Brazil: Is the 50% drop in the stock market an opportunity?
Pablo Riveroll explains the sharp sell-off in the Brazilian market, and why this may be an opportunity for investors
Brazil’s economy has come a long way in the last two years. An uncertain and polarised presidential election in late 2018 passed without a return to unorthodox economic policies. The new government successfully legislated pension reform last year, putting public finances back on a more sustainable path, and was focused on improving economic growth.
As a result, the country went into the Covid-19 pandemic with a top notch economic team in government, pension reform in place, which materially reduced future liabilities, high consumer confidence, record low interest rates and a declining fiscal deficit.
So why is the market down more than -50% in US dollar terms year-to-date, relative to a fall of less than -20% for broader emerging markets? As measured by the MSCI Brazil and MSCI Emerging Markets indices, as at 19 May 2020.
What has been the driver of market weakness this year?
Existing macroeconomic vulnerability, exacerbated by the impact of Covid-19, has been the main issue. The lack of a coordinated domestic response has further hampered efforts to contain the spread of the virus.
Although the policy direction was positive, public finances remained fragile coming into the crisis. Further actions were needed, and indeed were in the pipeline, both at a national and state level. But with public finances stressed further by the need for crisis stimulus, a current account deficit, and a central bank taking the headline interest rate down to a record low, the currency has come under pressure. The MSCI Brazil is down -50.2% in dollar terms, and a large share of the fall is attributable to currency weakness. The Brazilian real has depreciated by -30.0% against the greenback this year, as at 19 May.
In terms of the response to Covid-19, President Bolsonaro has taken a somewhat sceptical approach to the risks posed by the virus. Brazil has a federal political system, and state governors have been more proactive in their response, in some cases implementing quarantine restrictions early on. However, with the president contradicting these policies, their effectiveness has been diminished.
How concerned should investors be about public finances?
The main concern with the public accounts is the primary deficit; the shortfall in income to spending before interest costs are added. This is likely to be about 8% of GDP this year, and when one adds in interest expenses of about 5% of GDP, the total deficit for the year will be in the low teens. This is worrying, considering Brazil already has a debt-to-GDP ratio of about 76%.
There are two key points to make about these figures.
First, Brazil has made significant progress in reducing the deficit since 2016, as the chart below highlights. Indeed, the government remains focused on reducing the deficit. So 2020 should be a one-off deviation from the fiscal consolidation plan, as opposed to a new trend of higher and unconstrained spending.
Second, Brazil has large US dollar reserves, which are higher than most emerging market peers as a share of GDP. Once these reserves are considered, net debt-to-GDP is a much more manageable 55%.
The majority of Brazilian debt is also in local currency, with foreign currency debt having meaningfully diminished. This is beneficial, as otherwise the impact of currency weakness would mean an increase in the country’s liabilities in local currency terms.
Why has the currency depreciated so sharply and is there more to come?
The relatively large current account deficit started to widen very early into the nascent recovery seen pre-Covid-19, reaching 2.7% in 2019; the value of imported goods and services was exceeding the total value of exported products. This was not a major concern as a lot of the import growth was attributable to the purchase of intermediary goods directed to capital investment and not consumption. But it nonetheless resulted in some downward pressure on the currency.
By lowering interest rates, the central bank reduced the attractiveness of the currency to carry trade investors, who sought to benefit from the higher interest rates on offer in Brazil by holding local currency assets. And then Covid-19 hit, leading to the steep sell-off this year.
In contrast to previous crises, the central bank has been able to undertake strong monetary easing with less concern about the effect on the currency. This is because net external debt, borrowings in US dollars, is very low as a percentage of GDP. Whereas currency weakness can typically feed through to a pick-up in inflation, the degree of weakness in economic activity should offset near-term inflationary risks.
Today, the current account is likely to have already moved close to balance. This is due to the impact of the economic slowdown, as imports are likely to have decreased significantly. Meanwhile most commodity prices have held up well. Commodities make up about half of Brazil’s exports, led by soy, iron ore, meat, oil, pulp and sugar.
The real effective exchange rate (REER) of the Brazilian real is now almost as cheap as it was in 2002, as highlighted in the chart below, the absolute bottom over the past 30 years. REER measures the value of a currency against a weighted basket of other currencies, adjusted for inflation.
2002 was the year that Lula was first elected; it was the first time that a candidate from a leftist party had been elected president, and financial markets reflected major concerns over the policy outlook.
Although the currency looks cheap on a REER basis, it appears to have little near term fundamental support. The central bank has continued to cut interest rates as inflation is nowhere to be seen, and given concerns on how the growing deficit will be financed, the currency may continue to be the adjustment valve.
To what extent has political risk increased?
President Bolsonaro’s economic team has surprised the market positively from the start, and has stayed together for longer than many people expected. Some friction with other members of the cabinet and government has started to emerge recently, however.
Two health ministers have departed in the past month amid disagreement with the president over how to deal with the Covid-19 outbreak. In April, the justice minister, Sergio Moro, stepped down while accusing the president of interfering with the appointment of the head of the Federal Police.
Given Bolsonaro’s unpredictable style and the different interest groups within a fragmented congress, continued volatility is likely. For now the key people in the cabinet, led by University of Chicago educated finance minister Paulo Guedes, remain committed to Bolsonaro’s team, so the short term risks have moderated. The recent calls for impeachment seem unlikely to gather momentum at this point. Should we see the departure of Guedes, however, that would be a major concern.
Where do we see opportunities in the market?
Instead of spending time and energy counting the number of daily infections and trying to predict the size of the drop in short-term economic indicators, we have been focused on understanding how life will change after the lockdown ends.
We find a number of companies have strong growth potential which is independent from general economic growth, or can actually take advantage of the current turmoil and come out stronger on the other side.
There are a few things we can say with confidence about the future of Brazil. E-commerce will play a far larger role in the economy. People will receive education and healthcare services in different ways. Travel will experience a long term impact. Payments will be more digital.
Many companies will have their balance sheets materially impacted by the lockdown, so whoever is in a good shape to invest is likely to take outsized market share. The export sector will be much more competitive and foreign players coming to Brazil to compete against local companies will be at a disadvantage. This is because domestic companies’ cost bases are typically in Brazilian real, with return expectations also in local currency.
Why there is good reason to stay positive on Brazil
Uncertainty globally due to Covid-19 may take time to subside. In Brazil, the macroeconomic challenges are also not going to ease overnight and growth may take time to recover. But it is important to emphasise that the policy direction, with a credible team at the finance ministry, remains on the right track even if reforms will now be delayed. We expect discipline in managing the public accounts to return once the current crisis fades.
Meanwhile the currency looks cheap, political volatility appears to be somewhat contained, and there is support for the equity market from domestic investor flows. Moreover, there are a number of strong stock opportunities across different sectors. In many cases these are companies which we believe will be long term winners, or which have a strong growth outlook, independent of broader economic growth.
Any references to securities, sectors, regions and/or countries are for illustrative purposes only and not an offer, solicitation or recommendation to buy or sell any financial instrument or to adopt any investment strategy.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.