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04/16/2012

Update on Brazil: March 2012


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When Worldview last addressed Brazil in the autumn of 2010, the country was on the eve of presidential elections and had been enjoying a year and a half of outstanding post-crisis investment returns and celebrations in the press. The world had rediscovered Brazil and concluded it was a haven from the economic carnage that had ripped through developed world economies. Even among emerging markets, Brazil’s economic and financial performance looked spectacular.

Our piece suggested that while the long-term dynamic in Brazil still looked good, asset prices had likely gotten ahead of themselves and were no longer as attractive as before. The risks we identified had to do with the then presidential candidates lacking charisma, the temptation to over-rely on Petrobras “pre-salt” rents, euphoric animal spirits that could lead to imprudent fixed investments, and a rush of financial capital back to the developed world once signs of a recovery began to look stronger. Some of these risks have diminished, others have taken place, and still others remain.

RECENT ECONOMIC PERFORMANCE

After a comparatively mild recession in 2009, Brazil’s economy posted a banner year in 2010, followed by what the Economist Intelligence Unit estimates as an uninspiring-but-still-positive 2011. In Brazilian equity markets, 2009 was the banner year, 2010 was disappointing, and 2011 was downright painful (although not as painful as 2008), with a loss of over 20% in total return terms.

Table 1. Brazilian GDP and Equity Market Performance

Year Brazil Real GDP Growth 
MSCI Brazil Total Return in USD (Gross)
2005 3.2% 57.0%
2006 3.9% 45.8%
2007 6.1% 80.0%
2008 5.2% -56.1%
2009 -0.3% 128.6%
2010 7.5% 6.8%
2011 2.9% -21.6%

Source: GDP data from Economist Intelligence unit; Equity data from MSCI via Bloomberg. Data accessed on 24 March 2012.

Figure 1. Real Brazilian GDP in Constant 2005 USD (1981–2011)

Figure-1

Source: Economist Intelligence Unit. Data accessed 24 March 2012.

Figure 1 shows the long-term trajectory of Brazilian GDP growth, which continues more-or-less on track at approximately 4% per annum. The tumult over the 2008-2011 period disrupted the even delivery of growth somewhat, but so far has not broken the overall trend. Although Brazilian exports and fixed investment collapsed in 2009 with the global recession, they rebounded sharply in 2010, the fixed investment component especially.

Figure 2. Sources of Real GDP Growth in Brazil: 2000–2011.

Figure-2

Source: Economist Intelligence Unit. Data accessed 24 March 2012.

Figure 2 shows that the disappointing growth in 2011 is attributable to nearly flat fixed investment levels in 2011, and to a lesser extent a slowdown in export growth. Crimped fixed investment is most likely due to a combination of falling stock prices (making capital harder to raise) and a smoothing out after the jump in fixed investment in 2010. Fixed investment is likely to improve somewhat in 2012.

The export declines are a response to sluggish global growth in the United States, recession in Europe, and slowing (if still high) growth in China. Brazil has a highly diversified export base, which is normally a source of stability, but simultaneous headwinds in virtually all regions of the world are difficult to overcome. Currency strength in Brazil’s real also placed a damper on net exports, making it more expensive for foreigners to buy Brazilian goods and services.

If there is a cloud in the long-term macroeconomic picture, it is that Brazil’s trade balance is starting to deteriorate and it is beginning to look like a trend. The relatively strong real is partly to blame, but the real has remained fairly stable in euro terms and actually weakened in USD terms since mid-2011. In addition to the exchange rate, growth in the consumer sector has increased demands for imports.

Figure 3. Brazilian Real in USD and EUR Terms (Jan 2000–Mar 2011)

Figure-3

Source: Bloomberg. Accessed 27 Mar 2012.

Brazil’s central bank has been watchful over the exchange rate and both it and the government are keenly aware of the dangers that an overly strong currency can create. To some extent, the large and diversified domestic economy can cushion these effects, and the government does have active programs to try to promote local science and technology development as well as technology transfers in the industrial arena.

