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Investor Report Brazil: A foreign exchange

Sep 1, 2012

A major shift is underway in Latin America’s investment landscape as fund managers reallocate profits taken from Mexico’s high-returning equity markets to holdings in Brazil

By John Rumsey

Mexico’s stock market has been the darling of investors this year. By early August its main index, the IPC, had climbed over 10% since January. In contrast, Brazil’s Bovespa had returned just 3.4% over the same period.

For much of the past year, Latin American investment funds have cut allocations to Brazil, and their average allocation to the country has dipped below 60% for the first time since the start of the crisis, according to Cameron Brandt, director of research at fund flow company EPFR Global.

But a number of influential fund managers are now turning bullish on Brazil, arguing that its markets offer good value amid what some now believe are improving growth prospects.

Nick Robinson, head of Brazilian equities at Aberdeen Asset Management in São Paulo, has reassessed his Latin allocations and turned a Brazil fan. "Mexico is trading at a 40% premium to Brazil, which is a greater differential than for some eight years," he says.

"Our Latin fund has long had a structural bias to Mexico. That is no longer the case," he says. Over the past six months, he has become overweight Brazil and underweight Mexico. Robinson has $11 billion invested in Brazil.

Will Landers, managing director and senior Latin America portfolio manager at Blackrock in New Jersey, says Brazil is looking cheaper than either Mexico or the much smaller and more illiquid Andean markets. "At the moment, you can buy Mexico at some 15 times next year’s earnings, Chile for 16 times and Colombia for 14 times. That makes these markets look at best fairly valued," he says.

Landers now dedicates almost 66% of his funds on average to Brazil – as against a 59% benchmark. He believes better company results will be the trigger for a re-rating of the Brazilian market.

Antonio Miranda, co-chief investment officer of New York-based Compass Group with $4.5 billion of assets under management, says Mexico had been the more popular market because of excellent macro policies, a cheap currency and an improving US outlook. But at current levels, "Mexico is looking a little expensive on broad valuations," he says. He is revisiting his Mexican allocation and viewing Brazilian small-cap stocks, and particularly financials, more favorably.

Marco Freire, vice-president and Brazilian fixed- income chief investment officer at Franklin Templeton Investimentos Brasil, now favors Brazil instead of Mexico and is also trimming bond allocations in favor of equities. "Growth in Brazil will rebound more quickly than most people think," he says.

"Conditions in the credit markets are better, and banks are ready to increase loans again. This is a very different and a more positive picture compared to 12 months ago. Freire helps manage $2.5 billion of funds.

Brazil has other advantages over Mexico, say fund managers. The country boasts a far greater and more diverse range of listings, especially among smaller companies, where some have been carving key niches in the economy. Improvements in corporate governance have been more marked in Brazil too since the introduction of the Novo Mercado in 2004.

Time to trade: Brazil vs Mexico equity funds & net asset value change 2008-YTD2012

Bond market caution

But bond markets are nevertheless signalling short-term caution on Brazil: rates have come down to historic lows, inflation is likely to stay at 5% or more for the next 18 months, and the improving economy could fuel higher inflation. In July Mexico overtook Brazil in terms of fixed-income allocations for global emerging market bond funds for the first time in more than five years.

The average allocation to Brazil was 10.53% against 10.56% for Mexico, according to EPFR Global’s Brandt. This time last year, managers allocated over 2% more to Brazil than to Mexico.

Multi-asset investor Franklin Templeton sees more value in equities than Brazilian bonds for the moment. "We expect growth to surprise on the upside, which is not a good environment for bonds – but should help domestic cyclicals," says Freire.

Market volatility has led to a drop in interest from the traditional markets of Japan and Asia in Brazilian fixed-income, he says.

But the arguments in favor of Brazil over developed markets are compelling, Freire says. "Five-year Brazilian government bonds are yielding 9% while the gross debt ratio to GDP is 60%. That is unusual to find today, and now that the currency has weakened and there is less foreign exchange risk, it looks all the more attractive," he says.

The US Federal Reserve has indicated it will maintain overnight rates at or close to 0% through 2014 while rates are decreasing in Europe and sovereign ratings are under pressure, he points out.

Franklin Templeton is launching a new multi-asset fund called Brazil Opportunities. This aims to capitalize on the combination of Brazil’s relatively high rates and the good prospects for the equity markets. Freire has been marketing this in Asia: "The Japanese are willing to listen but are not coming back yet. We are looking for a return of interest in the future," he says.

Macro policies

The expected pick-up in growth in Brazil may knock fixed-income markets with higher rates in the short term, but the silver lining is that it will underpin a stock market recovery.

The timing and strength of a possible economic rebound, however, is hotly debated.

Alexander Gorra, senior strategist and head of the international platform at BNY Mellon in Rio de Janeiro, sees GDP growth this year at 1.5% overall, but believes government measures will help stoke a recovery that will ramp up growth to 4% or more next year.

Carlos de León, Latin America portfolio manager at Allianz Global Investors, forecasts 2–2.5% GDP growth this year, picking up in the second half and rising to a minimum of 4% next year.

