Find out what to expect for long-term inflation in Brazil in 5 charts – 08/12/2023 – De Grao em Grao

Estimating inflation is essential for an adequate investment decision. This is because depending on the variation in the prices of goods and services a fixed income type of investment may be more appropriate. Right now, we have a 12-month accumulated inflation of 4%, but is this the level we should expect for the coming years? How to select fixed income securities with this data?

The decision between fixed income securities referenced to the CDI and those referenced to the IPCA or prefixed is related to the real interest that must be implicit in securities referenced to the CDI in the future.

A few weeks ago, I explained that the real interest rate implicit today in the Selic and CDI is punctually high and should fall to its average of close to 3.5% per year. Therefore, long-term fixed-rate and IPCA-linked securities are better alternatives. However, how to choose between them and how does the expected IPCA affect the choice?

Considering the same issuer and term, the decision between fixed-rate and IPCA-linked bonds depends exclusively on the expected inflation until the maturity of the bond.

If you believe that inflation will accelerate, it is important to use investments that protect you from this erosion of purchasing power. If the expectation is for a deceleration in price increases, fixed-rate securities may be more advantageous.

Hence the importance of understanding where inflation should go, as well as what is priced today.

There are two basic ways to predict future inflation. The first is to consider that what is priced is correct. So, what would be the current inflation priced in long-term bonds?

According to a survey on the Anbima website (link), implicit inflation priced by the market, for the next 5 and 10 years, in federal public securities is 5.4% and 5.75% per year, respectively.

The second way would be to assume that the inflation that occurred in each month in the past is equally likely to occur in the future. This means that lower inflation such as that which occurred in the last 12 months would have the same probability of occurring in the future as the inflation that occurred in 2021, which exceeded 10%.

The question is which period to choose to carry out this survey. To solve this doubt, I collected monthly inflation in five-year windows since the Central Bank of Brazil (BC) started with the inflation targeting policy. The BC’s inflation targeting model was adopted in 1999, through Decree n. 3,088, of 06/21/1999.

The charts above and below show each of these five-year windows. The horizontal blue line that cuts through the graphs is exactly the mean. The table below summarizes the monthly IPCA averages for each five-year window and for the entire period since June 1999.

five year window	Monthly average for the IPCA
2018 to 2023	0.46%
2013 to 2018	0.52%
2008 to 2013	0.45%
2003 to 2008	0.45%
1998 to 2003	0.67%
total average	0.51%
Average from 2003 to 2023	0.47%

The lowest monthly average for the IPCA was 0.45%. This level means an average annual inflation of 5.53% per year.

The highest monthly average for the IPCA was 0.67%. We can assume that this average may not be expected, as it was at the beginning of the targeting model.

The monthly average since 1999 until today for the IPCA was 0.51%. This average results in an annual inflation of 6.3% per year.

If we exclude the first window, that is, from 1998 to 2003, the monthly average for the IPCA was 0.47%. This number points to an annual inflation of 5.79% per year.

Realize that the IPCA is not for nothing that the market prices in securities for the long term. It is close to what was observed in the past. After all, we know that in Brazil, history repeats itself.

Therefore, be careful when considering the inflation of the last 12 months as the trend for the future.

Conservatively, it is appropriate to expect an average annual IPCA in the future above 5% per annum. Thus, long-term fixed-rate securities with interest rates above 11% per year and linked to the IPCA with real interest rates above 5.5% per year are good investment alternatives to overcome the CDI and Selic rates. I prefer the latter because of the security of protection against inflation, but fixed-rate bonds with rates greater than 14% per annum can also be good alternatives.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

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