Brazil’s strong currency can cause trouble when the economy is overheating, because the monetary tool—tightening the money supply by raising interest rates—tends to draw in foreign capital seeking higher high-real rates of return, and strengthens the currency even more. Brazil has tried placing taxes on short-term foreign investors in order to reduce foreign inflows and relieve upward pressure on the currency. The 2011 growth slowdown permitted the bank to loosen policy and lower rates, offering some breathing room, but if expansion takes off again, monetary authorities will feel currency-based constraints anew.

Figure 4. Brazilian Interest Rates and CPI Inflation (2000–2011)

Figure-4

Source:
Economist Intelligence Unit. Data accessed 24 March 2012.

Figure 4 shows the evolution of interest rates and local CPI inflation from 2000 to 2011. Interest rates remain at relatively high absolute levels but continue in a broadly downward trend. Over the long term, this bodes well for Brazil’s economy and asset values, because there is a long way for real interest rates to fall and push up asset values, investment, and GDP.

Recently, there has been a small pickup in inflation, and that has pushed both the money market and the lending rate upwards to compensate. The current inflation rate of around 6.5% is above the central bank’s target of 4.5%, and sits at levels that would make US consumers complain loudly, but Brazil is a far cry from the hyperinflationary levels (up to 50% per month and higher) still within living memory. The fact that the central bank has felt the need to loosen monetary policy even with inflation above target is cause for concern, but so far it appears to be under control.

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RECENT MARKET PERFORMANCE

Figure 5 shows MSCI’s Equity Total Return Index (Gross) in USD for Brazil, several comparable emerging markets, the US, and global indices for the world and emerging markets. It uses weekly returns data and is set to 100 on the week ending 29 October 2010, the month of Worldview’s last Brazil update.

Figure 5. Weekly Total Return Curves Since Last Brazil Update

Figure-5

Source:
MSCI via Bloomberg. Accessed 27 Mar 2012.

The figure shows that—while markets have been highly correlated—the highest returning market since our last update was actually the US, followed by the ACWI world index. Emerging markets as a whole have not performed as well as the US, conforming to our previous warning that investment may be ready to flow back to developed markets, and especially the US as they recover. This seems to have happened in two phases: an earnings recovery in 2010 and early 2011 pulled investment back to the US; then, macroeconomic concerns in the last half of 2011 punished emerging markets more than developed ones, as investors cut their risk exposures to those riskier and more volatile assets.

 


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Among emerging markets, Brazil has performed reasonably well, even if emerging markets as a group have suffered. The best performing emerging market in this sample has been Mexico, which is not surprising, given the close integration of the US and Mexican economies. Brazil is the next best country in the list, with its performance roughly in line with MSCI’s overall emerging market index. China and India have been struggling more, particularly India. Figure 6 and Table 2 illustrate these points in more detail to explain what has happened recently. The sample sizes are relatively small and do not cover a complete economic cycle, so they should not be used to extrapolate further into the future. All emerging markets have performed poorly and generated negative alpha with respect to the MSCI World Index, while the US has done relatively well, if volatile. However, within the emerging markets, Brazil has done comparatively well, with smaller alpha losses.

Figure 6. Recent Risk–Return Performance. Return vs. Volatility (Weekly Data: 29 Oct 2010–2 Mar 2012)  

Figure-6

Source:
MSCI via Bloomberg. Accessed 27 Mar 2012.

Table 2. MSCI Index Performance Using MSCI’s ACWI World Index Benchmark.


Cash Brazil China India Mexico EM Index US World (ACWI)
Annualized Return 0.07% 4.12% -1.85% -13.38% 8.02% 3.75% 15.11% 8.31%
Annualized Volatility 0.03% 30.79% 27.47% 29.11% 26.52% 25.06% 19.47% 20.38%
Sharpe Ratio at Cash RFR 0.000 0.132 -0.070 -0.462 0.300 0.147 0.772 0.404
Benchmark = ACWI Index       
Correlation to Index -0.174 0.895 0.764 0.739 0.889 0.893 0.952 1.000
Relative Volatility to Index 0.001 1.510 1.347 1.428 1.301 1.230 0.955 1.000
Beta  0.000 1.352 1.030 1.055  1.156 1.099 0.910 1.000
 
Jensen Alpha -0.01% -8.40% -13.03% -25.22%  -2.77% -6.46% 7.16% 0.00%
Nonsystemic Risk 0.0% 13.72% 17.72% 19.61% 12.15% 11.26% 5.95% 0.00%
Information Ratio -0.411 -0.612 -0.735 -1.286 -0.228 -0.574 1.203 0.00%

Source: MSCI via Bloomberg. Accessed 27 Mar 2012.

