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Private banking clients in Brazil have been spoilt for decades.
The country’s wealthy have been able to invest in single-product, sovereign-backed, tax-free investments linked to the (typically high) overnight interest rate, with daily liquidity. They have been able to generate very strong real portfolio returns with virtually no market or credit risk.
That, finally, is changing and, while it will be a benefit for the nation that the state will not be paying out such large returns to Brazil’s wealthy, these investors are facing a new investment characteristic: risk.
Nominal rates are falling rapidly – expected to hit 6.5% at the end of this cycle, according to Itaú, from 14.25% in August last year – and real rates are expected to fall into low single-digit territory. Those rates may look good to investors in developed markets but terrible to Brazilians, who are accustomed to near double-digit rates.
We have been here before, albeit briefly. When previous president Dilma Rousseff pressured the central bank to lower the benchmark Selic – the Brazilian central bank’s overnight rate – to 7.25% in October 2012, inflation was rising and real rates went negative with some fixed income investments.
But that naive economic experiment in getting the country off its high interest rate fix did not last.
Brazilian investors had it all with fixed income products, and now they will have to accept different risk premiums and longer duration – Sylvio Castro, Credit Suisse Hedging-Griffo
There was much talk of the need to take risk but little real action; no mass shifts in asset allocations happened. Private banking clients winced for a moment and then the moment passed. Selic shot up again to fight spiralling inflation, ultimately hitting 14.25% and padding out annual returns.
This time it is going to be different. While interest rates will go lower than in 2012, they will do so thanks to sustainable dynamics. Inflation has collapsed, falling faster than even the central bank expected, which has enabled the easing of monetary policy while keeping real rates positive.
In fact, real rates have risen through much of the cutting cycle as the central bank could not keep up with falling inflation, even when it was cutting by 100 basis points at every meeting. This time, economists are predicting a multi-year stay in single-digit interest rate territory – at around 7% with inflation at or near 4%.
Crucially, the international situation is also different this time around. Last time, Selic was pushed down in the face of a deteriorating international background: the taper tantrum and prospect of higher rates in the US led to liquidity draining out of Brazil.
The current account deficit was also relevant in those days. Today, according to Bank of America Merrill Lynch, Brazil’s current account deficit is at its lowest level since 2008. The bank predicts it will be just 0.6% of GDP in 2017 and 1.3% of GDP in 2018, which is easily covered by foreign direct investment inflows.
“The external situation couldn’t be more benign than it is,” says Sylvio Castro, CIO at Credit Suisse Hedging-Griffo Private Banking. “The truth is it is almost impossible to foresee a better scenario than the current one that has high GDP growth spread across the most important emerging and developed markets, while, at the same time, there is very low inflation across the board. That provides central bankers with a fantastic opportunity to guide markets’ expectations prior to tightening.”
Stark fact
That benign scenario has been improving for over a year now; the dollar liquidity that has come into Brazil is the biggest complicating factor for private bank clients looking to move into risk assets.
Those surplus dollars in the country have driven down risk premiums across the board and valuations have rallied. In dollar terms, the Ibovespa has rallied about 45% from the sell-off in May when secret recordings of president Michel Temer threatened to end his term prematurely. The Ibovespa is now at all-time highs, hitting 77,000 in October.
The stark fact is Brazilian private bank clients have little choice but to accept risk. Luiz Severiano, head of private banking at Itaú Unibanco, says he sees 20% upside in the Ibovespa even at these levels.
“We think we can see the Ibovespa go above 90,000, so it can still appreciate about 20%,” he says. “I think investors will need to understand that a 20% return is huge [despite the fact that] two or three years ago that was an annual return from fixed income. But now a 20% return from the stock market will represent a three-year return from fixed income.”
That 20% equity return comes with risk however. That is the difficult part for clients who are used to risk-free strategies. Given the rapid advance in equities (that has been missed by the vast majority of the private banking industry), what provides the rationale for arguing for further strong up-side?
From fundamental and earnings perspectives, valuations do not look cheap any more. True, falling interest rates will further de-lever, driving investment and earnings potential, but the biggest part of the equation is investor positioning.
In 2016, according to Anbima, Brazil’s private banking industry grew assets under management by 16.7%. Meanwhile, the growth in variable return assets grew 31.7% and fixed income by 10.7%.
But given the high legacy domination of fixed income products, the overall composition of the industry barely moved: fixed income investments ended 2016 accounting for 44.2% of all portfolios (the same as at the end of 2015) and variable return assets grew to 12.6% from 11.2%.
Now imagine it is not just new assets that begin to move into variable return investments. And then add institutional investors, such as insurance companies that can no longer hit their actuarial targets by investing automatically in government debentures. Then there are foreign investors to consider.
Rogerio Pessoa, head of wealth management at BTG Pactual, says that in 2012 global investors had 2.3% of their investments in Brazilian equities. Today it is 0.7%.
“There is a lot of room for improvement,” he points out. “Even in hard currency government debt, foreigners have gone from holding 16% to 12%, so we see room for flow.”
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Sylvio Castro, Credit |
“This positioning factor is the biggest plus [to future appreciation] in Brazilian equities,” argues Castro at Credit Suisse. “Because of the poor historical performance of equities and the incredible rise of fixed income, the allocation of equities for all types of investors is at an all-time low. Brazilian investors had it all with fixed income products, and now they will have to accept different risk premiums and longer duration. It’s already happening, but this is definitely a strong force that can push up the equity market in Brazil.”
