There has been much talk about Brazil’s potential and the country is now poised to deliver on this.
There has been much talk about Brazil’s potential and the country is now poised to deliver on this. The drivers Brazil has in place are exciting, including high growth, an era of lower inflation and interest rates, and a stable banking system.
Also, in contrast to other emerging markets, returns in Brazil are expected to be generated from both the stock market and expected currency appreciation. Indicators such as rising wages and employment levels, which are creating a very buoyant middle class, are underpinning the long term growth prospects for Brazil.
Inflation and interest rates
In the 1980s Brazil saw significant levels of inflation, in the range of 7,000% to 8,000%. Since then, inflation has come down substantially, first with the introduction of the ‘real plan’ in 1993/94. It introduced severe limits, particularly on fiscal spending and the management of monetary policy. The big achievement, however, is that inflation has stayed at relatively low levels and nowadays inflation trends are in the region of between 4%-5%.
Currently, there are major discussions as to whether or not the central bank is going to increase rates, because inflationary expectations have gone up from 4.3% to 4.7% which, in the longer-term context, is very marginal but shows that the goals of the monetary policy are clearly directed towards sustaining inflation at substantially lower levels. This supports Brazil’s case for investment and consumption growth.
Inflation has two significant implications. Firstly, low inflation is probably the best social policy achievement you can reach as a government, because it is usually the poor who typically lose out in a high inflation environment.
Low inflation is accompanied by real wage growth, which we have seen in Brazil. This, by the way, is one of the main reasons President Lula continues to be so popular within Brazil. Even after having been in government for eight years, his approval ratings remain in the range of 80%, which is unprecedented elsewhere in the world.
The second implication is that if corporations believe there will be a continued low inflationary environment, their willingness to plan their business development in Brazil on a longer-term basis will increase. Where the planning horizon in the 1980s and 1990s was only a month or two, an investment boom is now apparent with companies planning investments for over five years, with a payback horizon of maybe five years or more, and they can now get longer-term financing as well. This is clearly a step change to what we have seen in previous years and we believe it will be an important driver for growth going forward.
Although there are many more aspects to it, these two examples show why Brazil has achieved an investment grade rating, showing just how much progress and change has been achieved.
The rising middle class
Over the last decade, unemployment has almost halved. What is even more remarkable is that Brazil only saw a slight increase in unemployment last year which, we believe, is partly a reflection of the relatively robust domestic demand. This has surprised many long-term observers of Brazil because, historically, Brazil was afflicted by a vicious cycle: a crisis would occur somewhere else in the world, causing risk aversion to rise; the real value depreciated as a result because Brazil was indebted in foreign currency; this in turn pushed up interest rates in order to attract capital back into the country, which kills off domestic demand.
This cycle has now been broken and did not occur last year. We think this was one of the main reasons that growth actually ended at zero percent, contrary to original expectations of a decline of something like three to four percentage points. Again, domestic demand was the main supporter of growth.
Performance
In a historical context, within the Bric universe or emerging markets universe, there has been constant rotation between the different markets. If Brazil was the strong outperformer in one year, this trend may not have necessarily continued in the next year.
However, over the last eight years, Brazil has been the best overall performer within the Bric universe in a long-term view. We have to remember that in 2002, when this positive performance began, Brazil was in the process of electing President Lula. Because Lula was strongly left wing orientated there was concern from outside that he could start to nationalise key industries and companies. So the market fell to a rock bottom valuation, with a P/E ratio of around three at that time. Since then it has risen to a point where we now have a P/E ratio of 11 to 18. (Source: Bloomberg).
This is certainly supported by a significant turnaround in growth, with the current consensus forecast in the region of 5.5% (Source: Bloomberg). This is somewhere in the range of what we saw prior to the financial crisis, so it is not unprecedented. We believe 5% is a sustainable rate, and do not expect Brazil, in the short-term, to reach China’s levels of 8%-9%. There are certainly some bottlenecks, especially on the infrastructure side, and therefore growth far above 5% to 5.5% could lead to inflationary pressures.
Growth rate has been well supported by the earnings growth side. It is at the upper end of the range within the emerging market universe, and compared with other Bric markets, shows very robust growth. For this year, we still have a valuation which is attractive, supported by good earnings growth and a clear recovery in economic activity. Brazil is currently the most important country in the MSCI Latin America Index, with the highest weight of almost 70%.
Second is Mexico with 20% and then come the other markets. This situation was quite different five to seven years ago. Not only has Brazil’s price appreciation resulted in this high weighting, but it has also performed somewhat better than Mexico.
Many new companies have come into the market, broadening it significantly. Mexico, Chile or the smaller countries have not seen the same extent. Brazil’s weighting should continue to increase within the Latin American region, to the extent where you could almost consider the Latin American index to be a Brazilian index, with some additions from the other countries.
Michael Konstantinov is manager of the Allianz RCM Bric Stars fund
