While its growth is strong, Brazil is heading straight for a zone of turbulence. With public finances in trouble, currency in decline, inflation on the rise, and credit increasingly expensive, this scenario was not necessarily expected by the largest economy of South America.
The free trade agreement between Mercosur and the European Union offers hope on the external trade front. However, Donald Trump's return to the White House will not fix anything. Here's a brief overview of an uncertain economy, which we reserve for bold investors.
Enviable growth
On the growth front, the Brazilian economy has experienced a favourable 2024. It reached 4.0% in the third quarter in an uptrend, a more impressive figure as the economy runs on all its engines. The seven key rate cuts made by the central bank between September 2023 and August of this year contributed to this momentum, making credit cheaper. The state aid and social programs advocated by President Lula also. Together, these two factors pushed household consumption expenditure up 5.5% year-on-year.
Private investment is not lagging and is increasing by 10.8%. Manufacturing and construction sectors are booming (4.2% and 5.7% respectively) and services are also in good shape (+4.1%).
These are enviable growth indicators; few other countries can boast of them now.
Overheating and inflation
But if the Lula government has managed to revive growth, it has forgotten about the reforms. Therefore, The Brazilian economy tends to overheat as soon as strong growth is felt.
At 6.2%, the unemployment rate is at its lowest, wages are rising at a good pace (+4.3% over one year in industry), and infrastructure is not keeping up with strong demand. So, the price pressure is real. Most major markets have seen inflation stabilise in 2024. Brazil went from a 3.7% low in the spring to 4.9% in November, exceeding the central bank’s target.
Another concern is that the Lula government continues to spend without counting, which leads to an apparent deterioration of public accounts.
In 2023, the deficit was 8.9% of GDP; over the 12 months ending in October 2024, it reached 9.5%. Such levels of deficit are rare in an emerging economy. Even more so for a well-performing economy. As a result, the public debt will be around 78% of GDP, according to the Brazilian Treasury, and should continue to increase until 2027, reaching a peak close to 82% of GDP.
Such a large debt is undoubtedly costly for an economy heavily dependent on external financing. Currently, 10-year Brazilian rates are above 14%, and at the lowest point of the yield curve, they are around 13%. At such levels, the interest on the debt will gradually move towards 10% of GDP—an impressive debt burden.
The fragile debt market
For a long time, investors believed in promises of fiscal reform that should put Brazil’s debt on another path. But Lula did not take their concern seriously and recently reaffirmed that the only problem for the economy is that the interest rates are too high. His words are not reassuring, and investors distance themselves.
Since the beginning of the year, the Brazilian real has lost about 17% of its value against the euro and more than 20% against the US dollar. As for 10-year rates, they had started 2024 far from the current 14.3%, at 10.7%.
The Brazilian central bank is doing what it can to reassure.
After revising its rates by 0.25% in September and 0.5% in November, it chose a 1.0% increase in December, noting that two new increases of similar magnitude are expected in January and March. This will stop the country’s strong growth in recent quarters. However, it is not sure that this will be enough to push the reforms investors are waiting for to put public accounts back on track.
Foreign trade: green light in Europe, red in the USA
Brazil is, therefore, likely to face a period of intense turbulence.
With domestic demand expected to weaken due to the expected rebound in credit costs, foreign trade could be the lifeline to keep the economy afloat. But again, Brazil is blowing hot and cold. The free trade agreement signed between Mercosur (of which Brazil is a member) and the European Union certainly opens up interesting prospects for specific sectors of activity, particularly in areas related to agriculture. It should also make the import of European machines and products cheaper, allowing the modernisation of production tools and increasing competition in the Brazilian market. Undoubtedly, this is good news for the consumer. However, it should be noted that, beyond the announcement effect, this agreement will still have to pass several approval stages.
Relations with the U.S. are expected to be more tense, and on the one hand, President Lula has never hidden his preference for Kamala Harris. On the other hand, Trump’s United States has no reason to give a gift to Lula: Relations between Brazil and Elon Musk, Trump’s advisor, are tense. Former Brazilian president Jair Bolsonaro is a Trump supporter and should be running for a return to power (like his idol). Argentine President Javier Milei also enjoys Trump’s complex relationship with Lula. A failure of Lula would, therefore, be a victory for Trump’s ideas in South America.
Is growth enough to make a market an investment?
Brazil suggests that this may not be the case. Although the economy may seem well and balanced at first glance, excessive inflation and public debt are creating a difficult situation that will eventually cost it dearly.
Its potential remains intact, and if it manages to manage these turbulences, it should prove to be a sound investment. But it isn't easy to bet on such an outcome at this stage.
We reserve Brazilian equities for dynamic portfolios only for investors with less risk aversion.