Yesterday brought fresh market volatility to Brazil in the face of a new political scandal, with the Brazilian stock market falling by more than 14% in sterling terms, triggering the volatility circuit breaker. This time, it was the new Brazilian President Michel Temer in the headlines, as allegations emerged he condoned bribes to silence a key witness.
The sharp market correction to the Temer scandal was unsurprising. Equity, bond and currency markets had rallied through 2016 on a combination of improved politics, giving more confidence that the government would sort out a number of issues challenging the economy, and improved commodity markets. Unfortunately, both are now in reversal, with the emergence of this scandal and as China withdraws its credit stimulus.
Our Global Emerging Markets strategy has long been underweight Brazil, and this recent news only underpins our long-term views on the country and challenges the bull case, which always looked optimistic to us.
What goes up…
Brazil was a major beneficiary in the 2000s from a dramatic boost to its terms of trade from a commodity bull market. This was driven by Chinese industrialisation that coincided with the aftermath of a commodity bear market lasting over a decade, which had seen supply retrenchment. Brazilian inflation also fell at this time, allowing a decline in interest rates that overlapped with the terms-of-trade boost, strengthening the Brazilian real and hence consumer purchasing power. This confluence of factors, together with favourable demographics and pent-up demand, sparked a powerful credit cycle and consumer boom that drove up company profits from a low base, leading to excellent stock market returns in US-dollar terms over a number of years – a boon for investors in the country.
…must come down
However, as Chinese commodity demand slowed, and energy and metal supply increased in response to higher prices, as well as rising imports owing to greater consumption, the terms of trade in Brazil deteriorated. Debt service costs as a proportion of incomes also rose as a result of greater borrowing over a number of years and the circular effect of substantial asset-price appreciation. Instead of allowing a correction in the terms of trade, the Brazilian government tried to sustain the high growth levels with fiscal expansion and by pumping credit into the economy via state-controlled banks, even as the private banks stepped back from the market.
We see the recent multi-year recession as the result of these policies becoming unsustainable in the face of the underlying deterioration in fundamentals, and the markets consequently forcing the Brazilian currency and cost of capital to adjust to a more realistic level. While the recession and a number of corporate governance scandals have led to some positive political change, the underlying issues have not yet been fully addressed. The consumer recession has led to balance-sheet repair as consumers and companies pay down their debt, leading to weaker demand. This has resulted in lower corporate investment and job layoffs, visible in the surge of unemployment. This still continues, but the rate of increase in unemployment has eased, which the market rightly, we believe, sees as positive.
The political change and a commodity rebound in 2016 saw the market reduce its perception of Brazilian risk, leading to a currency rally, bond-yield contraction from very high levels and a stock-market rally, particularly in the case of resources companies with high operational and financial leverage such as Vale and Petrobras.
Unfortunately, this does not mean that we are ‘off to the races’ and that the stage is set for a multi-year bull market. In our view the correction is not complete, not least owing to a 9% budget deficit that requires significant and unpopular political movement on inflexible costs such as overly generous pensions, which will require legislative change – the latest political scandal only serves to underscore the country’s political issues. The debt burden probably still needs to fall further, and this is not made easier by weak employment (and therefore wages – though this tends to be a lagging indicator) and the lack of fiscal room for manoeuvre. Therefore, while we believe the consumer environment may recover a little, the outlook is not rosy.
Chinese growth is likely to be far less commodity-intensive in the future, and Brazil lacks competitive export industries outside resources as a result of prolonged high tariff protection for domestic industries that has left them uncompetitive, a currency that has been strong for many years, relatively unproductive workers and expensive capital.
This does not mean that we see no potentially interesting investments in the country, but just that we don’t expect the broad market rally of 2016 to be sustained. In our view, Brazilian equities do not, in general, appear good value under a cool-headed appraisal unless growth is much higher than we expect. The currency is not cheap and bond yields are far less enticing than 18 months ago, having fallen from 16% to 10%. We believe we can find more attractive opportunities elsewhere across emerging markets with more growth potential and lower risk.