Brazil’s Nascent Recovery Can’t Conceal Challenges Still to Come

  • Improvement seen in inflation outlook, economic growth, budget
  • Budget deficit still primary concern for Temer’s government

Brazil’s economy is pulling out of its tailspin, and now traders are watching to see how quickly acting President Michel Temer can get the country flying again.

Investors, who pushed the nation’s stocks, bonds and currency to world-beating gains this year on anticipation a new government would restore growth, are seeing some signs their optimism is warranted. The budget deficit is narrowing from a record, inflation is slowing from more than 10 percent, bets on higher interest rates are being reversed and early indicators show the country starting to pull out of its worst recession in a century.

That said, there’s still a long way to go for Latin America’s largest economy, and the challenge for Temer will be to convince investors that further improvements are coming. He’s up against a plodding Congress that has taken more than nine months to consider the impeachment of Dilma Rousseff and will soon be distracted by local elections. Markets will rally on expectations for only so long, according to Roberto Padovani, the chief economist at Banco Votorantim in Sao Paulo.

“From a political and economic standpoint, the worst is over,” Padovani said. “We are on the right track. The question is how fast we can go.”

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After the currency’s 26 percent surge this year, the Ibovespa’s 34 percent gain and returns of 28 percent on local government bonds, the biggest worry for investors is the budget deficit. The reforms necessary to get government spending under control are unpopular and will require Temer to use all his congressional goodwill to get approved. Only then will inflation begin to ease, giving the central bank room to let up on interest rates, which are among the world’s highest.

“This moment of leniency from financial markets and the real economy for the current administration is not going to last much longer,” said Jason Freitas Vieira, the chief economist at Infinity Asset Management. “Now markets are going to expect results and the approval of fiscal measures without getting watered down.”

The federal government’s shortfall worsened in early 2014 as Rousseff ramped up her re-election campaign at the same time the economy began sliding into a recession. The deficit was among the reasons Brazil lost its investment-grade credit rating last year.

Addressing the fiscal imbalance would help curb inflation, which remains stubbornly above the 4.5 percent target set by the Central Bank. The outlook for consumer prices as measured by yields on fixed-rate and inflation-linked bonds has improved this year.

Still, traders expect rates to remain high relative to the rest of the world. That’s good for those who want to take advantage by borrowing in dollars and bringing their money to Brazil, but it’s also a drag on economic growth.

And while the worst of the economic slump appears to be over, it’s going to be a while before growth accelerates enough to give policy makers some fiscal breathing room. For now, the budget will have to be balanced by controlling government spending.

“There’s no miracle in this story,” Vieira said.

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