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The Brazilian Consumer: Capital Chases Yield

Conclusion: Don’t mistake yesterday and today’s weakness in the Bovespa for anything more than a global selloff due to weak U.S. economic data. At a point, U.S.-centric investors will be forced to look to places other than U.S. Treasuries and equities for a rate of return. We feel the emerging market consumer in places like China, SE Asia and Brazil will see the bulk of that investment.

 

Position: Long Brazilian equities (EWZ).

Today we sold our exposure to Indonesian equities for a modest 2.7% gain because we didn’t want to overstay our welcome, particularly as it relates to trade exposure to an increasingly weak U.S. consumer (10.5% of all Indonesian exports in 2009). Furthermore, we’d be remiss to suggest that exporting nations like those of SE Asia, China and Brazil will flourish if our estimate that U.S. GDP growth in 2H10 and 2011 comes in at about half of current consensus estimates. With that said, however, everything that matters in Macro happens on the margin. And in an environment where growth and trade are slowing globally, the marginal direction of domestic consumption will be paramount as it relates to where capital will likely flow.

We know what direction U.S. consumption growth is headed – down. Contrast that with the direction Brazilian consumption looks to be headed – up. As a result of favorable employment, inflation, and credit conditions, the Brazilian consumer is strengthening. Unemployment is 20bps off all-time lows, inflation has improved on the margin for the past three months (down to 4.6% in July vs. 4.84% in June), and, as a result of benign inflation, interest rate hikes have come to a halt (recent reports suggest the central bank expects 3Q inflation to come in below forecast, further reducing the risk of a Selic Rate hike).

The confluence of these three factors creates a bullish setup for the Brazilian consumer, which has been supported by recent data: 

  • Shopping Spree: Brazil’s June retail sales came in yesterday at +11.3% Y/Y, up from 10.2% Y/Y in May and the 1% M/M increase far exceeded consensus expectations of a 0.3% gain. The 11.5% gain in 1H10 was the largest gain ever on a six-month basis.
  • Taking on Debt: According to Brazil’s National Chamber of Commerce, the number of Brazilian families in debt rose from 57.7% in July, to 59.1% in August.
  • And Paying It Off: Credit reporting agency Experian reported a 1.74% delinquency rate among Brazilian checks in July – the lowest reading since 2004!
  • With High Hopes for the Future: For the fourth consecutive month, Brazilian families intend to consume more than the prior month. The consumer index of the National Chamber of Commerce rose 0.7% in August, to a reading of 134.4. Brazilians also expressed increasing satisfaction with their current employment and optimism about their professional opportunities, up 2% and 1.2% respectively. 

Globally, P.E.M.A.C. (private equity, M&A and capital markets) has been investing in this trend, and with the economic situation slowing in the U.S., we should see even more of this activity. According to KPMG Brazil, the number of Brazilian companies acquired by foreigners has more than doubled Q/Q in the second quarter. The 56 acquisitions (vs. 21 in 1Q10) was the highest second quarter number since the data started being tracked in 1994. Of the 77 total acquisitions in 1H10, more than one third were by American firms. It seems all that cash on U.S. corporate balance sheets that many bulls are hoping to fuel a cycle of investment domestically is leaving the country in search of higher growth and higher rates of return. Capital Chases Yield… globally. To affirm, international investors bought a net $1.35 billion of Brazilian domestic bonds in June, boosting their holdings to $13.5 billion in 1H10 – the most in three years.

The Brazilian Consumer: Capital Chases Yield - 1

Managing Risk

As always, our style of investing requires a prudent risk management approach that is duration agnostic. Given, we will continue to analyze and interpret the near-term risks to our long position in Brazilian equities. We don’t have to be bullish on the Brazilian consumer in perpetuity or at every price, so we’ll manage risk around market reaction to the Petrobras saga and the upcoming Presidential election.

Regarding Petrobras, recent reports suggest the company and the government remain split over the price of the oil reserves which will determine the size of the company’s upcoming share offering. As a refresher, the higher the price the government slaps on the oil, the more equity Petrobras will have to issue, creating further dilution of the share base. Market sources believe the government’s consultant priced the barrels at $10-12 per barrel vs. Petrobras’ consultant’s estimate of $5-6 per barrel. ANP, Brazil’s oil regulator sees a “reasonable” price for the oil somewhere in between, around $8 per barrel. The pricing disconnect has some investors worried that the share sale, which has a Sept. 30 target (three days before the election), could be delayed as far as 2011 on speculation that the elections and earnings season will force the issuing to take a back seat. Further uncertainty and speculation from here will continue to weigh on Petrobras’ stock price and, as a result, the Bovespa (Petrobras is Brazil’s second largest company by market cap).

With regard to the elections, it appears Lula endorsee Dilma Rousseff has taken a commanding lead. The latest IG poll shows Rousseff doubling her lead to 16 percentage points over opposition candidate Jose Serra. Support for Rousseff rose to 45% from 41% in the previous poll taken during July 17-20. Serra’s support fell to 29% from 33%, while Green Party candidate Marina Silva’s support was unchanged at 8%. A candidate needs more than 50% of the vote, excluding blank or invalid ballots, to win in the first round and the trajectory of Rousseff’s support suggest a victory for her in early October. The key takeaway here as it relates to the Brazilian economy is that former cabinet chief Rousseff is widely believed to be in support of big government spending, particularly when compared to the more austere Serra. Critics agree that her support is likely a function of her affiliation with current President Lula, whose social welfare programs and increased spending earlier in the year made him a very popular man amongst Brazilian voters. Investors fear that a Rousseff-led administration would bring about inflationary government spending and central government balance sheet deterioration, as her vow to cut taxes will likely force the government to fund any increases in spending via more debt issuance. This is all negative for the Brazilian private sector (and equities), as the need for higher interest rates to fight inflation and attract capital to public debt will keep a lid on private investment and credit expansion. Time will tell whether these fears are warranted.

For now, we are comfortable with our long position in Brazilian equities.

Darius Dale

Analyst