A swift exit from recession has shown that there is more to bountiful Brazil than commodities, according to ALEXANDER GORRA, director at BNY Mellon ARX
Brazil weathered the global economic downturn better than many countries and performed robustly in 2010. In 2011, it offers substantial promise amid expectations for strong growth led by domestic demand.
The charismatic Luis Inacio Lula da Silva, widely known simply as President Lula, is preparing to exit the presidential stage having reached the limit of two consecutive terms in office. Elections take place in October and the new administration will begin to govern in January 2011.
Since the military peacefully ceded power to civilians in 1985, it is a measure of Brazil’s political maturity that the country has comfortably moved from centre right to centre left, a direction that may well be reversed in the coming election. Irrespective of whether Dilma Rousseff, personally nominated by Lula and his chief of staff, or her main opponent, Jose Serra, the current governor of Sao Paulo, wins, both are committed to fiscal discipline and economic stability, and are expected to maintain a de facto independent central bank.
Thanks to the government’s prudent management of the economy, the recession, although the sharpest in Brazil’s history, has been relatively short, lasting only two quarters. The economy grew two per cent in the final three months of 2009. The country’s 2009 GDP growth rate came in at -0.2 per cent.
Brazil has been enjoying historically low interest rates, with the benchmark Selic interest rate at 8.75 per cent since July 2009. The reduction to 8.75 per cent was possible thanks to strong macroeconomic and monetary policies, a marked contrast to February 2003, when the Selic rate went to a decade high of 26.5 per cent with inflation above nine per cent.
Opinion among market participants is divided as to whether the central bank will start tightening interest rates to contain incipient inflation. The February 2010 rate of inflation increased 0.78 per cent month on month, slightly up from January’s 0.75 per cent. The 12-month cumulative inflation rate remained above the 4.5 per cent target, accelerating to 4.83 per cent over one year ago.
Lula has pursued orthodox economic policy, mindful that inflation has to be kept under control to have higher incomes and more consumption. BNY Mellon projects the Selic rate will be at 12.50 per cent at the year-end 2010, with downward movements in the medium term given Brazil’s relatively healthy condition compared to other countries.
Budget surplus
Despite some significant targeted stimulus, Brazil is still running a primary budget surplus – the surplus excluding interest payments on the outstanding debt is considered a gauge of a country’s ability to service its debt. As a stimulus measure, policymakers, beginning in September 2008, injected about 100 billion reals into the economy. The primary budget surplus firmed to 2.32 per cent of GDP in the 12 months through January 2010 and is expected to remain in the two-three per cent range.
Brazil has accumulated in a relatively short period of time a significant amount of foreign reserves, amounting to $242bn, according to the Banco Central do Brasil. Contrast this with the end of 2004 when international reserves were approximately $53bn. The country has considerably improved its debt ratios, enabling it to reduce its vulnerability to external shocks and excessive dependence on international capital flows.
International investors represent around 25-30 per cent of trading volumes but in some recent initial public offerings (IPOs) that can be closer to 70 per cent of the IPO allocations. FDI, which is very important for Brazil’s development, has been running at a rate of approximately $40bn a year.
Effective October 2009, the Brazilian government increased the tax on financial transactions related to foreign investments in the Brazilian financial and capital markets from zero to two per cent. The imposition of the IOF tax is intended to discourage a speculative bubble in the Brazilian capital markets, reduce the appreciation of the Brazilian real and counteract inflationary pressures.
Brazil, which has the fifth largest population in the world, has a pyramid-shaped demographic structure. The 0-14 years segment of the population comprises 26.7 per cent, the 15-64 years portion 66.8 per cent and 65 years and over 6.4 per cent. Brazil’s median age is 28.6 years, compared with 40.2 years in the UK or 36.7 years in the US. Those young people now entering the workforce will help to expand Brazil’s revenue base over the coming decades.
A significant portion of the population has enjoyed upward social mobility, with many lifted out of poverty. Social class C (lower middle and skilled working classes) has expanded from 43.0 per cent in 2003 to 53.6 per cent in 2008. Therefore, the middle classes have become the majority for the first time in Brazil’s history.
No big debts
Positive demographic conditions and improved social mobility are among the factors that favour increased domestic demand. Moreover, compared to the developed world, Brazilian consumers are not burdened by excessive debt and have the scope to borrow more. Similarly, the country’s banks are not “overleveraged”.
