Would President Jair Bolsonaro be an economic reformer or an authoritarian?

Today’s CIO Weekly Perspectives comes from guest contributors Conrad Saldanha, Marco Spinar and Gorky Urquieta.

This Sunday, Jair Bolsonaro of the Social Liberal Party will face off against Fernando Haddad of the Workers’ Party in the second round of Brazil’s presidential election, after Bolsanaro narrowly missed winning the first round outright two weeks ago.

Bolsonaro won a larger share of the vote than opinion polls had predicted, and his party outperformed expectations in elections for the National Congress. Opinion polls now make him the firm favorite to win on Sunday, as Haddad struggles to emerge from the shadow of former President Lula da Silva and lose the taint of scandal hanging over the Workers’ Party.

Financial markets have also made Bolsonaro their favorite, particularly now that the center-right alternatives are out of the race. Brazilian assets have opened up an unusually wide performance gap against other emerging markets since the first round of the election in the face of a globally volatile environment for risk.

In the unlikely event that Haddad pulls off a surprise victory, investors may well reverse this stance, even though a Haddad administration would probably act more pragmatically than recent Workers’ Party-led governments. But are markets justified in setting so much store in Bolsonaro as an economic reformer?

Radical

Bolsonaro, with his authoritarian instincts and controversial statements, is part of a global wave of conservative populism. However, while his campaign has been vague on the economy and he has voted against reforms in the past, his recent tone has been anything but populist. His chief economic advisor, Paulo Guedes, the University of Chicago alumnus tapped to be finance minister, advocates a radical reform plan of privatizations and spending cuts.

If Bolsonaro resembles U.S. President Donald Trump in his shoot-from-the-hip political style, he would also be like Trump in taking over a recovering economy that nonetheless faces a structurally high gross public debt and a fiscal deficit. Brazil’s public debt is on course to break through 80% of GDP, at high rates of interest, which makes getting to a primary budget surplus an important objective.

While subsidy cuts and privatizations are likely necessary to achieve this, they may not be sufficient. Pensions and social security consume almost half of the federal budget, and over the last 20 years they have accounted for 79% of the growth in federal spending as a share of GDP.

That is why investors are likely to cut short Bolsonaro’s honeymoon period if they see no real progress on pension reform by the middle of next year. Without it, it is difficult to see how Brazil can honor the public spending cap passed by constitutional amendment under the Michel Temer administration two years ago.

Political Capital

This is far from a done deal.

A pension reform bill is languishing in Congress that could regain momentum even before the new president is sworn in on January 1. Hopes have risen now that Bolsonaro’s Social Liberal Party, with 52 seats, is the second-largest group in the Chamber of Deputies, Brazil’s main legislative assembly. But the fact is that many of those deputies express economic views very far to the left of those of Paulo Guedes. Progress may depend on Bolsonaro risking his own political capital and, Trump-style again, appealing charismatically to the voters to force his party onside.

That raises the risk that creeping authoritarianism and corrosion of Brazil’s institutions of civil society might muddy any reformist zeal. So far, we are confident that governance standards can be upheld, particularly relative to the corruption of previous administrations, which ultimately revealed Brazil’s impressively independent judiciary. Bolsonaro is not unusual among the current crop of global populists, and he would come to office with a far weaker mandate than that enjoyed by, say, Andrés Manuel López Obrador in Mexico.

We anticipate a much tougher stance on social issues, especially crime, and while that carries some headline risk, we are not girding ourselves for a wholesale deterioration in governance.

Sentiment

Does all of this give us confidence in Brazilian assets? Yes, but selectively. We like the currency and rates, but the equities picture is not so clear.

We believe the real remains undervalued even after its recent rally, as Brazil lacks any Argentina-style external funding pressures. We also regard rates as attractive given the pairing of structurally low inflation at 2 – 4% with a two-year bond yield of around 8.5%.

In Brazilian equities, a strong rally since the first round of the election, together with a rotation out of exporting companies earning dollars into domestically focused companies earning reals, has, in our view, left the best-quality stocks trading at high multiples given the country’s sluggish growth. We are still finding opportunities in mid-caps, however, as they have tended to be forgotten in the initial stages of a flows-driven rally.

