Capital markets: Brazil’s unusual recovery

Brazil’s latest GDP figures were surprisingly bad: the economy expanded by just 0.1% in the fourth quarter of 2018, slowing from (a revised) 0.5% in the previous quarter. The Brazilian economy grew just 1.1% in 2018 and it is officially the slowest recovery from recession in Brazilian history – odd considering the slack created by the biggest-ever contraction.

Brazil’s recovery is unusual in other ways, too. Take international investors: usually the first to enter a country after a recession are the financial flows, with allocations of funds into public equity and the fixed income markets. The flows are usually more responsive to signs of renewed growth than other forms of investment – such as foreign direct investment (FDI) – that need to be more convinced of the robustness of a turnaround given the difficulty and expense of reversing such investments.

But in this cycle FDI has been performing better than expected – more than covering the country’s modest current account deficit – and the more speculative financial flows haven’t materialized.

Reticence

Some local bankers are perplexed by the international investors’ reticence. The international media, they say, are to blame for overplaying the portrayal of president Bolsonaro during his election campaign, though even they admit his first couple of months haven’t been reassuring from the point of view of establishing his ability to govern (his antics during carnival creating the first use of the term ‘golden showers’ in many ‘non-specialist’ publications – and now we can add Euromoney to that list too).

The usual explanation given locally and internationally for the caution being displayed by international investors centres on the future of pensions reform. Once that is passed – or it is clear that it will be passed – these investors will be reassured and reallocate to Brazilian assets. IPOs and follow-ons will come to market and we will have lift-off.

I can’t see any reason why the spread has collapsed 140bp for credits when nothing has essentially changed other than the benchmark rate 

 - Private banker

However, that hypothesis may be superficial. The reforms are important – incredibly so – but Brazil has a track record of walking away from ledges when they get to them. Given the importance of this reform – the country will be effectively insolvent if there is zero reform – something will almost certainly get done. One banker described Temer’s previous reform that saved about R$500 billion over ten years as the “bid” and the new Bolsonaro reform that is equal to R$1.3 trillion as the “ask”. The result will be somewhere between the two and he thinks anywhere over the midpoint of the two will be seen as a win by the markets.

Given this widespread expectation of some reform going ahead, why are the international investors waiting? Well, it could be that valuations have simply run ahead to the point where it’s not a very good entry point. The Bovespa has surged during the past couple of years – more than doubling to close in on 100,000. There are many factors to that run – such as the end of the recession and increased confidence about the much-needed structural reforms – but an important element has been the migration of local investments towards risk assets. This positional effect alone has been a strong driver of equity valuations.

The Brazilian benchmark interest rate is now at historic lows – and given those low GDP numbers the new president of the central bank, Roberto Campos Neto (confirmed in February), may well lower it below the level of 6.5%. That will increase the migration of money out of government debt and into equities, the multi-mercardos and corporate credit.

Slow recovery

With the Bovespa being pushed so far, so quickly, international investors may well be struggling to make a bottom-up investment case for stocks – especially as the slow nature of the recovery means that earnings are unlikely to spike in the near term.

It’s a similar problem in fixed income. Spreads on corporate credit have tightened considerably in the past couple of years as the Selic came down. One private banker said that he believes the current prices are “frothy” and is underweight the sector “as I can’t see any reason why the spread has collapsed 140bp for credits when nothing has essentially changed other than the benchmark rate”. If some locals are looking and not seeing value, why would it be the time for international investors to jump back into Brazil?

So the short-term return dynamics don’t look great. But the longer-term view is more constructive and is the reason why those FDI flows are preceding the financial this time around.

Again the story started two years ago – with the Temer administration. Arguably the reform to the financing rate of the state’s development bank was the most important. Forcing the bank to lend at market rates has dramatically increased the effectiveness of monetary policy and could lead Selic to be cut a few times from this record-breaking trough.

The main impact has been to create equilibrium in Brazil between rent-seekers (who have had it easy for 20 years) and entrepreneurs (who have not, fighting high interest rates and bureaucracy).

This is why strategic investors are coming to Brazil and the financial investors are not. It’s not pensions reform, it’s the many different consequences of the country’s new monetary policy regime.