In October, we wrote about the investment opportunity that presented itself in Brazil, when a new coalition government undertook to implement austerity in the wake of severe economic and political fallout after decades of fiscal spending.

There is unfortunately no easy way out of this fallout, as we concluded from our meetings with government officials, central bank employees and CEOs of corporations last month in Brazil. In the current context, we believe structural reforms—combined with productivity-boosting measures—should take priority in Brazil’s economic policy. Only by adamantly persevering in strengthening its macroeconomic framework will Brazil grow and hopefully see historically low real interest rates.

Fiscal Reforms May Promote Growth and Savings

Structural reforms on the fiscal side are being concentrated around a spending-cap bill that passed Brazil’s National Congress and social security reform that will be debated this year. These reforms are needed to break the dynamic of a growing debt burden that is ultimately curtailing growth. With the spending cap in place—and the 2017 budget that incorporates it and is already approved by the congress—Brazil will be able to direct its spending choices rather than have circumstances dictate them. So the spending cap should be seen as an important first step in generating viable options for economic recovery and growth.

In addition, a social security reform package has been submitted to congress and will be debated. In our view, not only is there congressional support to pass this reform, but, more importantly, an awareness and understanding among Brazil’s population of the importance of such reform given the dire fiscal situation of the country and its states and municipalities. Although many benefits of this bill would have a medium-term impact, the reform will also bear an immediate result since, for the first time in Brazil’s history, it will introduce a unified minimum retirement age for the entire population. The savings estimated by Brazil’s finance ministry are approximately R$5 billion Brazilian reais in 2018, R$16 billion in 2019, and R$27 billion in 2020, or a cumulative 11% of gross domestic product (GDP) for both public and private retirement systems by 2027. We expect a final bill to be passed by the second quarter of 2017 but will be closely monitoring the interim negotiations.

Other Government Initiatives Look Promising

Beyond fiscal policy, Brazil’s new government has a broad agenda of initiatives designed to boost productivity and medium-term growth and to improve the business environment: infrastructure investment, concessions and privatizations, and reforms in labor, taxation and education. Infrastructure investments, in particular, can play a significant role in boosting productivity given its multiplier effect, as they tend to lower the cost and risk of productive activities and increase the expected return on other investments in the economy, thus making new projects more attractive.

The government has made an effort to improve private-sector participation in infrastructure projects. We visited the government team tasked with this endeavor at its new office in Brasilia and found its members to be realistic about their prospects. The result of infrastructure spending, in our assessment, would be an increase in the country’s GDP.

Brazil’s monetary policy has been geared to control inflation and, as a consequence, the central bank has been slow to cut its benchmark Selic rate. However, inflation has been declining, and the central bank realizes that it must cut rates and also accelerate the pace of rate cuts—most likely this month. We expect the Selic rate, currently at 13.75%, to closely approach single digits by year-end 2017.

We see these developments as promising. After all, the very basic conditions for significantly lower real interest rates are fiscal responsibility and inflation control. Low interest rates and low inflation help preserve the purchasing power of households and corporations. Additionally, they reduce uncertainty and allow for a longer investment horizon. Yet remarkably, the economic view of local investors in Brazil is bearish given the unfolding episodes of widespread corruption, which are creating political uncertainty.

There is, however, a silver lining amid the corruption scandal: Society is demanding a fairer business environment in the medium term. However, for Brazil to live with a historically low real interest rate of 3%, or at least multiple percentage points lower than what is deemed achievable in this easing cycle, fiscal adjustment will not suffice. Investment and productivity will ultimately only respond to an overarching effort at structural reform as we just discussed. And in the long term, what will further Brazil as a country is education, which will endow a new generation of Brazilians with the intellectual capital they need to be productive and contribute to the country’s economy. Brazil’s education system suffers from the same inefficiencies as the country’s business environment, and the conversation on the efficacy of education has not yet started.

Last year, we were successful in identifying the inflection point in Brazil’s economic policies—namely, the shift toward fiscal responsibility and monetary easing. We expressed our view via overweight positions in various points along the yield curve. We mainly used nominal bonds1 as inflation levels began coming down to the central bank’s desired range. Although we can expect further short-term capital gains from declining yields of nominal bonds, we have started to build a position in inflation-linked securities based on the potential outlook for real rates to come down significantly over the next few years.

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1Nominal bonds offer payments of a fixed amount, as opposed to real-return bonds, which offer payments of inflation-adjusted value.