Perhaps more importantly, a win for Bolsonaro next weekend is likely to improve sentiment toward Latin America. It would add Brazil to the list of countries standing against the regime in Venezuela, and its recovery would also likely be a substantial tailwind for the economies of the region, especially Argentina and Uruguay. Given that it contributes almost 3% of the world’s GDP, the prospect of economic reform in Brazil may also lend support to emerging markets more broadly.

In Case You Missed It

  • U.S. Retail Sales:  +0.1% in September
  • China Consumer Price Index:  +0.7% in September month-over-month and +2.5% year-over-year
  • NAHB Housing Market Index:  +1 to 68 in October
  • U.S. Housing Starts:  -5.3% to SAAR of 1.20 million units in September
  • U.S. Building Permits:  -0.6% to SAAR of 1.24 million units in September
  • Euro Zone Consumer Price Index:  +0.5% in September month-over-month and +2.1% year-over-year
  • China Q3 2018 GDP:  +6.7% annualized rate
  • Japan Consumer Price Index:  -0.1% in September month-over-month and +1.2% year-over-year
  • U.S. Existing Home Sales:  -3.4% to SAAR of 5.15 million units in September

What to Watch For

  • Tuesday, 10/23:
    • Japan Purchasing Managers’ Index
  • Wednesday, 10/24:
    • U.S. Purchasing Managers’ Index
    • U.S. New Home Sales
    • Euro Zone Purchasing Managers Index
  • Thursday, 10/25:
    • U.S. Durable Goods Orders
    • European Central Bank Policy Meeting
  • Friday, 10/26:
    • U.S. Q3 2018 GDP (first estimate)

– Andrew White, Investment Strategy Group

Statistics on the Current State of the Market – as of October 19, 2018

Market Index WTD MTD YTD
Equity      
S&P 500 Index 0.0% -4.9% 5.1%
Russell 1000 Index 0.0% -5.2% 4.7%
Russell 1000 Growth Index -0.7% -6.9% 9.0%
Russell 1000 Value Index 0.8% -3.5% 0.3%
Russell 2000 Index -0.3% -9.1% 1.4%
MSCI World Index 0.0% -5.5% 0.1%
MSCI EAFE Index -0.1% -6.2% -7.2%
MSCI Emerging Markets Index -0.9% -7.2% -14.1%
STOXX Europe 600 0.1% -6.6% -8.8%
FTSE 100 Index 0.8% -5.9% -5.0%
TOPIX -0.6% -6.8% -5.0%
CSI 300 Index -1.1% -8.8% -20.5%
Fixed Income & Currency      
Citigroup 2-Year Treasury Index -0.1% 0.0% 0.2%
Citigroup 10-Year Treasury Index -0.5% -1.1% -4.8%
Bloomberg Barclays Municipal Bond Index 0.1% -0.7% -1.1%
Bloomberg Barclays US Aggregate Bond Index -0.4% -0.9% -2.5%
Bloomberg Barclays Global Aggregate Index -0.3% -0.8% -3.1%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.1% 0.2% 4.1%
ICE BofA Merrill Lynch U.S. High Yield Index -0.1% -1.0% 1.5%
ICE BofA Merrill Lynch Global High Yield Index -0.2% -0.9% -0.4%
JP Morgan EMBI Global Diversified Index -0.2% -1.5% -4.5%
JP Morgan GBI-EM Global Diversified Index 0.8% -0.3% -8.4%
U.S. Dollar per British Pounds -0.9% 0.0% -3.6%
U.S. Dollar per Euro -0.6% -1.0% -4.3%
U.S. Dollar per Japanese Yen -0.3% 1.0% 0.1%
Real & Alternative Assets      
Alerian MLP Index 0.2% -1.2% 4.6%
FTSE EPRA/NAREIT North America Index 2.8% -2.9% -0.6%
FTSE EPRA/NAREIT Global Index 2.1% -3.5% -4.3%
Bloomberg Commodity Index -0.3% 1.0% -1.0%
Gold (NYM $/ozt) Continuous Future 0.5% 2.7% -6.2%
Crude Oil (NYM $/bbl) Continuous Future -3.1% -5.6% 14.4%

Source: FactSet, Neuberger Berman.