Emerging markets: Brazil is set up for a classic virtuous cycle  

A long-awaited and bigger-than-expected rate cut in Brazil could usher in a positive cycle of growth for Latin America’s biggest economy. JAMES SYME explains

• Brazil cuts rates
• Positive cycle ahead
• Find out about Pendal Global Emerging Markets Opportunities fund
• Watch a recent Emerging Markets overview webinar with James Syme

INVESTORS are underplaying the likelihood of further rate cuts in Brazil, which is showing signs of entering a classic emerging markets virtuous cycle of capital inflows, strengthening growth and rising markets.

That’s the view of James Syme, who co-manages Pendal Global Emerging Markets Opportunities fund.

Brazil cut its key interest rate by a larger-than-expected 50 basis points in its August meeting.

The central bank took the rate from 13.75 per cent to 13.25 per cent, ending eight months of keeping borrowing costs on hold.

Markets expect further cuts to 12 per cent by the end of the year and 9.25 per cent by the end of next year.

But Syme says those expectations are likely short of the mark and a positive cycle of rate cuts and economic growth lies ahead.

“Emerging markets tend to overshoot to the downside and then to upside.

“We think Brazil is setting up to be in a cycle of much more positive news, and that should be reflected in equity prices as well.

“We’ve been talking about rate cuts coming in Brazil for a couple of years and they have now surprised markets with the size of the first cut.

“We don’t think this is the last of those surprises.”

Self-reinforcing cycles

Emerging markets tend to move in self-reinforcing cycles of rate cuts and economic growth attracting capital flows, which strengthen the currency, allowing for reduced inflation and further rate cuts, says Syme.

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“There’s a traditional view among investors that markets reflect the real world.

“You have a set of fundamental conditions and the output of them is what happens in markets, whether it’s exchange rates or stock markets or individual share prices, or bond yields.

“But we think what happens in markets also drives what happens in the real world.

“That means what happens with currencies, interest rates and bond yields has a real world effect.

“We think we’re heading to a point where we’re going to see that in Brazil, where a stronger currency, a stronger equity market, and declining bond yields feed back into the Brazilian economy.

“In these kinds of emerging markets, these are very positive, self-reinforcing cycles.”

Domestic demand stocks to benefit

Syme says investors can best take advantage of the rosy outlook by focusing on companies exposed to domestic demand.

“It’s going to be about banks and other financials, consumer durables and autos, services and leisure, construction and capital investment, and real estate,” he says.

“Now, that doesn’t mean we’re going to end up with exposure to all those sectors because we need to be selective at a sector and stock level as well. But those are the main beneficiaries.”

A rising level of new stock issuance is also a vote of confidence in Brazil’s outlook.

“Companies are raising capital to take advantage of the improving economic situation. We see that as a statement of a positive intent by corporate Brazil.

“One of our newer holdings in the fund is the company that operates the Brazilian stock market, which is a business that could really benefit from this.”

More rate cuts likely

Syme says the opportunity for rate cuts in Brazil is illustrated by the gap between its interest rates and inflation measures compared to other economies.

“Brazil’s inflation level is about the same as the US — but US rates are at 5.5 per cent.

“That’s a nearly eight percentage point gap so just the carry alone should attract lots of capital into Brazil.

“We think that economic data should pick up quite strongly as rate cuts come through.

“This is how emerging markets investing works — the bad times are bad, and the good times are good.

“A lot of the markets we like are doing very well right now including Mexico, India and Indonesia.”

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
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