Castro says that while the move has started, it is in its initial stages. The widespread movement is yet to come. Most bankers expect re-allocation to begin in the first quarter of next year – although that forecast always comes with the attached caveat of political risk that depends on how the presidential elections are looking then.
Private bankers report that the first move has been into increasing allocation to the multimercardos – Brazilian hedge funds.
Edinardo Figueiredo, Brazil market manager for JPMorgan’s private bank, says these funds have been developing different strategies, but the volatility-driven funds have become particularly popular in recent months.
“They will gain momentum,” he says. “We have seen some managers with good records hitting funding limits in 24 hours.”
Illiquid investments
Private bankers are also talking about illiquid investments. Real estate and private equity funds are now the buzz words among clients seeking high-yield products. Locking up funds from between five and 10 years was once unthinkable. However, while thought is now being put into these, action remains some way off in any great scale – these investments account for less than 2% of all portfolios.
Bankers report seeing private equity funds raising unprecedented levels of capital in recent times. Much of this is coming from offshore, where, according to Citi, there is an estimated $10 trillion earning zero or no return looking for positive yield. But onshore private banking clients are also interested.
“In the next few years private equity and real estate will increase participation,” says Itaú’s Severiano. “And international portfolios will become more important.”
However, Castro offers a warning to those clients getting excited about long-term investments.
He says the bank is “approaching the asset class more systematically for the first time in many years” – it has been sceptical in recent years about the asset class’s ability to generate excess returns because of companies’ valuations and the country’s growth trajectory.
The tax amnesty has helped a lot. We now have transparent conversations with clients – Edinardo Figueiredo, JPMorgan
The improvement in economic growth forecasts could make private equity tempting, but: “We have to confront the reality that Brazil still hasn’t gone through the necessary reforms to stabilize its debt in the long run,” says Castro. “Just because the market is ignoring this medium-to-long-term risk doesn’t mean it’s not there – it just means it’s not the theme of the market at the moment.”
This gets to the crux of the investment allocation issue. To be successful, banks need to guide clients through a structural reallocation of portfolios while managing the returns of each through a tactical strategy that hedges market ebullience and optimizes markets corrections and intra-asset class strategies.
The banks that better manage this mix of advice will outperform and will be rewarded by new clients and new funds from existing clients.
JPMorgan’s Figueiredo argues that clients’ funds will be much more fluid in the future.
“In the past, when clients had fixed income investments paying 14% with daily liquidity, they didn’t go anywhere. Now the fluidity of AuM will become a dynamic in the market,” he says.
“We have been working very hard to be prepared for this moment,” says Itaú’s Severiano. “It’s very hard to aggregate value for clients when they just invest in the CDI [the one-day interbank deposit rate].”
Meanwhile, BTG Pactual’s Pessoa says the private banking market in Brazil is evolving to be “the best scenario” for his bank: “Now it’s a much more open competition for service rather than [a requirement for] safety, and as the market moves to the service approach, the local banks with an international presence will be able to make that differentiator an effective one.”
International diversification
As if private bank clients did not have enough to deal with, there is another hurdle to jump: international diversification.
Although some investors have grasped the need to move wealth offshore, the picture is reportedly very patchy. Some private bankers tell of many clients with almost 100% of their wealth still onshore, while others have achieved real international diversification. Some have shifted part of their fixed income allocation into hard currency bonds from Petrobras, which offered juicy 8%-plus yields.
It also seems fair to generalize that investors still have a strong home bias.
A further consensus is that the new lower interest rate environment in Brazil, coupled with now-legal offshore funds thanks to the tax amnesty and the growing possibility that fundos exclusivos (funds established for a single or a small group of shareholders) will be taxed by the next government, will drive further internationalization of Brazilian wealth.
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Edinardo Figueiredo, JPMorgan |
“The tax amnesty has helped a lot,” says Figueiredo. “We now have transparent conversations with clients; everything is declared and then we can have a conversation about what should be the right mix for balancing wealth onshore and offshore. And, coupled with the prospect of taxes being applied to exclusive funds, many are thinking about increasing their allocations offshore.”
For the first time in years there is the prospect of higher returns overseas – especially when measured on a risk-adjusted basis.
“We work with clients to challenge their views and explain how other asset classes work,” says Cesar Chicayban, vice-president of Citi Private Bank in Brazil, which has stayed in Brazil after the sale of its retail bank. “For example, today we like US high yield. If you buy a diversified portfolio, you can have a similar or better risk/return profile than when you are buying onshore bonds. The investors are reacting very well.”
Figueiredo says that he has noticed that clients in Brazil are becoming increasingly interested in ‘new economy’ investments.
“The way we are advising clients is changing rapidly,” he says. “You have a new economy out there and we are getting a lot of questions about what is going on in the genetics sector, for example, or in US tech.
“I think that clients are closer to shifting to investing in these sectors than we think. Ten years ago, the client would be very conservative; if they did invest in equities, they would choose the big companies. But today you have to worry whether these giant traditional companies are going to be around in 10 years.”
Meanwhile, Citi’s Chicayban says he is working with clients to optimize both the assets and liabilities of clients’ balance sheets – adding leverage internationally where appropriate (given the low interest rates).
He says the bank has been executing single-stock risk management structures that allow concentrated equity positions in Brazil to be used to create liquidity for international investments.
The big local and the international banks argue about which is best placed to capitalize on the trend to international diversification, but the truth is that private banking clients will spread their portfolios across both types. The long-term winners will be those that can provide service and results.
