This time last year investing in Brazil was a true contrarian bet. Political corruption, an anaemic economy and weak commodity prices sent cash flooding out of the country. Yet during the past 12 months the Brazilian Ibovespa index has steadily risen to its highest point in almost five years, while the country’s currency, the real, has regained ground after a long period of depreciation.
Much of this hope has been pinned on the economic reforms of centrist President Michel Temer, who took office in May 2016 following the start of the impeachment process against his predecessor, Dilma Rousseff. The senate voted to permanently remove Rousseff – who was accused of manipulating federal budgets – from office in August. Now Mr Temer’s challenge is to restore public and investor confidence in the government, which continues to be weakened by the ongoing corruption investigation surrounding national oil company Petrobras. Ninety-three people have so far been convicted under ‘Operation Car Wash’ – so-called because the police first began tracking the money launderers at Brasilia petrol station Posto da Torre, which also had a money exchange business. Many more have been charged or remain under investigation, including former president Luiz Inácio Lula da Silva.
Just as tough will be restoring growth to the country, which is in its deepest recession in more than 100 years. GDP shrank a further 3.5 per cent during 2016, according to estimates from the International Monetary Fund (IMF). At the start of the year the IMF downgraded its expectations for Brazil’s GDP growth to 0.2 per cent for 2017, from its prior forecast of 0.5 per cent, due to weaker-than-expected output during the second half of 2016. What’s more, growth in GDP per capita is forecast to be negative this year. A rebound in some commodity prices is a positive sign for the heavily exporting country. However, with public debt piling up in China, its largest customer, the longevity of this recovery is no sure thing. Add in the renewed strength of the US dollar – which has traditionally hurt inflows into emerging markets – and the question is whether the rewards for investing in a volatile market are worth the risks.
Commodities boom or bust?
Following the supercycle that took place during the first decade of the century, 2011 marked a turning point for commodities prices. A construction frenzy fed Chinese appetite for raw material imports in the aftermath of the 2008 financial crisis. Lack of capacity caused prices to surge and, in response, producers ramped up investment in mining projects. However, a glut in supply coincided with a fallback in demand from the Chinese construction sector.
As a large exporter of steelmaking ingredient iron ore, Brazil has suffered. By the start of 2016 the price of iron ore had halved since its record high five years earlier. This hit Brazilian miner Vale SA, the largest producer of iron ore and nickel in the world and one of Brazil’s major export earners, which exports around 80 per cent of its mined iron ore to China and accounts for over 9 per cent of the value of the Ibovespa. Like other miners, weaker prices meant gross debt stood at 3.6 times adjusted cash profits at the end of September, up from 0.6 times at the same time in 2011.
A reduction in Chinese steel capacity, plus a surge in credit issuance by the People’s Republic, has engineered a partial recovery in iron ore prices. However, the recovery in Chinese demand must be considered in relation to the country’s broader growth strategy. China is still in the process of a shift away from a credit-fuelled growth model, based on heavy manufacturing and infrastructure investment, to one based on domestic demand and services. Therefore, this improvement in commodity prices could quite easily be derailed once again within the coming years, which could once again spell bad news for Brazil and its key miners.
There is better news for agricultural exports, which suffered due to a severe drought during the past two years. While this sent soyabean and corn prices surging, the limited supply also hurt exports. However, thanks to better weather conditions the Brazilian crop agency Conab upgraded its expectations for soyabean harvests to 103.8m tonnes for 2017, up 9 per cent on last year. The country’s corn crop should also benefit, which has encouraged Conab to revise up its forecasts by 0.7m tonnes to 84.5m tonnes.
Brazil's spending spree
Declining commodity prices may have acted as a catalyst for the downturn in the Brazilian economy, but fiscal policy under the administration of Workers Party leader Dilma Rousseff – as well as her predecessor Lula – made the country particularly vulnerable to a slowdown in investment. During her first term in office Rousseff implemented a series of stimulus measures designed to pump up the economy after commodity prices came under pressure, accelerating public spending. These included setting price controls on gasoline and electricity, as well as generous tax breaks for industries such as automotives and commodities. Brazil’s central bank also held interest rates low, cutting rates dramatically between 2011 and 2013 to their lowest level in 20 years. However rather than boosting economic growth, it encouraged a surge in inflation as the economy became overheated (see chart 1).
Welfare provision also flourished under Rousseff’s leadership. One of the cornerstones of this was the continuation of her predecessor’s ‘Bolsa Familia’ programme. Under the programme poor families with children receive a monthly cash transfer of RS70, on condition that their children attend school and attend regular health checks. The scheme covered 13.8m families or 50m people by the end of 2013, up from 3.6m families at the time of its launch in 2003. Expenditure on the programme has also increased (see chart 2). The scheme has been instrumental in reducing social inequality and lifting millions of Brazil’s citizens above the poverty line. As a result, it also helped fuel an increase in household consumption during the years leading up to the country’s latest recession.
