Brazilian stocks have rallied by over 50% since March 24, driven by bottom-fishers and a new generation of avid speculators trading through online brokers. The Brazilian trade has similarities with the “dash-to-trash” trade that has pushed up the worst performers and “zombie” stocks of the U.S. market (cruise-lines, airlines, malls, etc…). Brazilian stocks have also benefited from a weakening dollar, which, in itself, is a reflection of increasing investor appetite for risk.
The “risk-on” trade is underpinned by the following narrative:
- The Covid-19 pandemic is in retreat, and vaccines and therapeutics are forthcoming. This implies a “V-shaped” recovery of the economy.
- The U.S. Fed is fully committed to propping-up financial markets and provides a “put” which provides downside protection.
Moreover, according to the bullish-case, emerging markets such as Brazil from now on will benefit from a strong tail-wind from the following forces:
- Strong stimulus in China, which is evident from rapid credit growth (27% y/y) and surging cement and steel sales. China appears to be implementing a mini-version of its gargantuan 2009 stimulus.
- Commodity prices, which are at decade lows, will be pushed up by Chinese stimulus. We can see this already in iron ore and copper prices, which are both well off the bottom and trending higher.
- After a decade-long strengthening, the dollar may have started a down cycle. This would be caused by a combination of (1) the reckless implementation of Modern Monetary Theory in the U.S. (eg. fiscal deficits financed by money printing) and (2) improving growth prospects outside the U.S.
- Record-low interest rates around the world and persistent deflationary trends are allowing EM central banks to reduce benchmark interest rates. This is particularly true in Brazil where interest rates at historical lows are pushing the rentier class into stocks.
Finally, the bulls believe that a great rotation has started, from expensive “growth” stocks (eg, FAANGS) into dirt-cheap “value” stocks. This rotation has been happening in recent weeks and partially explains the rise in Brazilian stocks. Emerging markets in general and Brazil in particular would greatly benefit from such a rotation. This is because, aside from China, Korea, and Taiwan, which have buoyant tech sectors, growth stocks are exceedingly uncommon in emerging markets.
For the current rally in Brazilian stocks to continue this narrative will have to be confirmed. Given the enormous lack of visibility on several issues, however, a cautious positioning is warranted. In particular, the continued virulence of COVID-19 across many emerging markets, and especially Brazil, is of great concern, and the risk of a second-wave later this year is real.
Moreover, the bulls may not be giving proper consideration to the disastrous impact that the pandemic has wrought on present economic output and future growth prospects. Both the OECD and the World Bank this week released growth forecasts for Brazil pointing to the devastating effect of the pandemic this year and slow recovery next year. These forecasts are shown below.
Furthermore, the crisis will have a very debilitating effect on Brazil’s fiscal accounts and result in a massive increase in the debt-to-GDP ratio. This ratio has been ramping-up dangerously for the past five years and will surpass 100% of GDP over the short-term. The very high levels of debt in Brazil can be expected to significantly reduce the potential for GDP growth in the years to come. This is shown in the chart below.
Furthermore, the claim that Brazilian assets are cheap should be qualified.
First, let’s look at Brazilian stocks on a historical basis. The chart below shows price-earnings ratio (PE) and cyclically-adjusted price-earnings ratios (CAPE) for Brazil, with 2020 numbers from sell-side estimates. Based on history, Brazilian stocks appear relatively close to historical averages.
The following chart, based on MSCI data and sell-side estimates, shows the MSCI Brazil index and Brazilian GDP (LHS) and earnings (RHS), all in USD terms. What the chart shows is that the perceived cheapness of Brazilian stocks is the result of a decade of currency weakness and GDP stagnation, which have led to no earnings growth.
The unfortunate reality is that Brazil has undergone a disastrous lost decade, as far as corporate profits are concerned. Given the Coronavirus, the expected slow recovery and the poor prospects for GDP because of excessive debt, there is no clear end in sight for these woes. Remember that Brazil’s stock market is largely composed of banks, commodity producers and mature consumer businesses, none of which are benefited by the global environment of low growth and disruption. The chart below shows historical and expected MSCI Brazil dollar earnings. These assume a gradual appreciation of the BRL over the 2020-2029 period.
Applying a CAPE methodology to this earnings forecast, we put a Brazilian normalized CAPE ratio of 13.6x on 2027 CAPE earnings (10-year average inflation adjusted earnings), which gives us a target MSCI Brazil index value of 2383 in 2027, vs. today’s 1633. This translates into an expected annual total real return of 5.7% (including dividends). Needless to say, these expected returns are not enticing.
Of course, these kind of forecasts are full of pitfalls. Many things could happen to improve the prospects for Brazil. These are the primary ones:
- A strong weakening of the USD and sharp rise in commodity prices could dramatically improve economic growth, liquidity, the debt profile and earnings. This is not currently in analysts earnings forecasts, but the chances of this happening in coming years are relatively good.
- Successful economic reforms implemented in Brazil. Low-hanging fruit to increase productivity and growth potential are enormous. For example, Brazil has an abysmal ranking of 124th in the World Bank’s Doing Business ranking and has made no progress over the past 15 years.
- Successful financial repression, to allow a managed reduction in government debt.
- An innovation renaissance in Brazil, resulting in “new economy” companies. If Argentina could spawn a Mercado Libre, perhaps Brazil will do the same.