From PIMCO: Brazil is often known for soccer, samba and pristine beaches. Among investors, something else also stands out about Brazil: double-digit interest rates that are significantly higher than its peers’ (see chart). That may soon change.
We have long debated the causes of Brazil’s structurally high (nominal and real) interest rates: constitutionally embedded and unsustainable fiscal pressures; a dual credit system in which half of all credit is extended at subsidized interest rates, which means the other half, linked to the policy rate (SELIC), needs much higher rates to compensate for this subsidy; and a history of high and volatile inflation exacerbated by the widespread practice of indexing contracts to inflation. All of these issues have been entrenched in the economy for a long time.
Now, for the first time in decades, Brazil has a golden opportunity to tackle some of these underlying factors and structurally reduce interest rates to single digits. On our recent research trip to Brazil, we found that the deep economic crisis and recent political turmoil have come with a silver lining: In effect, they have propelled policymakers and politicians to work together with President Michel Temer’s interim government to undertake difficult and unpopular reforms ahead of the 2018 presidential elections.
So far, Brazil’s Congress has approved a ceiling to limit government spending and is trying to approve social security reform that would help balance fiscal accounts in the long term. The government is also gradually replacing the subsidized credit rate (TJLP) with a market-determined rate to be phased in over five years. This should improve not only the potency of monetary policy but also public debt ratios, as the state development bank (BNDES) will be less subsidized by Treasury. And finally, with inflation moving rapidly lower under the new central bank governor, Ilan Goldfajn, there is credible potential for lowering the country´s inflation target below 4.5% for 2019.
A lower target would help break Brazil’s inflationary inertia, lower inflation expectations further and contribute to reducing Brazil’s neutral interest rate.
A unique investment opportunity
Just as this is a once-in-decades opportunity for Brazil, it is also a unique opportunity for investors. We don´t see double-digit interest rates very often today, particularly in a country with improving fundamentals, a stable currency supported by firming external accounts and an ongoing reform agenda.
While there are risks – including the unpopularity of the proposed measures, the ongoing corruption investigations and the upcoming 2018 elections – Brazil stands out among emerging markets as moving in the right direction to transition toward sustained lower interest rates.
The iShares MSCI Brazil Index ETF (NYSE:EWZ) was unchanged in premarket trading Wednesday. Year-to-date, EWZ has gained 13.38%, versus a 7.12% rise in the benchmark S&P 500 index during the same period.
For more on emerging markets, please see our outlook for 2017.
Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. All investments contain risk and may lose value. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
This article is brought to you courtesy of PIMCO.