Valuation

Figures 7 and 8 look at current earnings and dividend yields (trailing figures) compared to their 10-year historical ranges for Brazil and four other large emerging markets. The indices for each country are

  • Brazil: Bovespa Index
  • China: Shanghai-Shenzen 300 Index
  • India: Sensex 30 Index
  • Mexico: Mexican Bolsa IPC Index
  • US: S&P 500 Index

Figure 7. Current Trailing Earnings Yields vs. 10-Year Historical Ranges (Mar 2002–Mar 2012).

Figure-7

Source:
MSCI via Bloomberg. Accessed 27 Mar 2012.

Figure 8. Current Trailing Dividend Yields vs. 10-Year Historical Ranges (Mar 2002–Mar 2012).

Figure-8

Source: MSCI via Bloomberg. Accessed 27 Mar 2012.

Both figures show that Brazil’s current valuations are within normal ranges, and so there does not appear to be extreme risk or opportunity on the valuation front. To the extent that there is a valuation story, dividends and earnings figures give conflicting results: dividends show slightly higher (more attractive) yields than average, whereas earnings yields sit below the mean and median figures. Given this divergence, the earnings figure probably tells the fuller story. Brazilian law also requires profitable companies to pay out a minimum in dividends, which accounts for its higher dividend figures.

Figure 7 suggests that Brazil may still be mildly overvalued, but not excessively so. Investors with a long-term time horizon should not be too worried to step in here, although it may make sense to scale in over time. Figure 7 also shows that China may be reaching attractive earnings valuations, while Mexico may be overdone.

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FORWARD-LOOKING CONCERNS

Brazil’s long-term prospects remain favorable for many of the same reasons we listed in our first coverage nearly four years ago. It is a large, stable, democratic emerging market with sizeable export base diversified among sectors (agriculture, commodities, light and heavy manufactures) and countries (China, US, Europe, etc.) along with a large domestic market and sophisticated banking system. The size, diversity, and resilience of the domestic market has been and will remain an important stabilizer in a global environment characterized by instability abroad.

Wealth and income inequality—for long an intractable Brazilian problem—is noticeably improving, with potentially millions of poor Brazilians now entering the middle class, consuming, and creating positive feedback loops for employment and domestic economic growth. To be sure, the country has a long, long way to go before regional and class disparities in wealth vanish, but it has made noticeable progress, even as the developed world backslides on these very same issues.

For all its strengths, however, there are still areas where Brazil can and must improve. As with many emerging markets, corruption is an endemic issue, and is primarily an issue in dealings with government bureaucracies. Business-to-business dealings that do not involve government agencies are relatively clean. Brazil is somewhat better than most Latin American countries on the corruption issue, and it is also the best of the BRICs. Within Latin America, Brazil scores favorably, although Chile and Uruguay are the best by orders of magnitude.

Brazil’s economy is held back by a large state presence in the economy through regulation, corruption, the presence of state-run enterprises, and a tax system that is both spotty and unevenly implemented. Brazil’s government debt levels are higher than most economists would like, but in a world where US debt obligations are close to 100% of GDP and Italy and Greece’s even higher, Brazil’s debt, at around 60% of GDP, seems downright conservative. With interest rates close to 10% interest, however, Brazil’s debt payments are a considerably higher portion of the government budget, compared US’ 0 to 4%. It is the interest rate, more than the absolute size of the debt that creates the burden.

In terms of human capital, Brazil’s top talent is as world class as anywhere, but there is not enough of it for such a large economy, and compensation for those with specialized skills is increasing rapidly, potentially driving inflation at the luxury end of the consumer spectrum. The government is introducing measures to make it easier attract and develop much needed human capital.

