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Far-right seven term congressman, Jair Bolsonaro, won Brazil’s Presidential election on October 28 by capitalizing on an anti-establishment wave that not only wildly disrupted views on Brazil’s politics and economics, but also rejected many traditional party structures that were perceived by voters as failed and corrupt. Mr. Bolsonaro and his team have pledged throughout the campaign and since election day to push a liberal economic reform agenda that primarily aims to reduce the role of the state, reinvigorate a long-underperforming economy, and anchor Brazil’s deteriorating fiscal and debt dynamics. While Mr. Bolsonaro’s agenda could be nothing short of transformative, questions remain over his ability to not only navigate a highly-fragmented and largely renovated Congress, but also around his ability to build future coalitions for reform. Although success is far from guaranteed, we view indications so far as having been somewhat promising and believe that Mr. Bolsonaro could have a higher chance of success than what the market is prepared to assign at present. Despite the rally in Brazilian assets over October, which was largely attributed to the market pricing out the chances of the left-wing Workers Party (PT) returning to Government, we continue to see particular value in Brazilian real, rates, and equities.
Mr. Bolsonaro and his economic czar, Paulo Guedes, have laid out an economic reform agenda that is unabashedly liberal and highly ambitious. They aim to boost growth through a large privatization drive and an investment-friendly concession program, to cut the tax burden on the productive sector of the economy through corporate tax cuts offset by a new dividend tax, to eliminate the primary deficit by the end of 2019, which is tracking to end the year around 1.5% of GDP as a result of higher growth and extraordinary one-off revenues, and finally, to make the Central Bank de jure independent. That said, we view the most important feature of the reform agenda as being the pledge to curb social security spending, which currently accounts for 45% of total spending and is on an explosive path should there be no reform to the social security model. This is a fundamental pillar of the agenda, without which the government will likely be unable to provide a firm fiscal anchor and to stabilize Brazil’s rising debt burden. Conventional wisdom has been that Mr. Bolsonaro will face huge governance challenges given his high rejection ratings, a highly fragmented Congress, and his refusal to acknowledge the need to distribute pork and patronage to grease the wheels of Congress. We would, however, challenge some of the aspects of this thinking.
Mr. Bolsonaro secured a strong mandate, coming within a whisker of winning in the first round of elections on October 7 and eventually beating rival candidate, Fernando Haddad, in a second-round run-off on October 28 by over 10 percentage points. This ultimately resulted in Mr. Bolsonaro winning four of Brazil’s five regions and 16 of the 27 states. He will face an electorate next year that has become increasingly pessimistic about the future and is looking for improvements in the delivery of public services that will not come to pass until Brazil’s fiscal house has been put in order. However, rising optimism on growth, anchored by inflation dynamics, early initiatives to shore up public security, and the savvy integration of popular figures like Judge Sérgio Moro into his cabinet to legitimize his government’s anti-corruption credentials, Mr. Bolsonaro should have a relatively strong starting platform to capitalize on.
While it is also true that the National Congress of Brazil has become even more fragmented, with 30 parties represented in the Lower House and 21 in the Senate, many of the new faces who have swept into Congress at the expense of the three biggest parties in Brazil have done so on Mr. Bolsonaro’s anti-establishment coat tails. The new Congressional members seem less beholden to established party structures and are therefore arguably much more pliable. Mr. Bolsonaro’s own Social Liberal Party (PSL) and the three smaller right-of-center parties that make up the ruling bloc, are likely to command close to 20% of the Lower House. This will likely follow when legislators, whose parties did not meet the minimum vote threshold to secure public funding and TV time, eventually switch parties. Alongside the many parties that make up the so-called Big Center (Centrao) of Brazil, Mr. Bolsonaro’s ruling bloc could command more than the requisite 60% needed to reform the constitution in the Lower House, and if they are able to secure the support of parties like the center-right Brazilian Social Democrat Party (PSDB) for line items in the reform agenda, such as social security reform, Mr. Bolsonaro may secure enough support from the Senate as well.
Mr. Bolsonaro’s team has also strongly indicated, over the last few days, that they will cooperate and lead constructive negotiations for reform, which directly contradicts the conventional view of his inability to acknowledge the needs of Congress. Mr. Bolsonaro is likely to reduce the number of ministries and is keen on making meritocratic appointments to both his cabinet and Brazil’s multiple state-owned enterprises. At face value, these appointments may be viewed as curbing his ability to reward legislators and parties for their support. However, Mr. Bolsonaro has so far appointed a well-known legislator from the Centrao, Onyx Lorenzoni, as his new Chief of Staff and is also considering making additional room in his team for other political appointments. Mr. Bolsonaro has also crucially excluded his ruling bloc from consideration in seeking the powerful position of Speaker of the House, a decision due to be voted by legislators in February. This provides the opportunity to negotiate that position with parties in the Centrao, with current Speaker Rodrigo Maia strongly rumored to be in poll position to retain his current post. Finally, while Mr. Bolsonaro and Mr. Guedes had initially floated an ambitious proposal to transition from the currently unbalanced defined-benefit pay-as-you-go system to a fully capitalized defined contribution system, they have recently discussed continuing outgoing President Michel Temer’s less-ambitious reform proposal. In its current form, President Temer’s proposition would guarantee savings of 7% of GDP over the next 10 years and stabilize Brazil’s debt at close to 90% of GDP, an increase from the current 77%. We view this as a sign of political pragmatism given that President Temer’s proposal has already been approved in various committees in the Lower House and could take as little as six months to be pushed through, while any new proposal could take the majority of 2019 before arriving at a vote with Mr. Bolsonaro’s political capital much more depleted.
Although it may be premature to reach any judgment on Bolsonaro’s future success, we view these early signs as reasonably promising. With Brazil’s sovereign credit already trading at what we consider to be fair levels, we see greater opportunities in the Brazilian real, rates, and equities. The real has rallied significantly since the highs of early September, but still trades cheap relative to long-term valuations, which should also improve if Brazil’s relative productivity strengthens under a more aggressive market-friendly agenda. Repricing of Brazil’s business cycle, privatizations, and future concession offerings should also attract further FX flows in a context where the investor community is still predominantly long dollars. We also think that the Central Bank of Brazil will maintain a more dovish monetary policy stance than what the market is currently pricing. This holds largely in the context of firmly anchored inflation expectations (1), ample slack in the labor market and a negative output gap, a stronger real, and past and future structural reforms that should help lower neutral rate estimates and contribute to a less intense monetary policy cycle in the future.
(1) 3.9%; YE 2018, 4.1%; YE 2019 and an estimated 4%; YE 2020