Brazil: Copacabana, carnival, commodities...and caution

Think of Brazil and you might conjure up images of carnival, Copacabana, picanha and football but away from the cities the greater part of Brazil lives simply, with a large proportion of Brazilians earning the minimum wage. The new president is Luiz Inacio Lula da Silva (Lula) and his marginal victory over the incumbent, Jair Bolsonaro, was secured by voters in the poorer regions.

Following the election result on 2 October 2022, the equity market rallied slightly before selling off a few days later. Its government bond market sent a starker signal a few weeks later, with yields moving up to 100bps in a single day on 10 November following comments Lula made regarding social priorities and the appointment of a left-leaning economic team.

I visited Brazil a couple of weeks later, at the end of November, and this time in Brazil has left us as a team incrementally cautious – it is hard not to be against this backdrop, particularly with weak domestic economic activity and fiscal uncertainty. However, China has since reopened – historically Brazil is one of the markets best correlated with Chinese strength – the dollar has lost ground and the commodity cycle has started picking up again. A mild recession expected later this year should help cool inflation and, having been among the first to raise rates, Brazil should be among the first to cut again towards the end of 2023. However, any constructive outlook can only be based on a sound new economic plan from the new government.

The market, having gone through the initial election relief rally, rolled over into the fear stage of digesting this transition, then sunk a little deeper with the rebellion stage (characterised by the riots). As we finally get to the stage of action from policymakers, things have improved and there is potential going forward to reach a stage of hope.

Balancing the books

This year will be one of slower growth for the country, coming off the back of strong GDP growth in 2022 (2.9%¹). Consensus forecasts are for c0.8%² growth this year, mostly lowered due to higher-for-longer interest rates, fiscal slippage risks and tepid consumer demand. Wages have been falling, but labour markets have already started improving and consumers in aggregate have accumulated savings built up during the pandemic to draw from which could provide an unexpected source of growth. While inflation is down from the April 2022 peak of c12%³, it remains elevated at c6%⁴ and is not expected to correct quickly from there, according to the Deputy Head of the Brazil Central Bank with whom I met.

The new administration has been clear there will be more spending which may be positive for growth but redoubles concerns on debt and fiscal discipline. Delivering on this successfully, without losing control of the currency or inflation and taking all segments of the country with them, will not be easy.

Brazil remains relevant

Benefits of a huge internal market and being highly cost competitive in the production of a number of soft commodities are significant advantages and, due to the abundant natural resources and forward action, Brazil’s energy mix is also much greener than the majority of other countries. Additionally, the country is developing truly world-leading technologies. It remains an economy that commands worldwide importance.

Lula has long been a man with ambitions for himself and for his country to be seen on ever-bigger stages, to have a seat at every table. As the leader of Brazil, he wishes to be a global leader so we could see free trade agreements, conspicuous presidential visits and reciprocal arrangements. Lula has spoken openly since the election about wanting to make a contribution to the “construction of a peaceful world order based on dialogue, the strengthening of multilateralism and the collective construction of multipolarity”. It is hugely positive that foreign policy looks set to be much more open and active again now, which could improve the outlook for foreign direct investment and future growth.

Investing in Brazil

Brazil’s equity market is notoriously as volatile as its cities are vibrant. The Ibovespa Index is concentrated in a few large-cap names in the energy and banking sectors which dictate direction and are high beta to external factors such as commodity prices, China’s fortunes and movements in the dollar (negatively correlated). However, this tells nothing of some of the home-grown quality companies that can get lost under the index heavyweights. While right now the domestic story on Brazil is less than optimal, expectations have been extensively reset among many of the high quality, growth names we look at. Historically, since 2000 Brazilian equities have returned an average of 20%⁵ during easing cycles, with the materials sector most positively geared to the upside.

For now, in the Polar Capital Emerging Market Stars Fund we have a slight underweight to Brazil. We own three long-term businesses with fundamental attractions across the technology, healthcare and financials sectors and keep a watchlist of other quality-growth companies that stack up against our existing portfolio and under our investment process. We have exited any names that were not true leaders in their industries or where we saw any sign of financial vulnerability given the economic environment – these were the biggest takeaways from the time spent on the ground in Brazil meeting companies.

It was clear from these meetings that management teams’ investment appetite to spend is just that bit more cautious, costs are being watched more closely to preserve or grow margins and the heady days of growth at all costs are behind us in favour of balancing profit.

Top-down positives are already in place to support Brazil: a softer US dollar, China’s reopening and stronger iron ore and soya bean prices. If Lula can remedy the fiscal overhang, Brazil could really outperform. That is a very big ‘if’, and history does not smile on the chances of a socially minded administration turning around a very poor fiscal stance, though there are always investment opportunities along the way.

Like many, we are in wait-and-see mode. We would like to really buy Brazil, especially with many structural problems elsewhere across the emerging markets universe, but we need clarity, and we need a reason. We are increasingly positively minded that we are at the beginning of a new commodity upcycle, where the size of demand for certain, especially green, commodities will surprise everyone – so it could just be that Lula is about to do it again.

Naomi Waistell

Fund Manager, Polar Capital Emerging Market Stars Fund

Discover more about the Polar Capital Emerging Markets Fund

Footnotes

^{1. https://www.reuters.com/world/americas/brazils-economic-activity-rises}

^{2. https://www.reuters.com/world/americas/brazils-economic-activity-rises}

^{3. Bloomberg; December 2022}

^{4. Bloomberg; December 2022}

^{5. LatAm Equity Year Ahead: Stocks for 2023. Thu Dec 08 2022 (jpmorgan.com) (page 10)}

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