Emerging Markets: why Brazil looks like an opportunity in 2021

Senior fund managers James Syme and Paul Wimborne specialise in Emerging Markets

 

Brazil may be attracting negative headlines, but 2021 looks set to be a period where the cyclical opportunity is strong.

Here James Syme and Paul Wimborne (pictured) — managers of Pendal’s Global Emerging Markets Opportunities strategy — explain why.

 

    • Brazil shows a move away from liberalising economic reforms towards a more populist stance ahead of 2022 elections
    • But by our reckoning the country’s fundamentals look very good indeed
    • Find out more about Pendal Global Emerging Markets Opportunities Fund

 
THE BOLSONARO government in Brazil has taken decisive action after weeks of increasing tension with parts of the corporate sector.

Most coverage has focused on a decision to replace the CEO of oil company Petrobras (held in the Pendal Global Emerging Markets Opportunities portfolio) after the company decided to increase petrol and diesel prices in line with crude oil prices in the face of government criticism.

President Jair Bolsonaro instead suggested the company should cut fuel prices by 10 per cent.

This management change was poorly received by investors because it reduces headline profitability and calls into question the outgoing CEO’s shareholder-friendly operational and financial strategies.
 
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This trend is not Petrobras-specific though. President Bolsonaro is also pushing utility companies to reduce electricity prices.

In addition, one of the major Brazilian banks, Banco do Brasil, has been under serious pressure to abandon its plans to rationalise its workforce.

Taken in the whole, this shows a clear move by the administration away from liberalising economic reforms, towards a more populist stance ahead of the 2022 elections.

What it means for investors

This has a number of implications for investors.

Coming at a time of rising US bond yields, the effect on the share prices of the companies concerned has been significantly negative. But at a wider level the stock market, local currency bonds and the currency have sold off and Brazilian Credit Default Swaps have increased.

This is partly because of the potential implications for fiscal and monetary policy.

As the Brazilian economy normalises post-Covid, the question as to how to (or even, whether to) end the worsening drift in the trajectory of public debt becomes more urgent.

There is a substantial domestic lobby arguing for prioritising economic support and it’s now more likely President Bolsonaro will move in this direction.
 

 
The key question for fixed income investors is the future of the fiscal spending cap.

The cap (given constitutional status in 2016) limits nominal growth in the primary (ex-debt interest costs) deficit to the rate of inflation. This would, over time, reduce the deficit as a proportion of GDP, and its existence anchors Brazil’s fiscal policy and contains bond yields.

In 2020, with serious pressure on government finances, the government was able to avoid the cap by using a parallel “emergency budget” for stimulus.

As that justification passes, pressure to return to a fiscal stance that complies with the cap will conflict with popular (and hence political) pressure to remain fiscally loose.

Impact of 2022 election

As we head into an election campaign (a Brazilian general election is due in October 2022) markets may assume the spending cap will be abandoned.

As fiscally loose, so monetarily tight.

The Brazil Central bank met in mid-March and lifted rates in response to a weaker currency and higher bond yields.

The old adage that elections are good for markets in emerging Asia but bad in Latin America may yet apply.

And yet, it is important not to be too bearish. Policy has to be viewed through the lens of fundamentals and, by our reckoning, fundamentals look very, very good indeed.

Barring a prolonged inflationary spike (end of December unemployment was 14.2%, pretty much the highest it has been in 20 years while capacity utilisation recovered to 80.5% in January, well below the 83-84% levels seen at cyclical peaks) Brazil’s enduring weakness is its balance of payments. This is in turn largely a reflection of trade-related and portfolio flows.

Right now both of those look great.
 
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Brazil’s terms of trade (the ratio of export prices to import prices) are by far the best they have been in 25 years, far above the mid-90s or late-00s peaks.

A year ago soybean spot prices were BRL 40/bushel — they’re now BRL 84. Iron ore has moved from BRL 380/t to BRL 900/t. Sugar has gone from BRL 0.67/lb to BRL 0.92/lb.

This feeds right through to the trade balance.

Through 2015 and 2016 the Brazilian trade balance moved substantially into surplus with exports rising and import compression.

Last year 2020 there was volatility in trade flows as Covid-19 hit domestic and external demand and the past few months have seen economic recovery lift imports.

But there is a close historical relationship between terms of trade and exports, and this points to a substantial lift in exports as we move through 2021.

Meanwhile the non-goods component of the current account has compressed to a deficit of 1.4% of GDP compared with deficits of around 4% at cyclical peaks.

Portfolio flows

Portfolio flows are another driver of the Brazilian economy and Brazilian financial markets.

In mid-2020 we saw large capital outflows from riskier emerging markets, particularly Brazil.

Foreign holdings of Brazilian government debt fell from $US140 billion at the start of 2020 to $US101 billion in April.

But by the end of 2020 we saw strong capital inflows with a better cyclical outlook and a weaker
dollar.

International portfolio flows into Brazilian government debt were $US16 billion in Q4 2020, with half of that coming in December.

Anecdotal information suggests a continuation of that in January and February and a similar pattern in the Brazilian equity market (where trading volumes have shot up in the past year).

Foreign direct investment (FDI) is perhaps the laggard.

Net FDI into Brazil was down 50% in 2020 compared with the previous year. The main trend there is a reduction of large investment flows into sectors such as autos and steel and a pick-up in much smaller flows into sectors like fintech and education.

Political outlook

History suggests a sustained recovery will attract inflows — but the negative impact of President Bolsonaro’s actions must be noted.

Concerns around politics and policy have caused us to be cautious about adding exposure to Brazil. We will continue looking to add opportunistically while the macro environment remains so supportive.

It remains our view that Brazil is a market best seen as offering cyclical opportunities rather than a long-term buy-and-hold case.

There will be periods where the cyclical opportunity is strong — and we believe 2021 is likely to be one of them.

The move higher in bond yields, reflecting a stronger global economy, is causing a drag on Brazilian financial markets in the short-term.

But that doesn’t remove the strong fundamental case for the medium-term.
 

About Pendal Global Emerging Markets Opportunities Fund

James Syme and Paul Wimborne are senior portfolio managers and 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.
 
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

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