Julian Thompson (pictured), Head of Emerging Market Equities at Threadneedle Asset Management, outlines his emerging market equity outlook for Brazil.
A recent trip to Brazil confirmed that the “land of the future” is presently booming. Brazil has consistently failed to live up to its promise in previous cycles, with every boom quickly leading to an even deeper bust. However, since 2003, Brazil has been on a virtuous path of debt reduction as the trade surplus generated from selling commodities such as iron ore and soybeans, mostly to China, has been used to build up reserves and reduce the country’s reliance on the external debt markets.
Brazil’s net debt to GDP ratio was over 55% in 2003 but has since come down to around 40%. This contrasts strongly with most developed economies, where debt to GDP ratios are heading towards 100% or more as low GDP growth and high government deficits increase the reliance on debt financing.
I have been particularly struck by the enthusiasm of the local banks for retail lending. There is a presidential election due in October of this year and, normally, Brazilian banks tend to be cautious ahead of elections. Also, interest rates are now heading back up and that would usually also signal caution for the banks. This time, though, the banks have very few concerns about expanding their consumer loan books. Having just come out of a period of slower credit expansion, and with unemployment rapidly falling, Brazilian banks are now very keen to increase their exposure to the underleveraged Brazilian consumer, precisely the opposite of what is happening in the developed world.
Auto loans, mortgages and credit card lending should all grow around 30% this year, while Brazilians are also getting access to cheaper lending through payroll loans that are deducted from salary at source. The availability of cheaper credit is fuelling consumption growth in a variety of areas – we have recently met companies operating in the white goods, beverages, clothing and car rental sectors, all of which are enjoying an extremely strong operating environment. Investment is also picking up and is expected to grow by 19% this year, making the area of capital goods an attractive investment space too.
The question, then, is why has the market sold off recently? Clearly, there is a risk here of boom and bust, a return to the old stop-go cycle which has kept Brazilian equities at much lower valuations than their Indian or Chinese equivalents. However, this cycle appears much more durable and is likely to result in Brazilian equities rerating to significantly higher levels than they are today.
The Brazilian market currently trades at less than ten times forward earnings, compared to 12x for China and 15x for India. In our view, the quality of Brazilian corporate management and accounting disclosure is vastly superior to China’s and certainly equal to India’s. Returns on capital are extremely high (reflecting a high cost of capital in previous years) and so a higher multiple seems entirely justified if a more stable growth environment can be maintained through prudent monetary and fiscal policy. The fact that Henrique Meirelles, head of the Central Bank, will stay until after the election in October (it had been rumoured he might himself run for office) and that he has already signalled the bank’s independence with a 75 basis point rise in interest rates ahead of the election, indicates that the Central Bank continues to have a strong anti-inflation mandate.
We believe that as we go through the cycle, market confidence in the sustainability of the cycle will increase and that Brazilian equities will begin to rerate at least towards 12 or 13x forward earnings. We also believe that the market is underestimating the operating leverage of companies in the consumer and financial sectors to the current recovery. On top of these factors, the market is also nervous about two large potential offerings, which will surely suck some liquidity out of the market.
The largest of these is Petrobras, which is potentially raising up to US$25bn in fresh equity to fund its capital expenditure programme in the pre-salt oilfields. It has a capex budget of US$220bn over the next five years, emphasising the scale of its ambitions in the deepwater fields off the coast of South-East Brazil. Banco do Brasil is also expected to raise around US$8bn in fresh capital, partly to improve its capital adequacy ratios but also to comply with the listing requirements of the Novo Mercado, an exchange which promotes good corporate governance standards and requires at least 25% free float. However, these are short-term factors and offer investors an excellent opportunity to buy into the Brazilian market at attractive multiples.
We have used the recent market weakness to increase our exposure to our favourite holdings such as Lojas Renner, the clothing retailer; Localiza, a car rental business; and Anhanguera Educacional, an education business. We have also significantly increased our position in Itau Unibanco, Brazil’s largest private sector bank, by taking part in the recent US$4.4bn offering from Banco of America, which was selling down its entire 6% stake in the bank.
Following these purchases the Threadneedle Global Emerging Markets Equity Fund currently has just short of 20% exposure to Brazil, making it one of the fund’s key overweight positions.
Meanwhile, Brazil’s foreign exchange reserves have increased from US$50bn to more than US$250bn, representing over 24 months of import cover. Brazil is thus now much more resilient to external shocks such as last year’s global recession. Despite the severe slowdown elsewhere, Brazil’s economy contracted by only 0.7% and had already returned to growth by the second quarter of 2009. GDP growth this year is expected to exceed 7%, one of the highest growth rates Brazil has experienced for many years.
The primary reason why Brazil experienced such a shallow dip in economic output is that the Central Bank was able to reduce interest rates to levels not seen since the 1960s – though still 8.75% at the low. This was very different to previous cycles, where poor debt ratios always meant a rise in interest rates whenever an external shock caused the currency to weaken. As a consequence of this counter cyclical interest rate policy, there was only a modest rise in unemployment, allowing consumer confidence to bounce back quickly once Brazilians realised that this cycle was indeed different.
The government also offset some of the contraction in demand with stimulus programmes in the housing sector and by reducing VAT on consumer durables and autos. The success of the programme can be seen in the fact that Brazil recently passed Germany as the world’s fourth largest vehicle market. However, the crucial factor in Brazil’s economic resilience was probably that the country’s banks were and continue to be well-regulated and well-capitalised. They also had no exposure to sub prime debt outside Brazil.