Over the medium term, Brazil is building substantial infrastructure in preparation for hosting the World Cup football (soccer) tournament in 2014 and the Olympic Games in 2016. There is some concern that necessary construction may not be completed in time and that schedules may have been overly optimistic. The recent resignation of Brazil’s World Cup organizing committee amid rumors of corruption has done little to inspire confidence, although this is not an unfamiliar story to those familiar with Brazilian political economy.

Our 2010 update on Brazil expressed concern that neither of the presidential candidates at the time were particularly charismatic, and that this could present trouble for keeping Brazil’s Congress in line with presidential policy objectives.

Dilma Rousseff, Brazil’s first female President, seems to have overcome this challenge with the electorate, currently enjoying close to 70% approval ratings, bolstered by her firm stance on corruption scandals in the Congress and executive branches. As with Lula before her, none of these scandals has implicated the President herself, but her public firmness has alienated many in the governing coalition, and it becomes more difficult to pass and fund the government’s policy. The results became evident as Ms. Rousseff attempted to extend and increase the breadth of the financial transactions tax, designed to counter the effects of monetary easing on the strengthening currency.

In our last update, we were worried that a continuation of the PT government might devolve into an acceleration of “creeping statism” in the economy. Although this remains an issue to watch for, the government so far has shown restraint, particularly for a world in which protectionist measures are becoming increasingly tempting. As long as Brazil is growing domestically, populist pressures will be relatively contained, and statist actions where they do exist seem to be centered on managing currency appreciation and the petrochemical sector.

For a country that is a net oil exporter and with substantial energy alternatives to fossil fuels (biomass and hydroelectric), recent high oil prices have improved net exports, increased government royalties, and enhanced international competitiveness. All the same, higher energy prices are still a drag on economic activity and are likely to continue, even if they affect Brazil to a lesser extent than other countries and give Brazil an overall comparative advantage in energy costs.

A major change in Brazil’s economic scene is the expansion of consumer credit, which has grown at close to 20% in 3 out of the last 5 years. This provides an important boost to the consumer economy whose effect should not be underestimated. It is difficult to tell when the availability of credit becomes too easy, and we are likely still early in Brazil’s credit cycle, but many of these new consumers have little experience in managing credit, and it will almost certainly get out of hand at some point down the line. For now, relatively high interest rates should keep consumers somewhat conservative with credit, but if interest rates continue to fall over time and credit continues to expand at this pace, one could begin to create problems of overleveraged consumers similar to what is seen today in the US. The danger is not imminent, but prudent investors will keep monitoring it.

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CONCLUSIONS: VALUATIONS SLIGHTLY HIGH, BUT LONG-TERM GROWTH ATTRACTIVE

 

Brazil’s long-term prospects continue to be highly attractive, even if valuations are slightly on the high side for now. To the extent that Brazil faces structural impediments to growth—such as corruption, a large state presence in the economy, and an unwieldy party system—these features are relatively well known and discounted into asset prices. To the extent that they can improve, investors should be rewarded to the upside.

Emerging market returns in general have fared poorly of late, but Brazil has done fairly well within the emerging market class. When investment again returns to the emerging markets space, those who are in Brazil should be happy to samba.

–Bruce Chadwick

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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Comments

Bruce. As usual great piece. I am a long term bull on Brasil, have been for 10 years. Hopefully Order and Progress have finally taken hold of the future. It is nice to see that the present administration is recognizing the importance of Brasil to the US, politically and economically (visa improvements, opening more consulates, trade agreements). Just ask any retailer in NYC and Miami how happy they are to hear Portuguese in their stores. With Americans still hesitant to spend in an economy 70% dependent on consumers, Brazilians are walking US stimulus packages.

However, the heavy handed, populist theatrics in terms of the recent Chevron issue, have been a little unsettling to potential investors. Added to the less than impressive 2.7 GDP, China slowdown, Olympic/WC problems, IOF, BTG insider trading story, ARG Respol nationalization, US market rebound, lower SELIC, etc..I think we will see investors hesitant to further invest in Brasil. Hopefully this will flush out some of the short term bandwagon investors of the last few years, and let us value guys back in to enjoy the samba and joga bonita.

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