Since 2011, Brazilian assets have re-priced to the downside – first to reflect the decline in commodities and then due to political uncertainty, with President Rousseff adopting a number of populist, but business-unfriendly policies that only served to make the economic adjustment more painful. Given the size of the adjustment – both in commodities and assets – the question is whether Brazil is now presenting attractive investment opportunities.
Nikko Asset Management’s Head of Global Equities, William Low and Senior Portfolio Manager for Multi Asset, Robert Samson recently undertook a joint research trip to Brazil to assess the current investment environment and identify any interesting investment ideas. Although the investment universe and strategies for our Global Equities and Multi Asset teams are different, they regularly share ideas and are similarly focused on trying to understand how these regional macro-political dynamics affect their asset class(es), although the Global Equities team are ultimately stock pickers. Both teams agree that time on-the-ground is essential to garner genuine insights that put them in a better position to understand the various risks and rewards of potential investments.
In our view, emerging markets (EMs) have increasingly divergent prospects, driven both by changing macro conditions (e.g. structural decline in commodities) and the political capacity to manage these risks and reform to achieve sustainable growth. Brazil is a perfect case study in this sense and these dynamics affect all asset prices: currencies, equities and bonds. The Multi Asset team’s partnership with Eurasia Group has been invaluable in assisting Nikko AM’s understanding of the macro-political dynamics affecting global markets. For this particular trip, Eurasia Group assisted us in setting up meetings with a variety of consultants, journalists and government officials to complement our company meetings and help us truly appreciate the investment context in the country.
Brazil faces significant structural and political challenges
Bearish sentiment is often a healthy starting point for seeking opportunities and indeed this had a notable bearing on the timing of the trip. However, given the scale of Brazil’s issues, it's worthwhile summarising what we found before assessing whether the market is discounting them appropriately.
Brazil’s fiscal position has been deteriorating rapidly and its 66% debt to GDP ratio is one of the highest in EMs, despite also having one of the highest tax burdens as a percentage of GDP (source: Heritage Foundation). With interest rates over 14%, the resulting interest burden is significant—hence the fiscal deficit in aggregate has been near 10% of GDP. One of the main causes of the fiscal deterioration is Brazil’s large public sector, which has been growing as a percentage of GDP and only sustained by rising taxes. The structure of the constitution makes it extremely difficult, if not impossible, to sack poorly performing public workers or to reduce salaries.
The required funding for such a large deficit is a significant problem given that gross savings to GDP are among the lowest across the EMs, with only Turkey and South Africa having lower savings rates. Big government is effectively crowding out investment. High interest costs, high taxes and fiscal uncertainty have depressed investment for some time.
The ruling party is also hampered in its attempts to reduce the fiscal deficit given that only 17% of the fiscal budget is discretionary, with the remaining 83% mandated under the constitution (see chart 1). Reforms to reduce these expenses require constitutional amendment and therefore a 60% congressional majority to pass. Although there is increasing recognition that reforms are necessary, the extent and path of execution is still highly contentious.
Chart 1: Brazilian budget 2015
Brazil also faces the impediment of endemic political corruption among parties and political paralysis, with few willing to negotiate concessions in a changing political landscape and with the threat of impeachment continuing to hang over President Rousseff. Originally, members of Congress supported Rousseff finishing her term to push through harsh reforms and hopefully to pass an improved economy to another party in the 2018 presidential election. However, with her power slipping away and the corruption probe spreading to multiple parties, politicians are more likely to wait before pushing any major reforms. As many Brazilians said to us in our trip meetings, markets may likely have to inflict more pain to clear political complacency, so that Congress can finally rise to the occasion and reform as needed.
Brazilian equities: still expensive valuations and high operational leverage
We did not find much evidence during our trip of promising conditions for equities. At the index level, Brazil equities are significantly depressed, driven by a collapse in earnings – mainly in the commodities sector, but now more broadly through declines in top-line growth due to the economic slowdown. The trend of downgrades is likely to continue as growth disappoints, credit issues emerge and operational leverage is underestimated.
We found that leverage issues extend broadly across sectors. Corporate debt to GDP is 75% on average, which is significantly higher than other major EM markets. As shown in chart 2, corporations have borrowed heavily from abroad, through intercompany lending and bond issuance to offshore investors.
Chart 2: Gross external debt in USD millions
Source: BCB and UBS. *To end June 2015. Includes direct investment: intercompany lending and domestic fixed income securities held by non-residents.
As volatile markets are not (so far) accommodating an equity raise, companies are being forced to sell assets, mainly to foreigners (e.g. China), which largely describes the recent increase in foreign direct investment as opposed to investment for growth. In fact, according to UBS, investment has contracted by 15%, both as a function of budget tightening and lack of credit, where state-owned banks’ balance sheets are stretched and public banks are unwilling to lend.
In our view, valuations are not that cheap for the market overall as enterprise values have declined little due to this rising leverage. Quality, defensive growth stocks are actually quite expensive, never mind when the domestic cost of capital is applied (see chart 3).
