Brazil: Low inflation and a longer easing cycle

The interest rate trajectory in 2019 should depend largely on the fiscal policy adopted by the next administration. A market-friendly and fiscally-responsible administration could pave the way for a moderately strong trajectory for the Brazilian Real (BRL), which is seen as the primary source of upside inflation risk by the central bank, and, therefore, could contribute to a considerable delay in eventual policy rate normalisation.

But the election of a market-friendly and fiscally-responsible administration remains highly uncertain. A positive assessment of electoral/fiscal risks depends on several key assumptions, including:

1. Former President Lula will not be eligible to run for president and may get arrested after the final ruling by the regional court (TRF-4) in the next few weeks.
2. The left will remain fragmented, with its electoral base split across potentially four presidential candidates,
3. To boost their chances of moving to the second round, centre-leaning candidates (currently trailing in the polls) will eventually consolidate around a single hegemonic candidacy, supported by a broad-based party alliance containing roughly the same parties that composed of President Temer’s congressional base in the past year, and
4. Candidates that are currently popular in the polls but lack in party structure will eventually lose ground because they will lack public campaign funding and access to free state-sponsored advertising, as both of these are now primarily determined by the candidate’s party size.

This last assumption is crucial and is perhaps the one that most divides local pundits. The differing views reflect, to a large extent, analysts’ views on issues such as 1) the importance of traditional media (radio and TV) vs. social media, 2) the electoral weight of the appeal of “non-establishment” vs. “establishment” candidates, and 3) the importance of the government “machinery”, especially at the local level, to boost the candidacy of establishment candidates.

The conclusion is that roughly two camps appear to be forming. The first is the more “traditionalist” camp, which expects the establishment candidate to win, i.e., São Paulo Governor Geraldo Alckmin, backed by the PSDB-DEM-MDB after the Lower House Speaker Rodrigo Maia, Finance Minister Meirelles and President Temer drop out from the race.

The second camp tends to weigh more heavily the impact of social media and anti-establishment sentiment, asserting that “this time is different”. For them, the current leader in the polls (ex-Lula), Jair Bolsonaro, a long-time Lower House representative known for his socially conservative and militaristic agenda, is most likely to get elected. This camp also typically considered Luciano Huck or João Doria, early favourites that decided to drop out of the race, to be the most electable candidates running with a centrist market-friendly platform.

There are legitimate reasons to question Bolsonaro’s ability to run a successful campaign and maintain his lead. These include his minimal party support base, his Trumpian penchant for controversies, which assures the greatest visibility in social media among all candidates but also tends to increase his rejection rate (notably among women and the socially liberal electorate). However, in principle, the importance of the rejection rate depends on the level of fragmentation of the electoral process. As it stands now, polls suggest that Bolsonaro is very likely to make to the second round. The latest poll gave Bolsonaro 20% support, followed by Marina Silva with 14%, Geraldo Alckmin with 9% and Ciro Gomes with 8% while close to 40% of the electorate chose the undecided/blank option.

Bolsonaro’s lead should diminish when the campaign gains steam, and the benefits of belonging to a resource-rich party alliance kick-in, boosting the visibility of the establishment candidates. But the lack of an establishment candidate with enough popular appeal to be a competitive candidate severely complicates our ability to make any high-conviction calls about the elections.

So long as the rationale for the eventual victory of a market-friendly establishment candidate remains relatively sound, a certain degree of investor complacency should prevail. More serious doubts about that scenario should creep in only gradually if, for instance, the race remains polarized between Bolsonaro and a candidate from the left (either Ciro Gomes or Marina Silva, who also appeals to segments on the left, for instance) through June/July, with the centrist candidate still trailing in third place. The official start of the campaign is on 31 August.

Questions over the ability of the next administration to re-anchor fiscal accounts would intensify if any of these three candidates win the election. The reasons for concern would include, in varying degrees, inconsistent or little known economic policy views, and expected difficulties to negotiate a working majority in Congress. Given the heavy legislative agenda, a weak Congressional base would exacerbate governability risks and pave the way for renewed financial market instability in 2019, when the biting budget constraints will force the new administration to deliver on the fiscal austerity front.