Ilan Furman, Columbia Threadneedle Investments’ Emerging Markets Equities portfolio manager, examines the outlook for Brazil and discusses where he finds opportunities.
In January 2016, Brazil’s outlook was very gloomy. The country had been experiencing not only a recession but also a political paralysis, curbing the administration’s ability to implement measures to improve its fiscal position, damaging both business and consumer confidence. At this time, Brazil’s stock market reached a low point and credit default swaps peaked.
But this has recently changed, with former Vice-President Michel Temer installed as interim President, following the vote to impeach President Dilma Rousseff.
The new administration will allow crucial governmental decisions to be taken, credibility to be restored and will provide a much-needed boost to investment confidence (the final impeachment vote is scheduled for the end of August, after the Olympic games).
From a ‘top down’ perspective, there are several reasons to be optimistic.
The country’s base interest rate is very high by global standards at 14.25%. Inflation, after peaking in 2015, is now coming down, as pressure from rising regulated prices in 2015 fades and the ongoing recession lowers capacity-related pressures.
Therefore, there is significant scope to cut rates from current levels to 10% by the end of 2017. Furthermore, after two years of severe recession – with GDP contracting by 3.8% in 2015, and expected to contract a further 3.5% in 2016 – we are expecting a mild resumption of growth, with an expected 1% GDP growth for 2017.
The high quality of the government’s new economic team is already helping to boost Brazil’s policy credibility. Furthermore, we are seeing early signs of change in some of the state-owned companies. For example, Petrobras changed its management and is now working more consistently on asset sales and restoring its balance sheet.
The macro and corporate outlook remains challenging, however, but the ‘read-through’ from the current earnings season is reaching a bottom in several sectors; which would also mean reaching the bottom in terms of negative earnings revisions seen in the past few years.
It is important to note that the consumer is still in bad shape given expectations of rising unemployment and lack of consumer credit availability. Therefore, we expect that the recovery will be led by investments and industrial production.That said, there are several internal risks to consider. Given that a lot is dependent on politics, any change in the current momentum will be taken very negatively. For example, a scenario in which Dilma is not impeached will be taken badly by the market. Furthermore, the ongoing corruption investigation continues.
A scenario in which one of the key members of the new government is under such a cloud will have negative consequences. The corruption investigation also weighs on several companies directly, and news flow will continue to create some volatility.
Moreover, taxes continue to be a risk considering Brazil’s challenging fiscal position. Tax risk in terms of additional taxes levied or tax benefits removed needs to be monitored closely. Also, the slowdown could last longer than expected. As discussed, Brazil’s normalization and return to growth will be challenging and the process could take longer than expected.
External risks are also important given the importance of commodity prices and the Brazilian currency rate to the adjustment process. The potential for a US rate hike would put the Brazilian currency under pressure and, while the recent recovery in commodity prices has aided Brazil in terms of trade, lower commodity prices will make Brazil’s recovery tougher.
Where can investors find opportunities?
Given that base rates are at 14.25% and inflation is falling, we expect interest rates to drop from here. Furthermore, the credibility of the new government can reduce the country risk in the eyes of investors. However, economic fundamentals remain tough and the consumer remains under pressure. We therefore see an opportunity in companies that benefit from lower interest rates including utilities, shopping malls and some non-bank financials.
Case study one
Iguatemi is a shopping mall company with a very high-quality shopping mall portfolio. The company is expected to benefit from the lower cost of debt. The high quality of its portfolio should enable it to weather the challenging consumer environment.
Case study two
Telefonica Brasil, a telecommunications company, is likely to benefit from resilient demand to its services in a weak macro environment and from data, which continues to grow. The company has an internal driver to improve its results – extracting synergies from its acquisition of GVT. The stock offers an attractive dividend yield, which should also be a performance driver, once rates start to decline.