Late Thursday afternoon, a reporter called to ask what I thought would be the consequences of Brexit to Brazil. Other than some short-term volatility in asset prices, nothing significant should happen, I replied. Brazil is already in deep economic trouble, it got there by itself and whatever Brexit could add would not change things significantly. And, I added to myself, Brexit will not happen anyway. What a surprise when I woke up Friday morning to find out that the UK was leaving the EU!

Was I equally mistaken about the consequences of Brexit to Brazil? I don’t think so. As expected, on Friday the real dropped against the dollar, as did most other currencies, and the stock market plunged, like everywhere. However, Brexit didn’t change the fact that the outlook for the Brazilian economy depends more than anything on the government’s success to implement its fiscal agenda. With Brexit, Brazilian companies may find it even harder to roll over their foreign debts, which hasn’t been easy anyway. However, the real bad news of the week in this area was not Brexit, but the bankruptcy of Oi, Brazil’s largest telecom, with almost $ 20 bn in debt, half of which is owed to foreign bondholders. Nothing important should happen through the trade channel either. The UK accounts for just 1.5% of Brazil’s exports, which in turn add up to a modest 11% of GDP. For Brexit to impact Brazil through this channel it would have to severely harm the UK’s economy.[1]

What scares me about Brexit is what it says about the political risk of a slow-moving economy going through an era of technological change that has increased income inequality and alienated large segments of the working force. As noted in the FT, the “vote reflected a roar of rage from those who felt alienated from London and left behind by globalization.” Observe the contrast between prosperous London and Scotland, which backed REMAIN, and working-class towns, seaside resorts & rural England, which voted to  LEAVE (see figure below).

Source: Financial Times.

Brexit will embolden populist, divisive parties across Europe. It will also cause investors to reassess the odds of Donald Trump being elected president in the upcoming US election, another likely source of market turmoil this year. Things will be different after the vote in UK this week. Perhaps, very different. As Paul Davies remarked in the WSJ, the “biggest risk of Brexit is that it is a signpost along a road toward declining international trade, less free movement of capital and a continuing global economic cooling” (see here).

Why, I ask myself, did I fail to predict Brexit? Of course, the polls are partly to blame, for they indicated that Remain would win by a small but solid margin. However, that’s only part of the story. Probably equally important is that I preferred to view the evidence as I would like it to be: in favor of the Remain option. I wonder how much of that is also true of other things at stake in the world nowadays.

This week, yields on 10-year German sovereign bonds, known as bunds, dropped below zero, following a path taken earlier by Japanese and Swiss sovereign bonds and adding to a pile of over $ 10 trillion in sovereign debt and roughly half a trillion dollars in corporate debt yielding a negative return. Yields in 30-year German bonds have followed in lockstep, dropping to a mere 0.55%.

Graph 1: Yields on 10- and 30-year German Bonds

Source: Bloomberg.

Why, I ask myself, do people invest in securities that yield negative carry? Why not just keep one’s savings in cash or deposited at a bank? In particular, why take so much duration risk for such a low or negative return? Indeed, it is easy to see that at the current juncture small increases in yields would be sufficient to produce huge capital losses. As Bill Gross tweeted last week, “global yields lowest in 500 years of recorded history … This is a supernova that will explode one day” (see also his June Outlook for a more elaborated analysis).

Over time, I have heard answers to this question combining four different arguments:

 i.         The world has embarked in a period of demographic transition and secular stagnation that will lead to rather low long-term growth. Interest rates have to fall in tandem, to reflect the lower demand for investment.

 ii.         Although nominal yields are negative, these bonds may yield positive real returns, as low global demand leads to deflation.

iii.         Investing on secure sovereign bonds at least guarantees the return of one’s capital, even if this requires sacrificing any return on your savings.

 iv.         Yields are negative because Central Banks have pushed them that way, in some cases through huge quantitative easing programs. This is the case of the Euro Area, where every month the ECB buys 80 billion euros in European sovereign bonds, € 19 billion of which of bunds.

Although all these arguments make sense to me, I feel they miss one important element: many people invest in these bonds for they expect their yields to fall even further in the future, thus reaping significant capital gains. As shown below, as investors and the ECB flocked into German sovereign bonds, their prices went up. Anyone buying 30-year German bonds six months ago would have gained an annualized return of 47%. Not bad, right? Not bad at all.

Graph 2: Yields and prices of 30-year German bonds

Source: Bloomberg.

The problem, as I see it, is that this is a huge Ponzi scheme, which only yields significant returns while more money is flowing into these securities. One day someone will be left holding an enormous amount of negative yielding bonds that no one wants to buy. The losses will be huge: according to JP Morgan estimates reported at the Financial Times, if US Treasury yields go up by 1 percentage point, holders of US Treasuries would lose US$ 1 trillion. The same dynamic, if not quite the same magnitude, could be seen if German bund yields were to suddenly rise. More importantly, in a game of “Hot Potato,” who loses when the music stops? The person holding the potato, of course, but the whole regional or even global economy may also get burned. 

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Yesterday, the Brazilian Institute of Economics (IBRE) held a seminar on Brazil’s Economic Outlook. What most impressed me in the presentations was the latent conflict between high hopes that the worst in the economy is behind us, with numbers that continue to show a daunting economic situation.[1] The surveys of business and consumer confidence illustrate this conflict: all improvements chronicled in recent months were due entirely to an upgrade in expectations about the future, with no significant progress in how firms and consumers assess the current situation.

