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10/06/2010

Update on Brazil: More Than a One-Note Samba, But Changing Key


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INDEX: WEATHERING THE CRISIS | EMERGING RISKS IN BRAZIL | A CROWDED TRADE | CHANGING POLITICS | THE IRRESISTIBLE COOKIE JAR (PETROBRAS) | OVEROPTIMISM AND “BRASIL GRANDE” | SUMMARY

Worldview first covered Brazil in the Winter 2009 edition of The Investment Professional. At the time, when it was not entirely clear that the dramatic crash of late 2008 had fully run its course, this column argued that investors willing to invest or hold on to their Brazilian exposure would likely find their patience rewarded. There were several arguments in favor of Brazil:

  1. Extensive Brazilian experience in surviving and adapting to economic shocks.
  2. Large foreign reserves and manageable debt loads, shielding Brazil’s government from fiscal and political crisis.
  3. Highly professionalized fiscal and monetary authorities.
  4. A substantial domestic sector that could buffer reduced international demand.
  5. A more diversified export base than generally appreciated by most investors.
  6. (Exports diversified by both export destination and industry.)
  7. Foreign investors predisposed to run at the first sign of trouble in Brazil, providing an opportunity to enter at attractive valuations.
  8. Attractive correlation (i.e., diversification) features.

In short, Brazil’s diversification and substantial domestic sector provided risk reduction, along with sufficient reserves to fund any temporary measures to absorb extreme shocks. Meanwhile, the tendency of investors to remember Brazil’s experiences in the 1980s and 1990s was likely to prompt them to overpanic over a crisis that was essentially a developed-country crisis.

And today? Brazil is still an attractive investment that should clearly be part of a global or emerging markets portfolio, but the valuation opportunity is no longer as compelling as it was, and new risks have emerged on the horizon. Brazil is still attractive for those with long-term investment horizons. Those without exposure to Brazil should consider building up an exposure over time, but short-term investors who are simply chasing returns could easily find themselves burned, particularly without proper risk controls.

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WEATHERING THE CRISIS

Emerging markets including Brazil registered dramatic drawdowns during the late 2008 financial crash. Many at the time considered the crash —more acute in percentage terms for emerging markets —as demonstrating that emerging markets were not “decoupled” from the developed markets as thought. Economic performance since the collapse has shown, however, that even if financial markets are not fully decoupled under panic conditions, emerging market economies may have made substantial progress in decoupling their fundamentals. Certainly, recession in developed markets still has an effect on GDP by reducing exports, but emerging markets are less dependent on capital from developed economies, they often trade with each other, and many have substantial domestic sectors with emerging middle classes and pent-up demand that can take up some of the slack. Brazil’s emerging middle class has definitely filled this role. Figures 1, 2, 3, and 4 show changes in Brazil’s market, currency, and interest rates over the period immediately preceding the crisis up to the time of writing. These charts are provided primarily for context, as this article emphasizes the changes in the investment climate going forward.

Figure 1: Quarterly Market Total Returns and Real GDP Growth

Brazil Quarterly Market Total Returns

Figure 2: MSCI Gross Total Return Index in USD

MSCI Gross Total Return Index in USD

Figure 3: Brazilian Interest Rates and Inflation

Brazilian Interest Rates and Inflation

Figure 4: Strength of Real vs USD and EUR

Strength of Real vs USD and EUR
Source: MSCI and currency data from Bloomberg (Accessed October 4, 2010); GDP, inflation, and interest rate data from Economist Intelligence Unit (Accessed October 4, 2010). 

Table 1 compares MSCI equity gross total return indices for Brazil, several emerging markets, the United States, and the All Capitalization World Index (ACWI) over the crisis period from January 1, 2007 to October 1, 2010. It shows that Brazil, China, and India each experienced remarkably similar drawdowns of about 73% from peak to trough. This compares with a 55% drawdown in the United States, 58% in the ACWI, and 64% in Mexico’s index.