Credit is only 40 per cent of GDP and mortgage credit is approximately three per cent of GDP, much lower than other emerging or developed markets. Stimulus measures, such as tax reductions and low-cost loans granted by the state development bank BNDES , have also given a fillip to domestic consumption. However, domestic demand has the potential to feed into inflation, hence the expected preventative action of a rate hike at some point.
Brazil’s hosting of the World Cup and the Olympics in 2014 and 2016, respectively, is also expected to give a boost, spurring the development of Brazil’s infrastructure, which needs upgrading and has been a focus of an economic and tax package. The Olympics, together with an oil discovery and the hosting of the 2014 World Cup, are expected to add between three and four per cent to GDP in the coming years.
With the prospects of slower growth in the US and Europe and of China’s slowing its expansion to control inflation, commodity demand is not expected to be as strong as the “super commodity cycle” of 2000-2008.
However, in contrast to other Latin American countries, Brazil is less dependent on commodities and accordingly less vulnerable should commodity prices fall. It should be noted, though, that stocks driven by consumption still trade at a discount to commodity ones, offering potential for upside for the former category.
As well as a developed mining sector, land-rich Brazil is strong in agriculture. Just as there is demand from China for Brazil’s commodities, its agricultural products are highly sought after. More than 60 per cent of China’s imports of orange juice now come from Brazil, also a supplier of one third of its soya bean and tobacco purchases.
In the view of BNY Mellon, Brazil has a potential GDP growth rate of about 5.5 per cent in real terms. Any growth above that figure brings the risk of inflation. Over time, as Brazil invests more in infrastructure, both physical, such as roads and bridges, and in the education of its youth, the country will eventually be able to raise that growth rate. A potential 5.5 per cent growth rate is almost double the amount Brazil has grown on average over the past two decades.
Domestic potential
Given the bank’s conviction in the growth prospects of the domestic-orientated portion of the market, it has a bias towards companies focused on the domestic market. In particular, it believes that companies exposed to Brazilian domestic consumption and some within the financial sector hold particular appeal.
Lojas Americanas is one of Brazil’s largest nonfood retailers and operates about 470 discount department stores. It offers a range of products and has a strong online presence through its websites. Natura Cosmeticos, Brazil’s biggest cosmetics maker, has direct sales through its shops. The company has exposure to Brazil’s north east region, where modest incomes have been rising steadily, partly as a result of government policies. As demand increased amid the country’s recovery from the recession, Natura’s fourth-quarter profits have gone up 35 per cent.
Rising incomes and more expensive tastes in countries, such as China, are driving demand for Brazilian beef, pork and poultry. Meat consumption is also rising locally. Food companies Marfrig Alimentos and Brasil Foods have made recent acquisitions, which are expected to deliver synergies.
Brazilian financial stocks have benefited from not being highly leveraged and from their lack of exposure to the sub-prime problems emanating from the US. With consumers largely “underleveraged”, they could benefit from an expansion in credit. Itausa, the investment holding company, is efficiently run and focused on delivering return on equity. Bradesco, one of Brazil’s largest private banks, has good penetration, especially in smaller cities, and is expected to benefit from an increase in bank accounts. Also well served by plentiful branches is Banrisul, the bank controlled by Rio Grande do Sul state government, which has the added advantage of being strong in the agribusiness. Additionally, Banrisul trades to a discount to other banks.
With the focus on Brazil-led consumption, BNY Mellon puts less of an emphasis on commoditiesrelated stocks. However, it notes that mining company Vale has a high exposure to the iron-ore cycle given its huge reserves. It also continues to expect demand from China to be high, moving into 2011. Oil and gas giant Petrobras is seeking to tap deepsea offshore crude reserves that could turn Brazil into a major energy exporter.
Despite Brazil’s historically lower growth rates than those of Emerging Asia over the past decades, the country has shown superior equity returns in most cases. This is mainly due to the relatively good governance and the respect of minority shareholder rights. It’s likely that this competitive advantage will continue as investors are more selective in their allocations. Overall, Brazil offers liquidity and breadth of companies and sectors.
All information has been prepared by BNY Mellon ARX for presentation by BNY Mellon Asset Management International Limited (BNYMAMI).