6 Mar 2023
My trip confirmed that the mood on the ground in Brazil is deeply pessimistic. Since the presidential elections, President Lula da Silva (Lula) has disappointed the markets on a variety of fronts: he has been more successful than expected at increasing fiscal spending; his ministerial appointments are highly questionable; and he has attacked the central bank and its autonomy.
It is the first point, fiscal risk, that is weighing most heavily on sentiment. Lula seems intent on driving growth through fiscal spending, which ultimately means weaker fundamentals facing debt investors. For context, Brazil’s debt-to-GDP ratio – already higher than regional peers’ – is expected to increase by 10% over the next four years. Coupled with this, supply and demand dynamics are likely to weigh on the external hard currency debt market: the capitalisation necessary among state banks is likely to involve some US dollar issuance, while the domestic credit market is tightening and this typically encourages offshore issuance given the relatively attractive funding costs.
However, the bond market appears to be priced for all this, and the overall fundamental picture for Brazil is not all bad news. A buoyant agricultural sector, which is enjoying a strong year, is a bright spot for growth, with the resultant currency inflows from soy exports likely to boost the Brazilian real over the next few months. Furthermore, the central bank’s decisive reaction to rising inflation last year (discussed as part of a wider piece here) – together with the downturn in domestic demand, well-contained inflation and Lula-led political pressure – all point strongly towards rate cuts this year given the exceptionally high real (inflation-adjusted) rates. While the overall direction of the Lula administration is worrisome from the perspective of debt investors, these shorter-term cyclical dynamics offer opportunities for the active investor.
‘Nearshoring’ by the US (moving part of production to countries that are geographically closer) and its potential to underpin growth and boost investment was a theme that came up several times during my trip. However, underinvestment in Mexico’s energy and water infrastructure – particularly in the north – means spare capacity is limited; this poses the risk of extra investment into the country potentially adding to inflationary pressures. Fortunately, President Andrés Manuel López Obrador (AMLO) is growing more pragmatic on his energy policy, recognising that the state-owned utility company CFE is not delivering on what is needed for increased investment in the north of the country. AMLO is starting to create incentives for projects such as a large solar field in Sonora, while the ministry of finance will try to facilitate access to financing for nearshoring projects and their infrastructure requirements (water and electricity) via the development banks. AMLO’s pragmatism will be key here if Mexico is to reap the benefits of nearshoring from the US.
During the trip, I also met with the CFO of Pemex, the state-owned oil and gas company. It was encouraging to learn that we are not the only investors asking the company for improvements on intentions and reporting around emissions reductions. Furthermore, the message appears to be getting through, as Pemex is working to improve its budget transparency to disclose the amounts it is spending on individual ESG-related matters. Pemex has also approved the creation of an ESG committee which will start in December.
Other takeaways from my trip that point to a relatively bright outlook for Mexico’s economy is that pension regulation changes appear likely to give the already strongly growing AFOREs (individual pension schemes) market further impetus, increasing the structural demand outlook for long-dated local bonds.
Against this more constructive backdrop though, I encountered a more cautious central bank. Banxico remains vigilant around high inflation in the services sector and the persistence of core inflationary pressures, as well as being concerned that a more hawkish US Federal Reserve will mean a higher US terminal rate. Further rate hikes and then a prolonged pause seem the most likely outlook for Mexico’s monetary policy, but this should allow the local bond curve to flatten and the currency to trade well.