Table 1: Brazil Compared to Other Economies Brazil Compared to Other Economies Source: Bloomberg (Accessed October 4, 2010)

Those who managed to pick or buy near the bottom were richly rewarded. As of October 1, 2010, Brazil’s total return index had grown nearly 209% from its low on 21 November 21, 2008, reaching 85% of its high water mark. Of the other countries, only India posts such high growth from the bottom. Mexico is currently closer to its high water mark primarily because it experienced a smaller drawdown. The US and ACWI, by comparison, are up only 80% off of the bottom, and have recovered to just under 80% of its pre-crisis high. Note that no country shown has yet topped its pre-crisis high, at least in terms of total return figures. Figure 4 illustrates the comparison graphically.

Figure 5: Relative High, Low, and October 2010 Values of MSCI USD Total Return Indexes

Relative High, Low, and October 2010 Values of MSCI USD Total Return Indexes
Source: Bloomberg (Accessed October 4, 2010).

It is noteworthy that Brazil’s market was one of the first countries to resume growth after the market collapse, about a month after China, and nearly three and a half months before other countries. China and Brazil appear to be the first major economies to recover from the crisis.

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EMERGING RISKS IN BRAZIL

The 2009 article described the more traditional measures of investment risk such as volatility and correlation, and most of those have not changed greatly over the long term. Some changes on the horizon, however, warrant more careful consideration. Briefly, they are:

  • A Crowded Trade
  • Changing Politics
  • The Irresistible Cookie Jar (Petrobras)
  • Over-optimism and “Brasil Grande”

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A CROWDED TRADE

The biggest danger to many investors in Brazil has less do to with Brazil itself and more to do with investor behavior. In the last 12 months, Brazil has made the news repeatedly: the cover of the Economist (November 12, 2009: Brazil takes off), CFA Magazine (September/October 2010: The Country of the Future), and numerous discussions on popular news sources like Bloomberg and CNBC. Brazil is no longer “the undiscovered country” or “the land where investors fear to tread,” but has arrived repeatedly on investors’ radar screens, whether through news of the 200% returns since the lows, FIFA’s World Cup in 2014, or the Olympics in 2016. Brazil’s performance is now well documented and disseminated.

Investors’ money flowing into Brazil and pushing up asset prices represents not just enthusiasm about the potential and performance of the Brazilian economy, but also a lack of compelling opportunities elsewhere around the world, particularly in developed markets. At some point in the future —perhaps sooner than many think —other developed and emerging markets may start to look more attractive, and portfolio investment will likely flow away from Brazil, not because Brazil has done anything wrong, but simply because there are other attractive options elsewhere that were not present before.

One challenge is to discern how much capital flowing to Brazil (and other emerging markets) is part of a long term reallocation of investment capital from developed to emerging markets, as part of what PIMCO’s Mohammed El-Arian calls “a bumpy ride to the new normal,” and how much represents short term tactical allocations in response to the poor investment climate elsewhere. Clearly the current flow of funds into Brazil represents some of each; however, Brazil can be affected both by reallocations between developed and emerging markets as well as reallocations among emerging markets. For example, the current attention to markets in India and Turkey may already be slowing the interest in new Brazilian allocations independent of any changes in developed or emerging allocations.

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CHANGING POLITICS

The conventional wisdom is that markets are not much threatened by the elections going on in Brazil this October because neither major Presidential candidate or party proposes to undo the market reforms put in place during Fernando Henrique Cardoso’s administration (1994-2002) or implement radical reforms. This view is largely correct, but it misses a critical change in Brazilian politics: the absence of a charismatic President.

