Brazilian assets have underperformed since the end of the second quarter, with weakness across all asset classes: FX, credit and rates. This has occurred at a time when market participants have continued to revise growth expectations higher, toward 5.5% for 2021.
In FX, we think the bulk of the weakness came with the repricing of China-sensitive assets on lower growth expectations. For now, rate hike expectations from the Brazilian central bank and higher carry versus the rest of EM has prevented the real (BRL) from underperforming similar currency investments.
On the rates front, a combination of negative YTD returns and increased political risk has forced several market participants to unwind their receivers in the long end of the curve. Forward rates are already implying a central bank target rate of well above 11% in the medium term.
Fundamentally speaking, we don’t see a need for Brazil rates to go to 11%. With central bank communication shifting toward an eventual pause, we expect curves to continue their steepening bias into 2022. The relative attractiveness of the front end continues to increase, with inflation likely peaking in year-over-year terms.
In credit, Brazil has widened a bit more than comparable stable BBs in Latin America since June. We would not expect much more widening from here should global growth expectations start to creep higher. Given that a large amount of public debt is in local currency, USD debt is generally better-shielded than in countries with pegged exchange rates or large external debt levels.
Regarding fiscal developments, it’s still too early to see how 2022 spending decisions will go. There is risk that the spending cap could be breached, but it’s well-flagged and the administration will continue to try to address the cap as politically amenable as possible in a pre-election year. Gross debt to GDP is now expected to end 2021 around 82% while net debt to GDP should finish at around 63%.
We continue to believe BRL offers value compared to other China proxy currencies despite the increased fiscal noise. The FX undervaluation by most measures remains at around 15% versus peers. However, to see more meaningful appreciation in BRL, we’ll need further improvement in global growth expectations, specifically from China. On the rates front, we expect curves to continue to steepen as the market looks toward a very uncertain election in 2022.