a resumption of the high cycle in 2023 — which is not the base scenario, for now,” they assess.

The higher interest rates for longer are expected to undermine the story of apparently attractive valuation for local stocks. “If we are correct in our assessment, the next few years should not be good for domestic stocks,” said the Morgan Stanley analysts, who maintained a “neutral” recommendation for local stocks.

In the first week of the new administration, Commerzbank sent its clients a note asking, “what does Lula represent for the real?” In response, the German bank said “probably nothing positive.” According to Antje Praefcke, Commerzbank’s senior foreign exchange analyst, Brazil’s fiscal scenario and the sustainability of public debt has been a stumbling block for investors for some time. Now the situation is likely to get worse, as the government plans adjustments to the spending cap to facilitate the increase in social spending it promised during its election campaign.

“Lula will have to manage to improve it [the debt], either with the help of spending cuts or revenue increases. No easy task in times of high inflation and deep political division. The prospect of higher spending will probably make investors even more skeptical and may drive them away completely.”

For the analyst, two questions will be decisive for the Brazilian currency over 2023. The first is whether Mr. Lula will manage to control the fiscal situation or whether it will deteriorate with adjustment to the spending cap. The second is how the Central Bank will react to the evolution of the budget and whether the monetary authority will continue to be an anchor for the stability of the real. “It is likely that times will get tough for the real. If investors question Mr. Lula’s budget policy and the Central Bank’s monetary policy, the currency is likely to depreciate rapidly, with the biggest risk probably being fiscal policy.”

Wells Fargo: fiscal fears materializing — Foto: Scott Eells/Bloomberg

Another foreign institution to raise concerns about the new government’s early directions was Wells Fargo. “With Lula now officially sworn in, the fiscal fears that have pre-emptively shaken investors are beginning to materialize and further affecting market participants’ confidence,” the institution said in a report.

Wells Fargo calls attention to the fiscal expansion already approved in the Transition PEC, while there is the prospect of using state-owned banks to leverage economic activity. “We believe that this new direction of fiscal policy will end up being inflationary, and we now believe that the CB will delay monetary policy easing until the third quarter of 2023,” said the bank report.

Thus, Wells Fargo recognizes that its projection made at the beginning of the year, that the dollar would end the first quarter trading in the R$5.30 range, runs the risk of not materializing. “Should future policy decisions indicate further erosion of fiscal responsibility, we will adjust our USD/BRL outlook to reflect likely pending capital outflows that would put depreciation pressure on the currency,” he said.

For Eirini Tsekeridou, Julius Baer’s fixed income analyst, the announced extension of the tax exemption on fuel prices not only affects tax collection but was also a “rug-pulling of Minister [Fernando] Haddad,” who was against the measure, weakening his credibility and also the country’s commitment to fiscal responsibility.

“There is still no clarity regarding Brazil’s fiscal structure, including the replacement of the spending cap, so until we have more visibility on Lula’s strategy, the real will likely remain volatile and affected by news flow,” Ms. Tsekeridou told Valor.

The Oxford Economics consultancy was another institution that revised its scenario for the country. As pointed out by Regis Chatellier, director and emerging markets strategist, Brazil’s fiscal outlook has deteriorated following the recent increase in the spending cap and Mr. Lula’s post-election speech. “In this context, inflation should remain relatively high and the CB’s interest rate cuts will be much slower than anticipated. We believe risk premiums will remain high, with strong investor positioning also limiting the appreciation of Brazilian bonds,” he said.

Mr. Chatellier says that premiums on Brazilian bonds are relatively high, which ends up being a buffer for risks. “However, we believe that risk premiums embedded in LTNs and NTN-Fs will remain elevated given the deteriorating fiscal outlook and slower normalization of monetary policy,” he added. “We cut our recommendation for exposure to local Brazilian bonds to ‘neutral’ from the above market average.”

*By Arthur Cagliari, Gabriel Roca, Matheus Prado — São Paulo

Source: Valor International

https://valorinternational.globo.com/