Walking to our hotel in Rio, the celebrations for Carnival had started early.

We have just returned from a five-day trip to Latin America, spending three days in Brazil (Rio, Brasilia and São Paulo) followed by two days in Argentina (Buenos Aires). Rio de Janeiro and Buenos Aires are known for their bustle and energy with a mix of cultures from across the world seen in everything from dance to food. Arriving a week before the famous Rio Carnival was scheduled to begin, the streets were already teeming with people as preparations mounted for the big event.

We met with a broad set of experts including local investors, independent political and economic consultants as well as political actors. Sentiment across the board was negative overall. There was a clear lack of conviction among locals, who generally could not understand why foreign investors appear much less concerned and even somewhat constructive on the outlook for Brazil.

Admiring the view from our hotel, we recalled our last visit in 2016, when Brazil was managing its way out of a deep recession and political crisis following the impeachment of President Dilma Rousseff, who was Lula’s anointed heir back in 2010.

A changed Lula

Before the October 2022 election, there was a strong sense that Lula da Silva, who was gunning for the role of president for a third time, would adopt a market-friendly approach, leaning to the centre and committing to responsible fiscal policies and more broadly to stability-oriented macro policies that characterised the previous Temer and Bolsonaro administrations. The consensus from our meetings is that Lula has so far disappointed on all possible accounts, including looser fiscal policy, acting as an ineffectual pseudo Minister of Finance (with Haddad the actual MoF having limited success so far in constraining Lula) as well as pressuring the central bank to cut interest rates.

This Lula appears not to be the same president he was in the past. He now has a determination to support economic growth quickly, almost at any cost to secure popularity.

Without significant checks and balances this could mean:

• more fiscal spending including quasi-fiscal spending via state-owned banks;
• plans to loosen the fiscal framework;
• and amplifying this fiscal lever with a monetary one regardless of the inflationary backdrop.

As the former President Dilma Rousseff put it: “Public spending is life!”

A high degree of uncertainty surrounds checks and balances given Lula’s majority in both chambers of Congress and the alignment of the Supreme Court with his Workers Party (PT). With former president Bolsonaro likely returning to Brazil soon, we could see a more concerted resistance to the above policy agenda from Congress; the coalition in Congress are, in our view, fragile and sensitive to populist policy initiatives.

In pursuit of more fiscal spending

While the change in the fiscal framework is still uncertain, all signals point to a weaker and more flexible policy where accountability is less clear. This scenario is likely unless Congress or financial markets effectively constrain Lula and his government to moderate. While Congress has shown some ability and willingness to do this, the constitutional amendment allowing for more social spending in 2023 still resulted in more funds than expected. We see less sensitivity from the Lula administration to financial market reactions to policies, but when Lula mooted a higher 4.5% inflation target right after the election, the market reacted badly, which led Lula to eventually tone down his rhetoric.

From our conversations, we expect double-digit increases in Brazil’s debt-to-GDP ratio under Lula. A primary surplus (currently a deficit) of 2.5% is needed to stabilise debt-to-GDP, an outcome we find highly unlikely under the Lula administration. While the most recently announced fiscal consolidation plan indicated a primary deficit between 0.5 and 1% of GDP, even the MoF himself signalled scepticism about his own plan to reduce the deficit. The announcement was likely made to convince the central bank to consider cutting rates sooner. The combination of these factors leads us to think that in the coming years, debt conditions in Brazil will likely deteriorate and policies will be less market friendly as the state takes a more central role in the economy like it did in the past. It does not appear that Lula’s PT Party has learned much since it was last in power. The biggest risk to policy quality is slow economic growth (driving a deterioration), while the opposite would likely lead to some moderation in Lula’s populist rhetoric.

Slow growth, high inflation can lead to bad policies

While economic growth is slowing in Brazil, strong external demand from booming commodity exports (a very strong harvest in particular) has been a tailwind and unemployment remains relatively low. Going forward, the main economic headwind is the exceptionally high real interest rate and what appears to be a credit overhang in the household sector.
Even as the economy is decelerating, inflation remains stubbornly high and recent inflation expectations have unanchored due to signals of loose fiscal spending, amplified by the absence of a clear fiscal anchor. Lack of policy coordination and higher inflation expectations present a significant challenge for the central bank. Without political interference, it could soon be able to loosen monetary policy, but now that is difficult as inflation expectations could unanchor even more if the bank is perceived to bow to political pressures. Hence, it is waiting for some visibility on the fiscal front.

Post the unveiling of the fiscal framework expected in April, it is highly likely that the government will push for an increase in the inflation target to at least 4% (most likely by June). This is key to watch as the government believes that this would give room for the central bank to cut rates, but the central bank will watch inflation expectations carefully and any sign of further unanchoring could actually lessen the chance of cuts. Nevertheless, there is a decent chance that the economy could decelerate significantly by then, allowing the central bank to cut rates without looking like it is succumbing to political pressures. Financial markets fear a replay of what happened in the Dilma era, when political pressure led to central bank governor Tombini clearly targeting the upper limit of the inflation band and not the target, leaving inflation expectations at the upper limit.

Three constraints facing Lula

The Brazil that President Lula faces today is very different than the Brazil he faced during his first terms in office. It is clear that he has a strong preference for more state involvement to promote economic growth to secure his and PT’s popularity. However, we believe three constraints will influence Lula’s ability pursue his agenda:

• Social constraint: To Lula, this constraint, in the form of high energy and food prices, appears the most important one, driving policies towards looser fiscal and monetary policy. As the economy slows, the risk of more populist policies increases.
• Political constraint: Brazil has become more polarised, as shown by the January riots and the return of Bolsonaro could lead to even more political instability. So far Lula has managed to garner working majorities in Congress, suggesting that the transactional nature of Brazilian politics has allowed for looser political constraints (at least during his honeymoon) than the general election outcome suggested. In the short term, this could allow Lula to push forward with his populist agenda but given the current precarious fiscal situation, there is the possibility of an eventual governance crisis.
• Financial market constraint: Lula’s tolerance for negative market reactions to policies appears higher, while the signalled policy path is likely to work against financial markets.

There are glimmers of hope for Brazil, however deteriorating debt dynamics amid slowing economic growth, more state-involvement and less market-friendly policies have led us to remain cautious on the outlook for Brazil.