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Summary of Brazil's Election and Economic Impact

Core Content

This document discusses the potential impact of Brazil's October general election on the country's economic outlook, focusing on how different policy agendas could influence GDP growth, inflation, interest rates, and the fiscal and external balance. It outlines three key scenarios: the base case, an optimistic scenario, and a pessimistic scenario, with a detailed macroeconomic model used to project outcomes.

Main Points

• Economic Impact of Policies: The election outcome could shift 2019 GDP growth by up to 3 percentage points, depending on the economic policies implemented by the next administration.
• Scenario Analysis:
  • Base Case: Continuation of current reformist framework.
  • Optimistic Scenario: Structural reforms (tax, credit, trade, pension) lead to higher growth, lower interest rates, and a stronger BRL.
  • Pessimistic Scenario: Failure to implement reforms could lead to inflation overshooting, higher interest rates, currency depreciation, and a rapid rise in debt.
• Fiscal Challenges: The next administration faces a significant fiscal challenge, particularly related to pension reform. Without reform, debt could reach 100% of GDP, and the primary budget deficit could widen.
• Monetary Policy Response: The central bank's policy stance is sensitive to inflation expectations and GDP growth. In a pessimistic scenario, it may need to raise rates significantly.
• Credit Market Trends: Banks have reduced non-performing loans, suggesting a more favorable environment for credit expansion. Both the base and optimistic scenarios benefit from improved credit dynamics.
• Labour and Inflation Dynamics: Labour market performance is linked to GDP growth. Inflation is expected to remain low in the base case but could rise sharply in the pessimistic scenario due to FX pass-through and unanchored expectations.

Key Information

GDP Growth Projections

Inflation Projections

Interest Rates

Debt and Current Account

Scenarios Overview

Base Case

• Assumptions: Continuity of reformist policies.
• Outcomes: Positive GDP growth, stable inflation, and manageable debt levels.
• Policy Expectations: Preservation of recent reforms (labour, spending cap), approval of social security reform, and advancement of the concession program.

Optimistic Scenario

• Assumptions: Robust market reforms, including pension reform, with strong congressional support.
• Outcomes: Accelerated growth, lower interest rates, stronger BRL, and potential rating upgrade.
• Key Factors: Structural reforms, anchored inflation expectations, and improved credit conditions.

Pessimistic Scenario

• Assumptions: Reversal of recent reforms, denial of necessary fiscal adjustments.
• Outcomes: Inflation overshoot, higher interest rates, currency depreciation, and rising debt.
• Key Factors: Unanchored inflation expectations, FX pass-through, and fiscal mismanagement.

Macroeconomic Model

• Variables: The model uses around 30 domestic and global variables, including GDP, potential growth, inflation, interest rates, CDS spreads, and commodity prices.
• Scenario Building: Domestic variables were adjusted while global assumptions remained unchanged.
• Fiscal Assumptions:
  • Pension reform is central to the model.
  • No pension reform leads to a higher deficit and increased debt.
  • The first draft of pension reform could lead to a more favorable fiscal outlook.

Market Implications

• Investor Strategy: Investors should consider a "structurally long the BRL via options in relative value" and "receiving rates at the short end of the Dl curve."
• Hedging Structure:
  • USDBRL call spread 1x2 at 4.00–4.40.
  • USDBRL one-touch spread (long OT at 4.70 and short OT at 5.40).

Legal Notice

• The document is non-independent research and may be subject to conflicts of interest.
• It is a marketing communication and not investment research.
• It does not constitute an offer to sell or a solicitation of an offer to buy securities.
• BNPP does not provide investment, financial, legal, or tax advice.
• All information is based on public sources and may not be accurate or complete.
• The content is subject to change without notice and should not be relied upon as authoritative.

Conclusion

The outcome of Brazil's election is critical for the country's economic trajectory. The model suggests that the next administration's commitment to structural reforms, especially pension reform, will significantly influence GDP growth, inflation, interest rates, and the fiscal and external balance. Investors are advised to take a positive stance with a hedge against potential negative outcomes.