Brazil: Off the fiscal crutches, but can it walk?

Brazil is implementing an ambitious plan to pivot 180 degrees from a state-led to a neoliberal, market-driven economy. Two of our Latin America investors share takeaways from a recent research trip about Brazil’s near-term growth prospects and potential to generate investment returns.

Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

WE RECENTLY TRAVELED TO BRAZIL TO MEET WITH COMPANY EXECUTIVES AND PUBLIC OFFICIALS to gauge the country’s economic progress and market outlook. We came away bullish on Brazil’s near-term prospects and its potential to generate attractive investment returns in the coming year.Under the leadership of newly elected President Jair Bolsonaro, who took office in January 2019, and Economy Minister Paulo Guedes, Brazil is implementing an ambitious plan to pivot 180 degrees from a state-led to a neoliberal, market-driven economy. The historic passage of pension reform in October 2019 was the beginning of a broader plan to shore up the country’s fiscal accounts, boost productivity, and improve economic efficiency. After many years of recession and heavy-handed government, we believe these efforts signal very positive change for Brazil.Bolsonaro has his detractors and still faces some domestic political challenges; however, we think global investors are underappreciating the ability of his economic team to effect real change. If successful, Brazil could be on the cusp of multiyear growth acceleration driven by private investment, infrastructure improvement, and privatization. Fiscal stability and this renewed growth could see Brazil return to investment-grade status as early as 2021.

Toward economic efficiency

Following the passage of pension reform, Guedes has been on a mission to make Brazil’s economy more efficient. He is calling for:

  • New laws intended to prevent state and municipal overspending
  • Easing of labor restrictions to make hiring and firing employees easier
  • A large corporate tax cut
  • A simplified tax code

Other constructive steps include the efforts of José Salim Mattar, a highly regarded former private-sector business executive who was named head of privatizations in January 2019. Mattar has already launched the country’s largest-ever asset divestiture program, selling the country’s biggest gas station network. There are hints he may also try to sell the country’s largest bank and electric utility in 2020. In a meeting with one of Brazil’s major toll-road companies, management told us that the pipeline of planned infrastructure investment has never looked healthier. Brazil’s leading steelmaker reported that São Paolo’s residential developers have been accelerating orders for rebar in recent weeks, and that the city’s high-end residential market is booming, as benchmark borrowing rates have fallen from 14% to 5%. Brazil’s affluent appear to be eschewing long-term, lower-yielding government bonds, reallocating into real estate. One high-end developer told us that the company plans to hire 7,000 workers next year. In general, civil construction generates jobs, which in turn drives consumer confidence and spending.

Steady growth, low inflation, attractive valuations

Brazil’s economy is finally growing again, and we believe it will progress faster than expected, posting approximately 2% GDP growth in 2020. Record-low benchmark rates may fall further, to 4%, and we believe the country may again return to low inflation of 3.5%. These are important conditions for the economic engine to rev up.

Brazil’s appetite for equities is also growing. Local investors are responding to low rates by looking elsewhere for yield, showing a willingness to take on more risk. For example, equity investment as a percentage of Brazilian savings is at approximately 13% today, but the CEO of B3, Brazil’s securities exchange, has said he believes it could be as high as 20% by the end of 2020.1 Many pension funds are increasing allocations to equities, hundreds of hedge funds are seeing strong inflows, and open investment platforms have been growing at a rate three to four times faster than Brazil’s traditional asset management business.

Equity valuations are generally attractive, given improving economic conditions. Brazil’s stock market, Bovespa, currently trades at approximately 12 times earnings, slightly above its 10-year average, but with the strongest growth outlook in over a decade.2 At the same time, real rates are hovering around 2%, significantly below their 10-year average of 5% – 6%. Equities are even attractive relative to bonds, with equity yields outpacing bond yields by one standard deviation below their 10-year average.3

The road ahead

We recognize that Brazil’s economic renaissance will take time and that local and global uncertainties remain. In our view, success requires reversing the economic policies of former Presidents Lula da Silva and Dilma Rousseff and establishing a new mind-set among the electorate that a smaller government is not only possible but also necessary for Brazil’s future success. Failure to pass additional fiscal reforms or win Brazilian hearts and minds could pressure the real (BRL) and derail the improving macro conditions. For now, however, Bolsonaro’s reformist government is pushing forward amid a favorable backdrop, something even long-time market observers have not experienced. We suspect that Brazil will walk again — or even run — with less government support, potentially proving to be one of 2020’s stronger-performing emerging markets.

1Company presentation to investors, 12 November 2019. Source: B3 S.A., doing business as BM&F Bovespa S.A. | 2As of 2 December 2019. Source: Bank of America. | 3As of 28 November 2019. Source: JPMorgan.

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