Freire is more bullish for this year: he thinks a recovery is already well established and will surprise on the upside, including next year. Whatever the timing, managers agree that government policies will have a significant impact on growth. Brazil’s central bank is likely to loosen monetary policy further this year.

That monetary easing will be accompanied by further measures to stimulate the economy, with the government working on a whole range of measures, says de León. They are likely to include new infrastructure developments, including more private participation in road concessions, ports, and airports as well as additional tax cuts on selected industries and a reduction in the cost of energy, he says.

Freire believes the government will act on a number of fronts and says that there is further scope for loosening credit controls through, for example, a slower implementation of Basel III.

Companies and valuations

Although fund managers are generally consistent in their optimistic prognosis for the Brazilian equity market, there is less agreement on which sectors are most attractive.

Freire and Gorra have been adding in financials. Stocks have been hurt by government actions to reduce spreads charged to customers on loans as well as higher non-performing loan (NPL) levels. President Dilma Rousseff has pressured state-owned banks to reduce charges and criticized charges levied by private banks.

Freire says lower interest rates and an improving economy will continue to drive down worryingly high levels of NPLs. He reckons there has already been an improvement over the past couple of months, with a fall of 5.68% in consumer defaults and late payments registered in July. The improving economy and lower NPL rates will persuade private banks to expand their consumer loan portfolios again.

Gorra has increased his allocations to financials as well. He is overweight in the sector and expects nominal growth in credit of 10% this year and 15% next. The valuations are compelling: bank stocks are trading at historically low levels of 8.5 times forward earnings with a 4.5% dividend yield, he says. Moreover, the recent weak performance has made the major banks focus on improving efficiency ratios, and their expenses are growing less than inflation.

Miranda is focusing on small-cap stocks. He says they have outperformed the broad indices and that, this year, small caps are up by 5% while standard MSCI Brazil is down close to 6%. "We love the diversity of the small-cap universe and the quality of management teams," he says. The fund is looking at sector consolidation opportunities in the space.

For Robinson, the heavily discounted commodities sector is looking good value. A number of negative factors have blighted key stocks. Both Petrobras and Vale have suffered from heightened government intervention. This has included selecting key managers and overseeing investment plans as well as influencing the very capital structure in the case of Petrobras.

"It’s hard to say where Petrobras starts and the government ends," says Robinson. Moreover, the uncertain global economic outlook with falling Chinese demand for iron ore has hit Vale hard.

These negatives have persuaded managers to dump Brazilian commodity stocks, and they now look oversold, says Robinson. "Petrobras and Vale are trading at levels that have not been seen for the last 10 years, and Petrobras is looking particularly good value," he says.

Petrobras shares have proven highly sensitive to good news at these lows. They had a near 6% bounce on August 8, on the back of the government announcing that gasoline prices in the country could be increased this year.

Landers has maintained a large position in Vale too. He was disappointed by weaker than expected second quarter numbers, which he attributes to weak demand from China. Even so, at five to six times earnings and a yield of 4%, the company looks attractive, he agrees with Robinson.

Public offerings

Global economic uncertainty has dampened down the still moribund IPO market, and few fund managers see any great pick-up before the start of next year.

Aberdeen Asset Management has not participated in a primary issue since the IPO of shoemaker Arezzo in February 2011. "The quality of companies coming to market has not been high. We feel that bankers have been opportunistic and are pushing fairly young businesses, sometimes with more than one business rolled together, just to get out an IPO," says Robinson.

Gorra says that while the quality of IPO candidates has improved, demand is limited. In Brazil, the launch of the much-awaited offering of bank BTG proved disappointing to investors with shares falling some 25% initially and, although there has been a recovery since June, shares are still down some 5% from initial pricing levels.

Brazil is not alone in facing a tough market, he says, pointing to the disastrous launch of Facebook this May. "Anything of interest will get pushed out to 2013," he predicts. Gorra says companies have an additional financing option of tapping private equity money as firms such as KKR, TPG, Blackstone, 3i and Carlyle increasingly focus on Brazil.

De León says that although there have been some eight possible launches presented in the last two months, very few have made it to the market, and the IPO environment remains very challenging.

Recuperation assured?

If the IPO market continues to suggest uncertainty, what do fund managers believe could derail the rosy scenario for Brazilian stocks? A further deterioration in global conditions remains the greatest fear. An increase in inflation is another risk as the central bank adjusts to an improving economy and seeks to maintain growth. The weaker value of the Brazilian real could feed into higher consumer inflation as the economy recuperates, says Freire.

Another dark cloud is meddling by the government in state-owned companies and even whole sectors. There has been much interference in companies and sectors under the Rousseff government, says Friere. As a counterbalance he says that the government is also acting in a positive way to stimulate growth. Moves to cut taxes and reduce energy prices are a positive for companies and the economy.

The Bovespa index has been climbing steadily of late and major fund managers reckon that there is more to come. The shift of reallocations to Brazil from Mexico is a trend firmly in place, they say. LF

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