However, the US Federal Reserve’s signal that it would begin tapering its quantitative easing programme in 2013, combined with the extreme downturn in commodity prices, exposed the weaknesses of this fiscal imbalance. It also pushed inflation higher as the real depreciated against the US dollar. A decline in industrial production and a reduction in investment have pushed GDP into negative territory. Meanwhile, rising unemployment that has followed the downturn in business confidence has curtailed the domestic demand for goods and services that helped fuel economic growth before this latest recession. As a result, public debt stands at around 45 per cent of GDP, according to data from Brazil’s central bank (see chart 3).
Temer: Brazil's great reformer?
In December the country’s senate passed a controversial budget cap that will freeze public spending in real terms for up to 20 years. A congressional committee has also approved a bill to overhaul the country’s pension system, the first legislative step in reforming the social security system. This would set a minimum retirement age of 65, in a country where women can retire on full benefits after 30 years of work and men after 35 years. Government spending on pensions accounted for around 11 per cent of GDP in 2015, according to data from the IMF, and without reforms will increase to 14 per cent by 2021 and 18 per cent by 2030.
This generous pension system and increased unemployment mean Brazil’s social security bill has continued to rise, while tax revenue has declined (see chart 4). The better news was that the rate of decline in tax collection slowed during 2016. Associate professor at Warwick Business School Dr Ana Galvano says Brazil needs investment in infrastructure to help kick-start growth. However: “The recession means the government tax revenues are very low, which means that our investment programmes are paralysed, so [recovery] is slower than people expected,” she says.
Temer has said he expects the bill to be passed by the senate as early as the second quarter of this year. The president has pledged not to stand for election in 2018, which some say has made it easier for him to propose reforms without worrying too much about his popularity ratings ahead of next year’s election. Unsurprisingly pension reform is unpopular with the majority of the electorate and its approval by the cross-party congress and the senate is by no means a sure thing. However, the price of credit default swaps on Brazilian five-year sovereign debt has fallen to its lowest level in 18 months (see chart 5), indicating that investors are more becoming more confident in the government’s ability to pay back its debt.
Progress has also been made in bringing down inflation, helped by the strengthening of the real during the past 12 months. The Brazilian Central Bank’s monetary policy committee, the Copom, cut its benchmark interest rate – the Selic – for the first time in four years in October to 14 per cent. Since then two more cuts have followed. In January the Copom cut the Selic rate to 13 per cent, after it estimated that inflation would fall more than initially expected for 2017 and 2018 to around 4 per cent and 3.4 per cent, respectively. This is within the committee’s target rate of 4.5 per cent.
Are the rewards worth the risk?
While Brazil has implemented the first of an expected series of interest rate cuts, the US Fed has signalled its intention to raise its target range several times a year until 2019. Historically, rate rises in the US have sent investment flooding out of emerging markets like Brazil. However, Ashmore head of research Jan Dehn reckons investors should not be deterred from investing in Brazilian debt, given that the yields are still so superior to developed market bonds. He says Brazil’s economy has entered a “super-goldilocks” scenario. “We continue to see considerable upside since inflation has had more room to decline,” he says. “We also expect the real to appreciate amid further rate cuts and a gradual return to positive growth.”
However, a rally in Brazilian sovereign debt means buying in has become more expensive, plus yields have been falling since March. Brazilian equities have also increased in price on average, with the Ibovespa trading at a multiple of 13 times forward earnings. This is compared with 10 times this time last year. However, on a cyclically adjusted price/earnings (CAPE) basis Brazilian equities were trading at a multiple of 10 times earnings at the end of 2016, according to data from Star Capital. This is compared with the average CAPE ratio for emerging markets of 14 times.
“What is a problem is that we no longer find a particularly attractive balance between long-term, high-quality opportunities and finding these at a reasonable price,” says Ed Cole, manager of Man Group’s GLG Unconstrained Emerging Equity strategy. However, he says those that look likely to benefit most at present are large asset-owning infrastructure that can benefit from the reduction in interest rates. He has investments in just three Brazilian companies – an infrastructure, non-financial and brewing company – out of a portfolio of 45 stocks across emerging markets.
The root of Brazil’s economic troubles is domestic rather than external, which makes Temer’s reforms encouraging. While it seems likely that the rate of economic contraction has peaked, momentum is weak and the high level of risk involved in gaining exposure to the country has been priced in to a greater extent than it was 12 months ago. As with many emerging markets, actively managed funds are usually the best way to gain exposure to Brazil. So if you are willing to take the risk, we’ve included a selection of the best fund options in the box below.
