Is the economy pulling away from the politics in Brazil?

Overall sentiment in Brazil’s financial and business capital of São Paulo is bullish. This is not surprising, as the economy is showing broad based short-term expansion after two consecutive years of contraction. Indeed, the higher activity is already beginning to impact sales for multinationals operating in the market, demonstrated by the 72% of participants in FSG’s biannual executive breakfast in Sao Paulo on October 18th that reported improved revenue performance year to date.

The overarching story used to explain this growth is that the economy is finally dislodging itself from the malaise of the political fiasco that continues to unfold in Brasilia (the country’s political capital). However, this is not necessarily true.

Here we look to identify what is driving the short-term boost in sentiment and economic activity, while also identifying and classifying the potential hazards that remain between the market and a full-fledged short-term recovery.

Why the politics still matter

After two consecutive quarters of growth, Brazil is officially out of recession. Additionally, despite a continued contraction in investment in the second quarter (the last quarter for which data is currently available), we do see growing signs of a short-term recovery in investment. In fact, capital goods production has shown growth for five consecutive months and continues to accelerate, while capital goods imports have shown growth in two consecutive months for the first time in nearly four years.

Nonetheless, Brazil still desperately needs to address the growing deficit in its pension system (see graph below). In that case, we are left with the question of why we are seeing a short-term positive economic activity, with signs pointing toward an imminent recovery in investment.

Source: Frontier Strategy Group

The answer is quite simple. While the economy has not dislodged itself from the politics, market actors have become more bullish on their view of the potential for the next president pursuing and passing pension reform. The current consensus is that former President Luiz Inácio Lula da Silva (the biggest perceived risk by markets in the 2018 elections) will be convicted at Brazil’s second level court, and be ruled ineligible to run for the presidency. Essentially, market actors see a bridge to 2019 even if current president Michel Temer were to continue with reform during the remaining two months of 2017.

Are there risks to the assumption that pension reform will be passed by next government if not by Temer?

While it is more likely than not that former president Lula will be convicted at the second level court (FSG places this outcome as a 60% likelihood), polls demonstrate that if he is not convicted (or not convicted by the start of official campaigns in July) then he would be a competitive candidate.

Source: Frontier Strategy Group

Unsurprisingly then, participants in FSG’s São Paulo executive breakfast identified Lula’s presence in the campaign as the number one risk to their business in 2018, with higher currency volatility as the most worrisome impact for their operation should this scenario come to fruition (inability to attract corporate resources and difficulty in demand planning were close runner-ups).

How to confront the continued uncertainty while being prepared for the large potential upside

While FSG’s base case scenario for Brazil in 2018 calls for GDP growth of 2.8%, if pension reform is passed under president Temer and a strong centrist candidate were to emerge early in 2018 (FSG’s upside scenario), then the market is likely to see growth near 4.1%. Of course, the downside scenario, which includes heightened political uncertainty both in the campaign and in the ultimate outcome is still a possible outcome and would result in near flat growth in 2018.

Considering the continued underlying questions for Brazil’s outlook, participants in the executive breakfast identified the use of scenarios as the best way to ensure rapid course correction throughout 2018, while also guaranteeing clear and consistent communication with corporate regarding market potential and appropriate resource allocation.

However, the executives also identified their struggle to maintain consistent reviews of their scenarios and contingency plans as the biggest threat to adequate implementation of robust market monitoring in the coming year. This should come as no surprise, as time is often limited and the payoffs from reviewing scenario and contingency plans are not also immediate, leading to a certain level of discounting when estimating the value of these exercises compared to competing initiatives.

This struggle actually plays out globally, as FSG benchmarking shows that 41% of multinationals lack structured reviews of markets that occur more frequently than every 6 months. To ensure success in 2018, FSG clients operating in Brazil should firewall time monthly to review market changes, leveraging FSG scenarios and signposts to create contingency plans linked to discreet events while assigning responsibility for implementation of change management should market conditions suddenly shift.


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