Chart 3: Discount rate for Brazilian stocks
Source: Credit Suisse HOLT Lens™
We are not seeing fire sale prices in safer blue chip stocks. In our view, value is more in financials and commodities, although to make a strong investment case, we would need to believe the cost of money was reducing and/or a bull market was returning for commodities.
Following the trip, we believe that equity risk premiums are likely to remain elevated due to on-going structural and political issues. In summary, the fall in the market just reflects lower profitability, lower growth and a more volatile and uncertain outlook. Mispricings are likely to be stock-specific rather than endemic for the market overall and generally there is no valuation discount for investing in Brazilian equities.
Commodities/currency: potential silver linings despite adjustment
The Brazilian real (BRL) looks cheap relative to history, but less so when one considers how much of the depreciation is simply offsetting the outsized gains achieved during the commodity boom. It has corrected 60% relative to the US dollar since 2011, following a period of significant overvaluation based on the rise in commodities and capital inflows. Nevertheless, real effective exchange rates are still 47% above the lows set in late 2002. While Brazilian labour is cheaper, it is still more expensive than China and Mexico, so it is difficult to argue currency support from any significant improvement in exports.
However, there may be an opportunity in commodity exports outside of energy and base metals. Proteins were specifically mentioned by several of the Brazilian analysts that we met as an interesting sector given the competitiveness afforded by the currency adjustment. While exports have declined in revenue terms due mainly to the decline in commodity prices, there has been a small increase in export volumes, so this is a trend that bears watching.
The BRL has recently been finding support through improvements in its external position, largely through a shift in sentiment. Most of the rally since the start of March has been due to broad relief in EM foreign exchange and commodities, as well as local dynamics relating to the increasing likelihood of Rousseff’s impeachment. This rally could have further to run if these dynamics continue. However, for the rally to be sustainable, we think it is likely to require a more definitive outlook on new leadership and the reform agenda. We also note that many of those we met on our trip feared that over the next four to five months, there is a relatively high risk that the government will start missing its primary surplus targets and without progress on structural reforms, markets could react quite negatively.
The prospects for the BRL over the next two to three years remain fairly poor even if there is positive progress on reforms because growth potential will not start to improve until after 2020 when debt to GDP will exceed 90%. If Brazil loses access to the capital markets, it may be required to monetise its debt, in which case inflation is likely to rise and the BRL could fall significantly. Both teams felt that monetisation is a wild card that should not be ignored.
It is worth noting that foreign exchange reserves are high, standing at 6x short-term external debt, although they have declined from as high as 12x back in 2012. Generally, levels less than 1x are considered to be very risky, so Brazil currently still has an ample buffer against capital outflows.
Brazilian bonds look cheap but maintaining market confidence is key
With high reserve requirements for banks, combined with the Central Bank of Brazil being allowed to hold high levels of government debt, funding for government bond issuance seems reasonably assured. However, the private sector banks have to achieve economic returns primarily via the remainder of their book, hence spreads are high and duration of lending is short.
In our view, hard currency bonds are currently reasonably cheap and may present a similar opportunity to the currency. The risk premium could compress over the near to intermediate term, but could also blow out much further over the longer term if markets lose faith in Brazil’s capacity to return to fiscal sustainability.
Local currency bonds are also fairly cheap and offer a similar opportunity to hard currency, although they are obviously exposed more directly to local inflation dynamics. During our trip, we met with members of the Central Bank of Brazil and they argued strongly that the rate of inflation is set to decline. They estimate this will occur through the base effect as last year’s significant electricity tariff hikes roll out; slowing inflation as the BRL stabilises; and a weaker labour market.
If inflation does reduce, there may be significant opportunity for rate compression as the central bank cuts rates, but this is increasingly being priced in as local currency yields have recently compressed substantially more than hard currency yields. The clear risk is that inflation does not decline and inflation expectations become unanchored. This outcome will depend on inflation data and evidence of fiscal slippage, which could well have a deeper impact, particularly if inflation levels remain elevated.
Conclusion: Investing in Brazil remains challenging
Brazil will need to enact reforms to return the country to a sustainable path before losing the confidence of the markets. However, dysfunctional politics, endemic corruption among parties and the threatened impeachment of the President have paralysed the political process, putting prospects for further reform on hold, potentially for some time. As a result, we believe that investing in Brazil remains challenging and requires vigilance from those investors prepared to deploy capital into the country.
For the time being, our Global Equity team did not find a supportive market for equity opportunities. Despite being stock pickers, William Low notes that stock selection in Brazil must incorporate some valuation support to justify the on-going market, currency and downgrade risks. Purchasing of overall market exposure is a trading strategy at best based on relative value, but this is not how the global equity team manages portfolios.
Our Multi Asset team felt that it is too early to invest in Brazil for the long term, although there may be tactical opportunities (particularly in bonds and the currency) in the medium term. Brazil will remain vulnerable to ongoing volatility in the commodity space, but Robert Samson’s concern is more for the long term, as deteriorating fundamentals may accelerate past the political system’s capacity to address them.