Brazil learning to cope with growing pains

“It’s an overplayed joke but the whole joke about Brazil in the past was that it is the country of the future and always will be,” says Phil Guarco, chief investment strategist for Latin America at JP Morgan Private Bank in New York. The joke was perhaps true until President Luiz Inácio Lula da Silva was elected in 2003, as the country was facing a major financial crisis. The local currency, the real, was weakening terribly and the Brazilian sovereign debt had just been downgraded to B2 level by Moody’s and single B+ by Standard & Poor’s.

In less than eight years, the situation has changed dramatically. Brazil is perceived as a stable democracy, fiscal management has improved remarkably since 2003 and this year under President Dilma Rousseff, who took over from Mr Lula, the primary fiscal surplus is expected to be above target. Brazil government debt is just 40 per cent of GDP, which is roughly half of that of the US or France, which still have Aaa ratings from at least two ratings agencies (in the case of France from all three major agencies). The capital market has proved to be well regulated during the financial crisis. The economy is growing at steady pace and the middle class is rapidly expanding.

The question is whether this is just one of the many cyclical changes Brazil has been subject to in its history, because of its strong dependence on the price of commodities, which it exports, or, rather that the country is now where it should be, argues Mr Guarco.

Brazil is still a relatively closed economy. Total exports in Brazil represent only 24 per cent of the total GDP, the remaining 76 per cent is dependent on the internal economy. Yet, the recent super-cycle in commodities has really served as a jump start for the local economy, observes Mr Guarco.

Like many developing countries, Brazil’s story is the story of the emerging middle class. Around 47m people will have enlarged the middle class ranks between 2003 and 2012, fuelling the domestic economy’s growth. “The real Brazil play over the medium to long-term is the consumption story driven by a transition from being an emerging market economy to a middle class economy,” says Mr Guarco.

But a number of short-term challenges are present. High inflation negatively affects the outlook for growth – GDP growth is expected to be just below 4 per cent this year – and is having a negative impact on the stock market. Hyper inflation has been one of the long-term problems for Brazil, which over the past 25 years was forced to take 6 zeros off their currency. While inflation reached an annualised rate 6.6 per cent in July, higher than its target of 4.5 per cent, it is still only a tiny fraction of the kind of hyper inflation Brazil has had in the past.

The Brazilian Central Bank has been tightening monetary policy and has also increased banks’ reserve requirements to try and reduce credit growth. “There is this sort of rhetorical battle between the Brazilian Central Bank and the market, and the credibility of the Central Bank continues to be questioned,” says Gustavo Rangel, chief economist, Brazil ING Financial Markets in New York.

The Central Bank favoured this new route over hiking interest rates, which would drive the currency to appreciate. And a strong currency, which is the other major problem, is hurting the manufacturing exports industry.

Equity markets in Brazil have been greatly hit by the uncertainty in the financial markets and the sovereign debt crisis, as well as investors’ worries on inflation. Foreign investors have been withdrawing money from the equity market since 2009, even though the prices are attractive and country macro-economic indicators are very positive, says Otávio Vieira, CIO at Sao Paulo’s Safdié Gestão de Patrimônio.

“We are suffering shock-waves from Europe mainly,” he says. “Risk aversion in the world is very high and investors are profit taking, because Brazil has offered good returns since 2002, the currency has been appreciating and the stock market was skyrocketing. We see a lot of opportunities in the Brazilian equity market, but the volatility will probably continue, because it is linked to the sovereign debt crisis in Europe and, to an extent, in the US. But it is a very good moment for long-term investors to build their equity portfolios.”

The lack of foreign flows has been a primary reason why Brazilian equity markets have underperformed. Brazilian investors are mainly invested in fixed income. Even aggressive investors invest only 30 per cent in equities, says Charles Ferraz, CIO and head of wealth planning at Itaú Private Bank. Brazilian government bonds offer a coupon of 12.5 per cent, and even with inflation at 6 per cent, deliver an attractive return in real terms.

Foreign investors, however, have to take the FX risk into account. Another worry is that the local government may introduce new taxes, in addition to the one-off 6 per cent tax introduced to curb foreign money inflows, which drove the real higher. “Given the very high rate differential – 10 year US treasuries are currently at 2.5 per cent and interest rates are unlikely to go up soon – there is a lot of space for the real to depreciate and even in this kind of scenario, it is possible for long-term investors to make money,” says Mr Ferraz.

Investment limitations on the fixed income side have partly driven private equity growth. This adds to the fact that the Brazilian stock exchange, the Bovespa, is not representative of the Brazilian economy, being largely dominated by commodities companies and banks. Many sectors and companies that are focused on the consumption story cannot be accessed through the stock market, for example.

Private equity and venture capital investments represent about 2.3 per cent of the Brazilian GDP versus a global average of 3.5 per cent of GDP, according to a study from Fundação Getúlio Vargas, so there is still plenty of room for growth, he says. Assets in private equity and venture capital investments have increased to $46bn (E32bn) today from $36.1bn in 2009 and $5.6bn in 2004. Around 58 per cent of the money in these asset classes comes from foreign investors, more willing to invest in more illiquid investments than the Brazilians.

“Some private equity funds have been providing a return of 25 to 30 per cent a year for the last five years,” claims Safdie’s Mr Vieira. “Diversification is important and those investing with very active managers in fixed income and equities, as well as private equity, will have very decent returns for the next five years.”

Although it is damaging the profitability of industrial companies, the strong real is also creating good investment opportunities, explains Alex Duffy, co-manager of Fidelity’s Latin American fund. Firms whose stock prices have been “punished by the strong FX”, are a buying opportunity, especially when these are robust businesses with a future as exporters. Also, the currency cannot continue to appreciate at this current rate, he says.

Year to date, as of the 12th August, the Brazilian equity market was down around 20 per cent. The decline was due partly to the slowing in domestic demand. The businesses have not generated the expected earnings growth and consequently the equity market has de-rated, says Mr Duffy. Moreover, certain sectors, such as the domestic steel industry, were affected by a much more competitive environment than in the past, which eroded their returns, driving down the equity markets.

“We think there is still a bit more pain to come, so it is important to remain vigilant to the risks of owning companies in sectors that are seeing a structural change in their return profile, and to make sure that we continuously understand the sustainable cash generation and appropriate balance structure of the businesses we are invested in.”

Nobody should invest in an emerging market unless they have at least a five-year time horizon, because the ability of individuals to time equity markets is very poor, as many studies have shown. However certain sectors, such as the banking or steel industries, are derated and trading at a significant discount to their historical valuations of the last five to 10 years.

“It is important to understand the sustainable return generation of those businesses, but fundamentally that’s a far better starting point to invest than it is when multiples are higher and the equity market has just gone up by 30 per cent,” adds Mr Duffy.

A positive long-term outlook on Brazil explains Commerzbank’s neutral weight on Brazil, despite the short-term challenges the country faces, explains Andreas Wex, head of equity research at the German bank. Emerging markets are a proxy for “risk on, risk-off” positions. A more “risk-on” environment will make these countries, including Brazil, a more interesting investment story, says Mr Wex.

Currently, the German bank recommends the BlackRock Latin American fund to wealthy clients that want to invest in the country. The fund invests more than 70 per cent of its assets in Brazil and 20 per cent in Mexico.