The Bullish Case for Brazilian Stocks

Brazil is coming out of one of the worst economic slumps in its history, after having lost more than 7% of its GDP over the past three years. A huge binge caused by a boom in commodity prices (2004-2011) which led to hot-money capital inflows and excessive credit and consumption was followed by a large hangover, made much worse by a political crisis and a draconian monetary policy of extremely high real interest rates. But all downturns come to an end, and Brazil is now poised to start a new growth cycle on solid ground. Corporates now have very lean cost structures, and they will see significant margin leverage as sales recover. Profits are very depressed; in 2016 they were at 2005 levels. At the same time, the market is inexpensive relative to its history and one of the cheapest in the world, so there are good prospects for both vigorous profits growth and multiple expansion over the coming years.

It can be argued that the past 10-15 years were wasted by Brazil. The Workers Party (PT) governments of Presidents Lula and Rousseff coasted on the reforms passed by the previous administration and sat back to enjoy high commodity prices and ample foreign capital inflows.  Several important achievements of the previous government, such as depoliticized regulatory agencies and the professionalization of public companies, were discarded, and new reforms were taken off the agenda. The PT focused mainly on a multitude of poorly-designed social welfare programs and corporate subsidies, without consideration for the fiscal consequences. When commodity prices retreated and the mismanagement and corruption of the public sector was revealed, the party came to an end.

The interim president Michel Temer, who replaced Rousseff after her impeachment, has made good progress towards putting Brazil’s economy back on the right track. For the first time in nearly twenty years, Brazil now has a reform agenda and a real opportunity to break out of economic stagnation (Brazil’s Economic Stagnation). An inbred love for experimental developmental economics and a complacency facilitated by the commodity boom and Petrobras’s oil finds, seem to finally have been replaced by a new realism and a desire to follow market economics. The country has woken up to the evidence that Argentina and Venezuela are not better models to follow than Chile and Mexico, and that wholesale antagonization of the U.S. leads nowhere.

Temer has already secured passage of a “fiscal responsibility law” which limits public spending increases to inflation and provides a possible anchor to a future of fiscal rectitude.

Temer has also brought competent management back to the state-owned national oil company  Petrobras, the electricity-holding Eletrobras and other public entities. Petrobras has started a process of selling non-core distribution and refinery assets, to focus on managing the development of its prodigious deep-water oil reserves. Temer has also proposed privatizing Eletrobras, a state electricity conglomerate that has long been a hotbed of patronage for politicians. Moreover, additional privatizations and infrastructure concessions once again are being advanced. It appears that these will be done in a manner to promote investment and efficiency, not for the convenience of corrupt construction companies and their political friends, as was the case during the Lula and Rousseff governments.

The good news for the stock market is that there are plenty of low-hanging fruits for Brazil to collect.

First, after this dire 3-year economic recession Brazil will enjoy a natural rebound. That alone should guarantee moderate growth in coming years. The negative effects of low commodity prices have already been felt and these are likely to stabilize from now on.

Second, important reforms of social security and labor are likely to pass. Consensus appears to have evolved in favor of these fundamental reforms. Social security reform is vital to stabilize fiscal spending. A labor reform could create enormous opportunities to create jobs in the formal economy.

Third, productivity is very low (at about a quarter of US levels) and productivity growth has been abysmal. Brazil has huge potential to increase productivity by pursuing two tracks:

  • Lower tariff and non-tariff barriers to open the economy. Brazil can take advantage of the enormous presence of mutinationals and the scale of their Brazilian businesses to promote integration into global supply chains and increase exports. For example, the auto industry currently has very low productivity and is mainly domestic focused.
  • Brazil has a pathetically low rank in the World Banks’s “ease of doing business survey”, and has seen no progress over the past decade. It has the worse ranking in Latin America and one of the worse for the main emerging markets. A methodical approach towards deregulation and tax-simplification would quickly yield high dividends.

World Bank’s Cost of Doing Business Country Rankings

Fourth the stocks market is inexpensive relative to both its history and other stock markets.

  • Dollarized earnings rebounded strongly in 2016 and will rise another 20% this year, but they remain below the level of 2005 and at about half the level of 2010-11. With very lean cost structures, companies will see better margins and earnings as the recovery progresses.
  • Cyclically adjusted price earnings (CAPE) ratios on a dollarized basis are cheap relative to Brazil’s stock market history as well as compared to other markets. In a world of very high assets prices caused by the impact of monetary policies on the pricing curve for capital duration and risk, emerging markets equities in general and Brazilian equities  in particular still trade below long term averages. Though CAPE ratios in general are not a good timing tool, they are very predictive of market performance on a 7-10 year basis in developed markets and a 3-5 year basis in emerging markets where cycles tend to be shorter and more abrupt.

There are sufficient risks in Brazil so that the market will face a wall of worry. At the top of the list is the outcome of next year’s presidential election. A successful run by Lula, a low probability at this time because of his legal problems, would certainly unsettle the markets.

Longer term, Brazil faces two fundamental issues.

  • A chronically overvalued currency. It is an absurdity that Brazil has the sixth  most expensive BigMac in the world, a reflection of the very high costs of doing business and an over-valued currency. Policymakers need to constantly remind themselves of former Finance Minister Mario Simonsen’s dictum, “A inflação incomoda, mas o câmbio mata. (Inflation is a nuisance but the foreign exchange rate kills.“ )

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  • Pro-cyclical policies. Every cycle, Brazil ‘s politicians increase spending during the boom times and then are forced to retrench during the busts. As John Maynard Keynes wisely noted, “The boom, not the slump, is the right time for austerity at the Treasury.”

 

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