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Brazilian markets price in pension reforms, but Bolsonaro has work to do

Brazilian markets that have been boosted by the election of new President Jair Bolsonaro could be in for a snapback if his substantial reform proposals fail to garner the support needed in the country's politically fragmented legislature.

Markets have generally strengthened since Bolsonaro first emerged as a leading presidential candidate, mainly on the back of his promise of market-friendly reforms, as well as a commitment to put the country's finances in order through substantial changes to a pension system that has long dragged on government accounts. Brazil's benchmark IBOVESPA index gained 10.8% in Bolsonaro's first month in office and closed at a record 98,588.63 on Feb. 4, while the country's five-year credit default swap spreads have dropped to a level typically reserved for sovereigns with credit ratings slightly above Brazil's current BB-.

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CDS spreads are "trading as if Brazil's [upgraded credit rating] was already happening," Itau equity strategist Luiz Cherman said in an interview. He also said Brazilian equity markets have priced in the successful implementation of pension reform.

"Any additional increase would have to come from more economic growth, commodity prices, global growth … other issues related to, but not as a direct result of … the approval of reforms," Cherman said.

Meanwhile, other observers note the difficulty in moving anything past a divided Brazilian congress.

With 30 parties, the new congress "is the most fragmented in Brazilian history," which will require "a great deal from the president and his ministers in terms of their capacity for dialogue and negotiation, Mauricio Santoro, a professor at Rio de Janeiro State University, said in an interview. Adding to the difficulty, Santoro noted, is a lack of "political coherence" and experience among congressional members within Bolsonaro's own party.

"Its members have shown difficulty adapting to the legislative discipline, with strong internal disputes," he said. "This will not be easy."

Markets already have begun to react as the difficulty of passing such reforms becomes more apparent. Economy Minister Paulo Guedes recently confirmed that the government, lacking congressional support, was abandoning plans to push a pension reform proposal that former President Michel Temer failed to pass during his tenure.

In an interview with the Financial Times published Feb. 10, Guedes said he now expects pension reform to gain passage within five months, compared with previous government promises that the reform would be finished by the end of the first quarter.

The IBOVESPA index, coming off its record highs, lost nearly 4% on Feb. 5 and 6, and has been trading at around 95,000 in the days since.

Importance of reform

Credit rating agencies have long flagged pension reform as a prerequisite to any potential upgrade to Brazil's sovereign ratings, given the weight it represents on government finances. Brazil spent nearly 680 billion reais in 2017 on about 30 million public and private pensions, and official data show that the system's deficit jumped 18.4% that same year to 268.70 billion reais.

In the FT interview, Guedes estimated that Brazil would save 1 trillion reais over 10 years by reforming the pension system.

"Reforming the pension system is seen by the market as essential for restoring the state's investment capacity and for restoring Brazil's growth," Santoro said.

Reforms also may be essential in drawing in foreign investment funds. A December 2018 report from BTG Pactual noted that foreign investors have shown "extreme cautiousness when it comes to investing in Brazil," but noted "huge potential inflows" should confidence rise, calculating that 193 billion reais of offshore funds could target Brazilian equities if their allocation returned to October 2014 levels.

Renato Ometto, Equity CIO at Maua Capital, estimated that the IBOVESPA index could hit 115,000 to 120,000 by the end of the year, but only if government leaders "get these reforms approved; we have to see the numbers." Ometto also expressed some reservation that the pension reform will be passed quickly.

"We've been looking for this [pension reform] for the past 10 or 15 years. I do not expect everything to get approved in a week or a month," he said, adding that in the meantime, markets will be "very sensitive."

As of Feb. 8, US$1 was equivalent to 3.74 Brazilian reais.

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