Is Brazil a crumbling BRIC? Threadneedle’s Furman asks
Brazilian GDP growth forecast process is disappointing, but potential for investment is huge, says Ilan Furman, Emerging Markets Equity Fund Manager at Threadneedle Investment.
With slower growth, higher inflation and, more recently, the street protests, it’s a pressing question. And, judging by recent outflows from Brazil, many investors aren’t waiting for a considered answer. I recently spent two weeks in Brazil, visiting companies and talking to economists and government officials to get a better picture of the prospects for equity investors.
Since 2010, when GDP in Brazil grew by 7.5%, growth has disappointed. Last year’s GDP came in at just 0.9%. But it’s not only the absolute outcome of GDP growth that’s frustrating, but also the forecast process. Every year since 2011 has started with growth expectations of 4-4.5%, only for these to be revised downwards over and over again as the year progresses. Speaking to local economists, I learned that this dynamic resulted from a belief that the potential GDP growth for Brazil was 3.5-4%. Today, they are coming to accept that under current conditions, Brazil’s potential GDP growth is around 2.5%. The main drag on GDP growth potential is low productivity, a result of unskilled labour and poor infrastructure. A good example here is 2012 – a year in which unemployment as low as 4.6% nevertheless resulted in growth of just 0.9%.
In 2012, the government was still trying to boost growth through consumption and credit (by increasing loans from the public banks and pressuring the private banks to reduce lending spreads, among other measures). More recently, the government seems to have realised that boosting investment is the only way to shift Brazil onto a sustainable growth path.
Infrastructure – the main focus
Travelling in Brazil provides a wealth of anecdotal evidence of the infrastructure challenge. In just ten days we had protests, major traffic jams, airport problems, cancelled flights and the declaration of a spontaneous holiday in one of the states, resulting in cancelled meeting and a changing agenda. Everything seemed to take two or three times longer than expected. This is well reflected in international rankings. For example, according to the World Economic Forum, Brazil’s overall infrastructure is ranked 104th out of 142 countries. Its ports, air transport and highways were ranked 130th, 122nd and 118th, respectively.
The government is determined to spur investments in the country. Public banks are ready to lend cheap money for infrastructure projects. Furthermore, the government is determined to attract foreign investors, as domestic capital will not be enough.
The potential for investment in Brazil is huge, partially as the flip side of so many years of sustained underinvestment. In the past 20 years, Brazil invested an average of around 18% of its GDP, 4-5 percentage points below the average for emerging markets. For sustainable growth in the 3.5-4.0% range, the required ratio of investment to GDP in Brazil is estimated at around 22%-24%.
The investment framework in Brazil is still very complicated, bureaucratic and inefficient. It is a significant obstacle for rolling out a meaningful investment plan. But a few successful and transparent auctions for private concessions for toll road or airports in the second half of this year may help to improve investment sentiment towards the country.
Inflation is running at 6.5%, although the government is likely to pull out all the stops to prevent it rising above this level; any further increase would be extremely damaging politically, especially with the presidential elections looming next year. But capital flight has been driving down the Brazilian real, posing a conundrum for the authorities: a significantly weaker currency would make the country’s exporters globally competitive again, but each 10% fall in the real is likely to increase inflation by 0.5-1 percentage points.
The demonstrators are far from a cohesive group, and their demands are not always clear. There is general dissatisfaction with the government’s management, including, high taxes, poor public services and widespread crime and corruption. The vast expenditure entailed by international football tournaments provides an obvious focus. In the short term, the government’s response to the protest indicates continued pressure on regulated industries in Brazil, as an administration looking to restore its popularity will be reluctant to allow price increases. In the medium-to-long term, this could be positive, putting pressure on future government to emphasise a more sustainable policy mix. For now, though, it is too soon to tell.
Time to invest?
In general, then, the tone of my trip was bearish. However, for the first time in many years, this bearishness is the consensus among foreign investors, local investors and financial journalists worldwide. Coupled with one of the worst stock market performances for the year to date, this is in itself an interesting signal. Also, it is important to remember that today’s Brazil is much stronger than the country that endured previous crises, given its ratio of gross public debt to GDP of 55%, around US$370 billion in foreign-exchange reserves (as at the end of 2012) and a stronger middle class with higher consumption power .
Given that, we see opportunities in several areas. Shopping malls continue to offer growth, as malls continue to increase their share of retail sales. Investors need to be selective, though, as there are marked differences between malls in terms of traffic, sales and rents. This is in contrast to the situation a few years back, where virtually any shopping-mall company was guaranteed to do well.
The increased formalisation of the economy and investments continues to drive IT spending in Latin America. In that context, both Totvs and Linx, which sell software solutions, look interesting.
In the consumer sectors, feedback received was for a strong April and May, followed by an unexpected deceleration in June. For example, many chains were starting their promotions, which normally occur in June, from mid- or late May. Our preference at the moment is to get exposure to food and lower-ticket items, which are less dependent on credit. CBD which operates supermarkets and electronics stores looks interesting in that context. The company is focused on rolling out its expansion plan, enjoys a rational pricing environment in the food business and is expected to benefit from a government stimulus package, which seek to give money for members of subsidised low-income housing programmes to buy electronic appliances and furniture.