Daily Comment (September 30, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an overview of the upcoming Brazilian elections on Sunday. Next, we discuss how other countries are looking to fight inflation while generating economic growth. We end the report with a summary of the ongoing troubles in Europe.

 Brazil Election: Sunday’s election has sparked concerns of a potential coup and a return to left-wing policies.

  • Brazil will hold its presidential elections on October 2. Former President Lula da Silva and current President Jair Bolsonaro are favored make it out of the first round that has 11 candidates competing to lead the country. Lula is heavily favored to win the election and is predicted to take an outright majority in the first round. Assuming he does not win a majority, a run-off will occur on October 30. The return of Lula will not be viewed favorably by markets as his party has a reputation of being fiscally irresponsible.
  • A Bolsonaro loss may lead to a military coup. In the run-up to the election, Bolsonaro consistently blamed his potential defeat on electoral fraud. Given the country’s history of right-wing dictatorship from 1964-1985, the risk of political violence following the election is elevated. Although members of Bolsonaro’s political teams have stated that they would seek legal remedies if Lula won, they also mentioned the possibility of national protests and strikes. A military coup could lead to Latin America’s fourth largest economy being targeted by Western sanctions. For now, it does not appear that the military is interested in running the country.
  • The next president of Brazil will have to deal with the “Centrão” to pass meaningful legislation. The group contains an established bloc of politicians likely to oppose left-wing policies. Currently, the economy is on pace to grow 2.5% for the year, and the latest CPI report shows that inflation is falling. As a result, Lula is unlikely to have the political clout needed to reverse many of the pro-business laws put in place by his predecessor. Therefore, a Lula victory is unlikely to change investor sentiment about Brazil and should not impact the country’s currency much.

The Fed Speaks: As the Federal Reserve looks to continue tightening its monetary policy, other countries are looking at fiscal stimulus as a way to reduce inflation.

  • Fed officials insisted that the central bank will continue to raise interest rates to tame inflation. St. Louis Fed President James Bullard claimed that markets are right about the Fed’s rate intentions going into 2023. Meanwhile, Cleveland President Loretta Mester mirrored the sentiment but added that the bank could increase its policy rate above the Fed’s dot-plot median target rate. Although remarks by officials indicate rates will increase by another 125 bps before the end of the year, the level of hikes for each of the remaining meetings is still unknown. The latest CME FedWatch Tool suggests a 44.8% chance of a 50 bps increase and a 55.2% chance of a 75 bps increase.
    • The next meeting is on November 2; thus, the October CPI report released in two weeks will likely give us insight into how aggressively the Fed will tighten monetary policy.
  • In a surprise, revised data showed that economic activity in Britain grew in the second quarter. The latest report showed that output increased by 0.2% from April to June, slightly above the original estimate of a 0.1% decrease. Despite the upward revision, concerns about the British economy remain. The figures reveal that consumption and investment have declined in that period, and this situation likely worsened in Q3 as the country adjusted to higher inflation and borrowing costs. The Truss administration’s stimulus plan may provide some economic reprieve but probably not enough to avoid a recession later this year and could make inflation worse.
    • The U.K. Prime Minister Liz Truss and Chancellor Kwasi Kwarteng are looking for solutions to stem concerns over its controversial tax plan. They will hold an emergency meeting with the Office of Budget Responsibility on Friday. The agency is expected to release the budget estimate on November 23. The meeting most likely explains the recent rebound in the pound.
  • Japanese Prime Minister Fumio Kishida instructed the government to develop a budget that will tackle inflation and support a stronger yen. The move comes as the country looks for alternatives to ending its monetary policy accommodation to reduce price pressures. The next budget is expected to add to the country’s burdensome debt load and will probably weigh on future economic growth.

More Problems for Europe: Europe is struggling to cope with rising inflation and lack of energy resources as it looks to punish Russia for its invasion of Ukraine.

  • Russia announced that it annexed four of Ukraine’s regions on Friday, a sign that tensions on the European continent are rising. The annexations are controversial because Russian forces do not fully control these areas, and many residents vehemently oppose Moscow. As a result, maintaining stability in the region will likely be difficult and expensive for a country struggling with economic sanctions. That said, the annexations could give Russia a pretext to use more dangerous weapons.
    • The biggest takeaway from the annexation is that Russia is prepared to go all out in this war. Therefore, we believe that, barring an overthrow of Vladimir Putin, the battle is likely to be prolonged. This outcome suggests that the European energy supply crunch could extend into next year and even worsen.
  • Eurozone inflation jumped 10.1% from the previous year in September, a new record. The latest CPI report showed that price pressure is becoming more broadly based. Core inflation rose 4.8% from the prior year, higher than August’s reading of 4.3%. Persistently higher inflation could pressure the European Central Bank to increase its policy rate more aggressively in its October meeting. The market has priced in a 75 bps hike at its next meeting; however, we cannot completely rule out a more aggressive move.
    • Diverging borrowing costs among eurozone members may force the ECB to intervene in bond markets if it decides to raise rates. The spread between the Italian and German ten-year bonds is approaching its yearly high, thus increasing the likelihood of European fragmentation.
  • The European Union will levy windfall taxes on energy companies in a move designed to pay for subsidies for households. The EU is now expected to focus on implementing a price cap on Russian oil. The moves suggest that the bloc will find it difficult to expand production and may worsen the energy problem.

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