Carnival spirit could turn Brazil’s fortunes around

In today’s environment, a whiff of good news may be sufficient to draw large amounts of money to a country. This can turn round developing markets in particular, such as Brazil, which have been left behind, offering opportunity for short-term tactical trades.

“Brazilian equities have been digging a hole this year. The Bovespa is down around 10 per cent in local currency and it has one of the worst performing markets in the world,” says Gary Dugan, CIO for Asia and the Middle East at Coutts, who does however see stabilisation in the local currency, the real.

By contrast, the MSCI Developed Markets (USD) is up 10 per cent and the MSCI Emerging Markets Index (USD) is down approximately 3 per cent, year to date.

The Brazilian central bank’s decision to increase interest rates by only 25bp in April, versus the expected 50bp, and the debate among the governors about whether there was real need to increase interest rates suggests the market could start to discount an early end to rate rises, particularly with the weakness of global growth and fall in global inflation, explains Mr Dugan.

This may drive money to the largest economy in Latin America, also considering Brazil is an under-owned asset. Institutional investors’ portfolios have typically placed their bets on countries such as India or China. But concerns about the banking system in China and high valuations in many markets may contribute to the channeling of assets into Brazil.

Mr Dugan expects up to 10-15 per cent absolute return from this tactical call on Brazil, which should be implemented through ETFs. 

“Any rally will be driven by this huge liquidity. Over the past two years, whenever there is a whiff of good news for an economy, a lot of capital jumps in very quickly, and the market could turn round very quickly,” he says. In India recently, the market went up by more than 8 per cent within a month, and in Russia the hope for a cut in interest rate drove the market up a few percentage points.

Inflationary woes

In Brazil, relatively high interest rates imposed by the central bank to fight inflation and a tax of 6 per cent introduced two years ago on foreign tax transactions to curb capital flows and slow appreciation of the real have not been conducive to foreign investments.

However, a recent survey from the Economist predicts Brazil’s inflation will dip from 6.5 to 6 per cent later this year, which would benefit financials. Also Petrobras, the multinational energy corporation controlled by the government, and the oil and gas sector in general, which is a large component of the Brazilian stock index, the Bovespa, have been performing well of late, states Mr Dugan.

Money is going to flow to Brazil, but more towards the currency and fixed income, driven by interest rate rises, rather than equities, according to Phil Guarco, chief investment strategist, Latin America at JP Morgan.

“The Brazilian economy is growing beneath its potential and with inflation trending up, we still expect some tighter monetary policy in the future. We are much more positive on the opportunities for carry investing in Brazilian money markets, bonds or real rather than equities,” he says.

The Brazilian equity market has fallen behind because of lower than expected growth rates, just under 1 per cent last year, and also because of government policies. These for example negatively affected share prices of electricity firms in the Bovespa last summer.

Petrobras, which represents about 7 per cent of the index – but its weighting increases by 50 per cent when adding up all the different forms the company takes in the Bovespa – has fallen by about 40 per cent in dollar terms over the past two years, along with electricity companies and miners, dragging the index down by more than 20 per cent. The Mexican stockmarket, for example, has risen by almost 20 per cent.

Brazilian companies serving consumers, included in the Solactive Brazil Consumer Index, have increased by 40 per cent over the past 12 months, versus 9 per cent of the broader market, in dollar terms. But these companies are a relatively small portion of the stockmarket and are not cheap, says Mr Guarco.

Lower commodity prices and cancellations of commodities purchases from China – which sets the price for many commodities Brazil exports, like soybeans and iron-ore – are negatively affecting the country’s trade balance.

“China slowing is a risk for Brazil; we believe that Brazil has a beta to China of 1.2,” he says. If China’s economy slows by 1 per cent, that is going to hurt Brazilian economy by 1.2 per cent. The issue is that Brazil is not growing at 7-8 per cent but is expected to grow at around 2.5 per cent this year.

Brazil vs Mexico

While Brazil is facing these macro-economic challenges, Mexico is enjoying much better fundamentals. Its political situation is improving, its economy has stabilised and exports have increased. Around 80 per cent of them are manufactured products. Mexico is competitive not only versus the Chinese but also against the Americans. This year the country is expected to account for about 15 per cent of the total US imports of manufactured products, according to JP Morgan. This is in contrast with Brazil, whose growth from 2000 to 2010 was driven by price rises in raw materials which the country exports, rather than increases in efficiency and competitiveness.

The top-down environment in Mexico looks better than in Brazil, agrees Nicholas Morse, fund manager at Schroders, which runs the SISS Latin America Fund. In Mexico, inflation is under control, and the level of consumer debt is not as high as in Brazil. The Mexican peso is undervalued and the many reforms in progress and planned in the country will stimulate foreign investments. Growth forecasts on Mexico have been downgraded slightly to 3.5 per cent partly as Q1 GDP was worse than expected, but it remains “a pretty solid story”.

Looking at valuations of the 12-month forward price-earnings ratio, these are around 18 for the Mexican Stock Market, making it an expensive market, versus 11 for the Bovespa. These are in line, if not slightly ahead, with the average Brazilian historical PE.

Both markets offer opportunities, as the aim is to look for undervalued companies, says Mr Morse. In Brazil, these are found mainly in the mid cap space in consumer oriented companies.

This consumer story is the focus of most investments with a medium to longer term horizon. Funds investing in the infrastructure sector and consumption story, as well as dividend generating strategies, are very popular, confirms Denise Pauli Pavarina, deputy officer at São Paulo-based Banco Bradesco and managing officer of Bradesco Asset Management (Bram), which runs more than R287bn (€109bn) in total assets.

“We see more and more demand for absolute return funds, including multi-asset strategies, rather than index-based funds,” she says, proud of the firm’s 54 strong investment team and in-depth knowledge of the local market.

Over the past few years, Bram launched Luxembourg-domiciled funds for cross-border distribution, including two Brazilian hard currency bond funds and a mid-small cap equity fund, which mirrors its nine-year track record Brazilian strategy. The equity product invests in a concentrated portfolio of 35 stocks focusing on high-growth liquid companies in the consumption and infrastructure sectors.

“When speaking to European distributors, the conversation starts from dispelling the myths. Brazil is not an export-focused economy, but a service economy,” explains Ileana Salas, head of business development and sales, Europe and Middle East, Bram. Sixty-five per cent of Brazilian GDP is generated by domestic demand and around 55 per cent of the total 200m Brazilian population are in the middle class. Brazil enjoys very favourable demographics and a level of debt to GDP, which, at around 34 per cent, is much lower than Germany (56 per cent), France (86.5 per cent) or the US (89 per cent).

“Brazil has performed poorly over the past two years, but it has some very good long-term growth prospects,” concludes Mr Dugan at Coutts.