Neither Dilma Rousseff nor José Serra are leaders with demonstrated charismatic capacity to lead movements. Instead, both are seen as highly competent administrators riding the coattails of former presidents and their political party. On the surface, smooth administration may sound harmless enough, or even positive for markets, but ultimately, this will make securing legislative support from the Congress more difficult. In the absence of solid Congressional support —difficult even in the best of times —policy may begin to lose coherence, and the government’s capacity to coevolve with the global economy will be impaired, particularly as new political rivals attempt to take advantage of the charismatic gap to make names for themselves. If things deteriorate, the government may start to push largely symbolic efforts because real policy has become difficult to manage.

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THE IRRESISTIBLE COOKIE JAR (PETROBRAS)

Brazil’s relations with foreign investors warmed in the 1990s and 2000s when the state began to distance itself from heavy involvement in state enterprises and liberalized the economy. Although there seems to be little danger of Brazil going the way of Venezuela or Bolivia, recent years have witnessed a small but noticeable shift in the commitment to reduce the state’s presence in the economy.

The most obvious example is Petrobras, where discovery of vast oil reserves off of the Atlantic coast promises to launch Brazil into the top-ten oil exporting countries. Brasília certainly has a right to charge royalties to oil developers, as other governments do. However, the danger remains that the programs created and funded by oil royalties will be many times larger than the actual royalties themselves, or implemented and the funds spent before royalties actually start arriving.

The 2% tax recently levied on foreign fixed income investors, while mostly harmless in itself, raises questions as to whether more arbitrary-sounding surprises are in store, particularly if the government wishes to weaken the currency. World demand for Petrobras’ oil is likely to push the currency higher once the oil comes online.

None of these policies are necessarily problematic in and of themselves, but investors in Brazil need to ask themselves if state economic policy has reached an important inflection point and whether this pushes down the appropriate valuation multiples.

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OVEROPTIMISM AND “BRASIL GRANDE”

Optimism is one of the more delightful features of the Brazilian character, but at times it can morph into overconfidence. Brazil certainly deserves its current place in the sun and has much to be proud of. The conquest of hyperinflation in the 1990s and its reinsertion as a powerful player in the global economy in the 2000s are major accomplishments. The natural impulse of Brazilian government and entrepreneurs in this environment is to think and dream big.

In the 1960s, during the last “Brazilian Miracle,” the military government imagined “Brasil Grande [Potência]” or “Brazil, the great power,” constructing bridges, dams, highways (including the trans-Amazon highway), much of it financed with debt that became unmanageable in the 1970s and 1980s, particularly after oil crises knocked the economy into recession. Currently, Brazil has similar great power ambitions, although today it is focused more on soft power development, as well as bolstering the power of its private sector and the government’s role as a neutral, emerging-market arbiter.

In itself, there is nothing wrong with thinking big. But if “being confident” becomes as a substitute for careful planning and the evaluation of risks and return, capital can be misallocated and spent badly with devastating long-term effects, much as it was during the US credit bubble or the first Brazilian Miracle. Thus far, Brazilian ambition appears to be in line with its capacity, but, be assured, these animal spirits are real, and will at some point rear their head. Investors will need to keep a careful eye on whether promised returns are backed by “confidence” or by reliable planning.

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SUMMARY

Overall, the primary reasons to be long-term bullish on Brazil remain the same, but the valuation may be getting ahead of itself. Investors with a long-term time horizon are well served to maintain an allocation, but might seek to trim their exposure, take some profits, or convert profits to exposure through options. Investors without an exposure should consider building one up gradually, as the valuation does not appear to warrant jumping in all at once.

The risks in Brazil center primarily around a changing environment—mostly subtle changes, almost like tiny shifts in the weather that a farmer might notice. None of these changes signal imminent danger, but they do indicate a need to stay alert. The most imminent danger to an investor in Brazil would be a substantial improvement in the developed economies, which would result in a flow out of Brazil as capital is reallocated. Ironically, that same moment would be a good one for an investor considering building a Brazilian position, since it would permit entry at an attractive valuation and improved developed economies will presumably help Brazilian export growth.

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Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Global Research and Consulting, an independent consulting firm specializing in macro strategy, including quantitative, emerging market, and SRI research.

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