Potential Inflection Points In Brazil

Conclusion: There are a number of potential positive catalysts on the horizon which would be bullish for Brazilian equities.  Any combination of these catalysts will likely provide substantial upward pressure on the Bovespa – especially with a hoard of “value investors” sitting on the sidelines waiting to deploy capital. 

Brazilian equities are a value investor’s dream: the 65-stock Bovespa trades around 11-12 times NTM earnings vs. ~17 times for India’s SENSEX and ~15 times for China’s Shanghai Composite. It even trails Mexico’s Bolsa (which we are short), which trades at ~14 times NTM earnings. As we say at Hedgeye, however, valuation is not a catalyst. Keeping this in mind, it is important to understand that the Bovespa is “cheap” for a reason. Those reasons include: uncertainty over the regulatory and investment environment brought on by the upcoming election, an overdependence on agricultural trade, and an oversupply of equity issuance. Below, we dive into each of these issues and the potential catalysts that might create bullish inflection points for Brazilian equities.

Issue: Investment Uncertainty/Catalyst: Jose Serra wins the upcoming Presidential election.

Investors are concerned that Dilma Rousseff (current President Lula’s hand-tapped successor) will continue to accelerate government intervention with Brazilian corporations. These fears are exacerbated by her vow to continue onward with more social inclusion, which effectively translates into even bigger government. As head of the Government Accelerated Growth Programmes (PAC I & PAC II), she is directly linked to what will amount to over $500 billion (33% of GDP) of planned infrastructure spending over the next five years. While the progress of the PAC’s and the outlook for Brazilian Infrastructure is the subject for a future debate, we do contend that Rousseff’s direct ties with these programs will likely force Brazil to keep the Selic rate at elevated levels to continue attracting foreign capital to government debt in order to finance these investments. Her promise to lower taxes will likely exacerbate this outcome, as government revenues slow from current record levels.

The obvious problem to a Rousseff-led Brazil is the lack of a multiplier effect brought on by increased government spending. Moreover, elevated interest rates will continue to hold back the pace of private sector investment, of which there is strong demand for, as evidenced by last week’s $1.93 billion purchase of a 30% stake in a unit of Usiminas (Brazil’s second largest steel mill) by Japan’s Sumitomo. Enter Jose Serra, Rousseff’s opposition for the Brazilian Presidency. Serra, who has a reputation for managerial efficiency and fiscal austerity, is in heavy contention with Brazil’s high interest rates and would likely attempt to have them lowered to unprecedented levels after reducing the wasteful spending that has plagued the Brazilian government. According to O’Globo, Brazil’s tax revenue is roughly 36% of GDP (~ Germany), but the return on government spending is akin to a country with tax revenues of only 20% of GDP (~ Chile).

In addition to fostering higher levels of domestic consumption, a lower Selic rate will create more-attractive valuations of current cash-flow opportunities by Brazilian businessmen, which will lead them to take in more foreign direct investment. As traditional economics teaches us that savings = investment globally, Serra would likely try to create a pro-business environment where Brazilian companies are able to profitbaly take advantage of China’s wealth of FX reserves ($2.45 trillion). China has invested over $2 billion YTD in the Brazilian mining industry and $10 billion last May to help Petrobras develop Brazil’s vast pre-salt oil fields. A business-friendly interest rate environment will increase the amount of foreign capital going directly to Brazil’s private industries, where such dollars have a multiplier effect. And, as we have seen earlier this year, Brazilian companies have not been afraid to walk away from capital markets when borrowing costs are too high. All told, a Jose Serra-led administration is more bullish for Brazilian equities than a Dilma Rousseff Presidency. A recent Ibope poll showed a tie in voter support at 39% each. We’ll continue to watch the campaign process closely to uncover more clues as to who will win this very important race.

 Potential Inflection Points In Brazil - Brazil Investment as a   of GDP

Issue: Overdependence on Agricultural Exports/Catalyst: Commodity reflation brought on by either a) continued dollar debasement or b) a relaxation of Chinese policy.

It’s no secret that Chinese demand largely led the world into recovery in 2009, and Brazil, a top agriculture and minerals producer, gladly went along for the ride – so much so that China overtook the U.S. in 2009 as Brazil’s top trade partner, absorbing $28.3bn of Brazilian exports. Brazil’s economy benefited greatly from the rapid growth of China’s construction industry, led by a massive expansion in domestic credit. Unfortunately for Brazil, the dollars brought in their exports have a significantly low multiplier effect on the Brazilian economy, as they are used to employ low-skilled labor in a shortened production chain. 76.8 percent of Brazil’s exports to China were commodities, including soybeans, iron ore, and oil. All told, commodities make up over 50% of Brazil’s exports (vs. only 37% in India and just 7% in China).

Now, with China tightening policies within its construction sector, Brazilian exporters are suffering, which is one of the reasons the Brazilian government announced a policy to subsidize exports to any exporters who derived at least 30% of their revenue from exports. Furthermore, the Bovespa’s woes can also be traced to a decline in commodities over the previous three months, as Brazilian equities continue to be highly correlated with commodity prices (especially with names like Vale and Petrobras dominating the float). The Bovespa, down just over 4.5% since the end of March has positively correlated r-squareds of 0.87, 0.79, and 0.88 with oil, copper, and the CRB Index, respectively, over the same duration. The Hedgeye Risk Management quant models continue to have oil and copper broken on a TREND, which suggests that the recent REFLATION we’ve seen brought on by the near 4% decline in the Dollar Index over the past month is not strong enough to counter waning Chinese demand for commodities. We’ll continue to watch closely to see how copper and oil trade, as a sustained breakout of one or both above their TREND lines will signal to us that growth commodities and perhaps Brazilian equities have caught a bid. Moreover, any relaxation by the Chinese government in their tightening policies would be very bullish on the margin for commodities and Brazilian equities.

 Potential Inflection Points In Brazil - Bovespa

Issue: Equity Supply Glut/Catalyst: The Brazilian government sells its oil reserves to Petrobras at the low end of the range.

An oversupply of equity issuance also has many investors worried about the potential dilution of potential returns to Brazilian stocks. After having Banco do Brasil SA add $5.4 billion of equity supply to the market, Petrobras, Brazil’s state-run oil company, is looking to raise $25 billion in September to help finance $224 billion in investment over the next five years. With Petrobas being one of the largest companies listed on the Bovespa, its recent ~24% decline in market capitalization has dragged the entire index down alongside it. The near $48 billion of lost market cap is the direct result of uncertainty surrounding the government’s pricing of oil reserves it will sell to Petrobras in exchange for stock. The offering was delayed by two months because the government required more time to determine the value of the oil, which will determine the size of the share sale. All told, the offering has the potential to be the largest in the Western Hemisphere since at least 1999. One needs to look no further than the Shanghai Composite (down 21.5% YTD) to get a sense of what happens to the underlying index when there’s an influx of new supply brought to the market. The only positive catalyst we see here is if the government undercuts estimates for the oil reserves and Petrobras sells less equity than currently feared. Even then, that benefit would just be on the margin.

In short, despite last week’s 6.4% gain, Brazilian equities continue to be in quite the conundrum from a directional standpoint. There are, however, a number of potential positive catalysts on the horizon which would be bullish for Brazilian equities on their own. Any combination of these catalysts will likely provide substantial upward pressure on the Bovespa – especially with a hoard of “value investors” sitting on the sidelines waiting to deploy capital.

Stay tuned.

Darius Dale