The presentations revealed an external scenario with mixed impacts on the Brazilian economy. They stressed the importance of low growth in both global GDP and world trade, a factor that will weigh on the demand for Brazilian exports. On the other hand, they discarded major shocks coming from either higher interest rates in the US or a hard landing in China. Downside risks are apparently more concentrated in China, where expansionary fiscal and monetary policies produce ever less bang for the buck. In addition, risks are mounting around the vote on BREXIT (June 23) and the US presidential elections (November).

IBRE presented a favorable outlook for the external accounts, with a current account surplus in 2016 and a deficit next year, both of 0.1% of GDP. With net FDI inflows projected at 3% of GDP, and a Central Bank less willing to pile up foreign reserves, this should pressure the currency up. However, IBRE foresees the exchange rate at R$ 3.70/ US$ at the end of 2016 and R$ 3.85 / US$ a year later, on account of rising sovereign risk.

Whether the real strengthens or not will have direct implications for inflation and the degrees of freedom of Brazilian monetary policy. Here we see both good and bad news. Inflation will come down significantly in 2016, to an expected 7.1%, from 10.7% last year. However, in the base case scenario, it will reach 6.2% in 2017 and 5.7% in 2018, far from the target of 4.5%. Indeed, the seminar sent a clear message in this regard: if the Central Bank is serious about pursuing the inflation target, it will have limited room to lower the policy interest rate.

The most critical challenge the Central Bank will have to face is an adamant inflation in services, projected to come down to 7.4% this year, from 8.1% in 2015. This is surprisingly little disinflation considering that the unemployment rate should hit 12.3% by the end of this year and real labor earnings will likely drop 2.0%. IBRE expects unemployment to rise further in 2017. However, how much longer can unemployment remain at these record levels before the authorities are forced to provide some relief? In my view, this is will raise the temptation to let the real strengthen.

Much of the conflict between bulls and bears focus on how much GDP will grow next year. IBRE believes the economy is still going down and foresees a rather gradual recovery in GDP, which it expects will drop 0.1% in 2017. As I discussed in a previous post, bulls believe the economy has already hit bottom and predict an expansion between 2% and 3% next year.

A slow and lackluster recovery will make the fiscal problem Brazil currently faces even more worrisome. In IBRE’s scenario, the public sector debt will rise to 75.4% of GDP by the end of this year and 80.9% a year later. Higher growth would mitigate the problem, but it will not be sufficient to solve it.

The seminar revealed a great demand for optimism and widespread hope that the new administration will be able to put the economy back on track. The positive expectations about the future lay on sound foundations: a better economic team, a sounder diagnosis about the economy’s problems, and a more favorable attitude towards the private sector and international integration. It will be a great help if actual numbers reinforce these positive expectations.

Unfortunately, I myself believe that in a confrontation between optimism and hard numbers, it’s usually the high hopes that leave the arena bloodied. The positive initiatives the new administration has ventilated in the press are insufficient, on their own, to power an economic upturn. A sustained turnaround would require the government to secure congressional approval to measures that put stringent and sustained limits to the expansion of government expenditures. Otherwise, the honeymoon the new government currently enjoys may be short lived.

In a previous post I commented on the views of economists who are optimistic about the outlook of the Brazilian economy, foreseeing GDP growth in the 2% to 3% range already next year (see here). In this post I present the views of economists who remain bearish about the Brazilian economy in 2017.

The OECD economists are an example: in the first week of June they released their revised forecasts, which now foresee a GDP contraction of 1.7% next year, on top of a 4.3% drop in 2016. A week later, the World Bank followed suit, projecting a decline of 0.2% in next year’s GDP. Several Brazilian institutions also doubt that GDP may recover before 2018.

Bearish analysts question the strength of the arguments that support the optimistic view and point to other, less bright ones.

First, they are skeptical about political support to measures that actually tighten public sector spending, pointing to the vote in the Lower House in favor of substantially increasing salaries of civil servants. Indeed, this year the public sector’s primary expenditures should break another record. 

Moreover, they argue that, with the ongoing investigation of the corruption scandal in Petrobras, the political crisis may still be far from over, which will hamper support to harsh measures and affect confidence.

Second, inflation has proved to be much more resistant than earlier anticipated and it is not clear that it will converge to target if interest rates fall soon and substantially. In the last 12 months, prices went up 9.3%, more than their increase a year ago (8.5%). Despite rapidly rising unemployment, inflation in services has declined only marginally, from 8.2% to 7.5% in the same comparison.

Third, it is still far from certain that manufacturing has hit bottom and, if yes, how strong the recovery will be. In particular, if the real strengthens, helping to control inflation, it will stifle net exports. It is not very clear either how fast the new government will solve Petrobras’s financial problems, or launch new infrastructure projects.

In addition, there is much pessimism regarding the recovery of domestic consumption, and thus of sectors such as commerce and other services. Bearish economists point out that the labor market still has room to worsen: unemployment will move higher and real earnings will decline further. In addition, households and firms need to deleverage, meaning domestic credit will continue to contract, boding ill for sectors such as construction and financial intermediation.

Finally, there is a statistical issue: to expand 2% in 2017, after contracting 3.5% in 2016, GDP would have to grow at a seasonally adjusted annualized rate between 4% and 5% in the four quarters of next year. That is, the economy would have to accelerate quite substantially, which would require that confidence and interest rates move fast and substantially in the near future.

How do we balance the contrasting views of bullish and bearish economists about the Brazilian economy in 2017? In my next post I will give my answer to this question.