Why we still favour Brazil despite a rollercoaster year
With commodity prices falling, and election uncertainty rising, has gloominess on Brazilian equities peaked?
Brazilian equities have been volatile so far this year. In early April, the MSCI Brazil Index had rallied by over 34% from the start of the year, as the impact of stronger commodities prices fed through.
The tide then turned rapidly and as at 15 July the market is down -2.5% in US dollar terms year-to-date.
Despite this rollercoaster ride, Brazil remains one of the better performing emerging markets so far this year, and is ahead of global and US equities. Indeed, Brazil is a market which we favour, and have done for some time.
So, what’s behind the recent volatility, and what risks and opportunities lie ahead?
The changing growth outlook
At the outset of the year, GDP growth expectations in Brazil were relatively muted. After an expansion of 4.6% last year, consensus expectations were for GDP to be flat this year – with no growth.
However, expectations have been upwardly revised to around 1.5% as higher commodities prices earlier in the year boosted exports, the labour market and improved business confidence.
Some of this momentum is now tailing off, however. Monetary policy tightening from the central bank, which began in earnest a year ago, has acted as a brake on activity, while commodity prices have declined amid fears of an impending global recession.
Has inflation peaked?
Headline inflation ticked up again to 11.9% year-on-year (y/y) in June. However, there are signs that pressure is beginning to ease, as a quick analysis of the different components of inflation shows.
Regulated prices have started to moderate, with fuel and electricity prices actually down on a month-on-month basis, aided by government tax reductions. With crude oil prices now moving lower, the outlook is for a more fundamentally-driven drop in fuel prices to follow.
Food price rises have been even more acute. Headline IPCA food and beverage inflation remains elevated at 13.9% y/y, with fresh food inflation up by a multiple of this figure.
On a month-on-month basis, though, food prices have been easing, and with agricultural prices coming down, as the chart below illustrates, we anticipate that food price inflation will continue to fall.
In addition, the IGP-M wholesale inflation index has already come down significantly, and likely has further to fall. It was up as much as 37% past last year and typically leads the headline consumer price inflation index.
If these trends continue, or at least prices do not rebound, this should help to ease headline inflationary pressure.
As a result, we are starting to become more confident that rate rises are reaching a peak. After a 50bps interest rate hike in June, the policy rate sits at 13.25%. So far this cycle the central bank has lifted policy by a total of 1125bps. However, the pace of rate hikes has slowed from 150bps only a few months ago, and the central bank has adjusted its message accordingly.
Consensus expectations are for the policy rate to reach 13.75% by the end of the year, with expectations for easing to come through in 2023, to 9.25%. That said, we do not expect the headline SELIC rate to fall quickly, and the outcome of the presidential election could change this picture.
Balance sheet and FX
On the fiscal side, government efforts to provide support without breaching the spending cap have continued, most recently via a congressional approval to spend $7.6 billion to help the poor, the elderly and truck drivers.
There has also been support through measures to constrain fuel price rises. Congress has approved a bill which caps a state tax on fuel, public transport, electricity and telecoms. Federal taxes on ethanol, natural gas and petrol have also been lifted for the remainder of the year. Other measures are in the pipeline.
Although this issue has attracted some attention, we still anticipate that the government will end the fiscal year with only a small primary deficit.
The CEO of state-controlled oil company, Petrobras, was changed again in late June, the fourth change in leadership in the past 18 months. Petrobras has a policy to set fuel prices in line with international market prices. With fuel prices and inflation more broadly at elevated levels, this has attracted increasing political pressure.
Despite the change, the company has so far not made any amendments to its pricing policy.
Brazil’s current account has moved into surplus, benefitting from higher commodity prices earlier this year. However, these have now fallen back quite sharply in the past month, triggering a depreciation in the Brazilian real. There is now a risk of deterioration in the current account, and the currency could see further pressure on a near term basis, with potential volatility also stemming from political uncertainty.
That said, the real is one of the cheapest emerging market currencies globally. The currency is cheap relative to its five-year average, and even more so when compared with its long-term average, as the chart below illustrates.
How might the presidential election impact the outlook?
Brazil will hold presidential elections on 2 October. Opinion polling, shown below, is currently led by opposition candidate and former president Luiz Inácio Lula da Silva, with incumbent Jair Bolsonaro in second place. There are no signs of a third candidate emerging at this point.
With right and left wing candidates dominating the race, the election looks to be as polarised as four years ago.
A Lula presidency, on the other hand, would mark quite a sea-change in the policy direction. The consensus among most economists is that the fiscal accounts would see some deterioration, with inflation at least remaining elevated and interest rates at high levels.
Lula has appointed former governor of Sao Paulo, Geraldo Alckmin as his running mate. This had spurred speculation that Lula might be more pragmatic, but recent feedback from meetings with the business community in Brazil has been less positive. This has in part contributed to recent equity market and currency weakness.
Given a markedly different policy outlook under a Lula or Bolsonaro presidency, market volatility may well increase in the run-up to the ballot.
What do valuations look like?
On a combined basis, valuations in Brazil are one of the cheapest in EM. As the chart below shows, only Chile is cheaper on this basis.
Decomposing the above, dividend yield and to a lesser extent, 12-month forward price-book are the main drivers. On a dividend yield basis, Brazil is the cheapest market in EM. Looking at 12-month forward price-earnings, Brazil is also cheap, having reached levels not seen since 2008.
However, this masks the fact that earnings forecasts are yet to fully adjust for the sharp fall in commodity prices in the past month or so. On a price-book basis, Brazilian equities are cheap, but less so when compared with other EM.
Our market view
From a sector perspective, the cyclical sectors, including energy, materials and banks, trade on the cheapest valuations. By contrast, the consumer discretionary and health care sectors are more expensive, but now sit at more reasonable valuations after a sharp de-rating.
Digging a bit deeper, and as another illustration of the extremely negative scenario being priced in, it is worth emphasising the valuations of the main state-owned enterprises in Brazil. Some of these are at all-time lows, despite positive reforms in recent years and significant improvement in their balance sheet positions.
In some cases discounts relative to private sector competitors are close to highs, despite progress in recent years. In some industries, companies are paying out huge dividends, and the outlook for cash flow generation over the next 12 months is healthy.
Even if policy under the next government is only moderately orthodox, a number of SOEs may well offer upside to current market levels.
Why we continue to favour Brazil
We continue to favour Brazilian equities, albeit we acknowledge that in the near term it is quite likely that we see further volatility, particularly given the political risk in the outlook.
Earnings revisions have only just begun to turn down and overall earnings for Brazilian equities are likely subject to further downgrades, but the market has already moved. Aggregate valuations for the MSCI Brazil are attractive, and the central bank is getting closer to the end of the policy tightening cycle.
There is no doubt that the weaker commodities price outlook and political uncertainty could continue to cast some shadow on Brazilian markets in the near term. This may be more acute if the global outlook continues to deteriorate, but the market has adjusted and the balance of risks is, in our view favourable, with a lot of gloom reflected in valuations.
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