Two Opposite Pictures: Asset Prices and the Real Economy
Executive Summary
In the midst of economic performance that can be characterized as stagflation, asset prices have recently been appreciating. The Ibovespa has risen more than the stock market indexes of other emerging markets, and has far outpaced the S&P-500 in recent weeks. Simultaneously, the yield curve has been flattening out, with a decline of the yields of NTN-Bs and their implicit inflation rates. That behavior does not come from any improvement in the economy. It only comes from the growing probability that an opposition candidate will win the presidency, something that would bring a major change in the economic policy regime. Although this likelihood has been growing, an opposition victory is by no means assured. For this reason, nothing guarantees that the present optimism will be borne out.
In the rest of this report, we analyze what has been happening with the economy. We start with the real side. The deceleration is not restricted only to demand: it also affects potential GDP, due to the decline in the investment rate and also of total factor productivity. The deceleration is being temporarily worsened by an inventory cycle, but the end of this cycle will by no means be sufficient to usher in a sustained recovery.
The Central Bank has indicated it will keep the SELIC at the current level for a long period. But inflation is far from being dominated, with the only hope in this respect being a possible temporary fall of inflation due to lower food prices. There is a need to correct relative prices, and the effect of the widening negative GDP gap is being minimized by the deceleration of potential GDP. In this situation of stagflation, the Central Bank is only intervening in the future foreign exchange market to prevent weakening of the exchange rate, a movement that, however, is necessary to reduce the current account deficit. These interventions attract capital from investors seeking carry trade gains, completing the need to finance the balance of payments.
The quality of fiscal policy continues to deteriorate. After eliminating non-recurring revenues, the primary surplus is only 0.4% of GDP, and even with these revenues, it is below the promised target of 1.9%. There are also signs of renewed artifices, such as the postponement of expenditures, which will show up in the public accounts later, revealing a more worrying picture than assumed a few months ago. One of the negative legacies of the present administration will be to leave a higher gross debt than it inherited. This aggravates the risk perceptions.
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