Perspectives on the Economic Evolution of Brazil
inasmuch as the brazilian government has taken an aggressive stance to combat inflation while providing stimuli necessary to jumpstart its economy, investors need to determine whether the risk/reward profile of a highly concentrated portfolio of brazilian assets can be justified on a risk-adjusted basis.
After an extended period of solid economic performance and equity market returns, headwinds are pushing Brazil into a challenging phase of its global emergence. From 2003 to 2010, growth in Brazil was fueled in large part by rising commodities prices for core exports, including soybeans, sugar, coffee, crude oil and iron ore. Demand from key downstream markets such as China and Europe base-loaded Brazil's economy, and when coupled with smart fiscal policies, Brazil paved the way for strong economic growth and an increase in the size of its middle class.
Following the global financial crisis, Brazil was one of the first major economies to post a strong recovery. Brazil's dip during the crisis was not as severe as other markets, with growth of 6.1 percent in 2007 and 5.2 percent in 2008, compared to 1.9 percent in 2007 and -0.3 percent in 2008 for the United States. Its recovery in 2009 and 2010 exceeded most other leading economies, with growth of -0.3 percent in 2009 and 7.5 percent in 2010, compared to -3.1 percent in 2009 and 3.0 percent in 2010 for the U.S.
Since 2010, Brazil has been dealing with a number of economic issues—some are the result of its success. Heightened investor demand strengthened the Brazilian Real and at the same time made Brazil less competitive in global commodities markets. Largely through the use of taxes, interest rates and currency controls, the Brazilian government took steps to cool the economy following 2010. Today, a number of factors are clouding the investment landscape in Brazil and, when viewed collectively, may influence investors to consider other options as part of an overall diversification and risk mitigation strategy.
Inflation and real rates of return
Since the adoption of the Real Plan and the introduction of the Real in 1994, inflation management has been a central component of Brazil's economic policies. The government communicates inflation target ranges and uses its available tools to keep inflation within that range. The current target is 2.5 percent to 6.5 percent.1 Reported inflation rates are currently beyond the upper end of the target (6.7 percent through June of this year), and this limits the government's ability to use its full panoply of tools to stimulate the economy.
Beginning in 3Q11, Brazil began aggressively reducing its benchmark risk-free rate (SELIC) to help stimulate economic growth. Rates decreased from 12.5 percent in 3Q11 to 7.25 percent in 4Q12. This policy required inflation to stay within the target range. However by 1Q13, inflation levels had become intolerable and the government began to reverse course and raise interest rates. In 1Q13, the spread between SELIC and actual inflation declined to its lowest level since the introduction of the Real (see figure 1). Declining real rates of return limit the government's ability to fully use the stimulus provided by lower interest rates. The SELIC rate is currently at 8.5 percent and the government has a stated year-end target of 9.25 percent to 9.5 percent.
Equity market performance
Aside from stellar performance during the recovery of 2009, Brazilian equity markets have been negative and/or have underperformed other global markets (see figure 3). Prior to 2010, Brazilian investors had grown accustomed to higher than average volatility and higher than average equity returns. Subsequent volatility has remained high, but absolute returns have lagged broader global indices. Recent interest rate reductions and broader economic stimulus have not provided significant lift to the Bovespa. Historically, rising inflation has served as a leading indicator of downward pressure on equity market valuations (see figure 4).
Equity market capitalization remains at historically high levels, at 54.6 as percent of GDP in 2012 (see figure 5 for historical data). Brazil is also the world's sixth largest investment funds market with approximately $1.1 trillion of assets under management.
Agricultural products, metals and crude oil are leading Brazilian exports and approximately 40 percent of all exports are concentrated across five commodities:5
- Soybeans represent 6.4 percent
- Sugar is approximately 5.9 percent
- Coffee is 2.4 percent
- Iron ore and related products constitute 16.3 percent
- Crude oil represents an additional 10 percent
The overall commodity price index has slumped approximately 13 percent since peaking in April 2011. Although the index is elevated when compared to historic levels, this will nonetheless present a challenge to Brazil as the economy adjusts to more normalized pricing and reduced global demand. From 2003 to 2012, the Real appreciated along with investor demand for Brazil. As the Real appreciated, Brazil's pricing advantages for global commodities deteriorated. To combat this, the government has allowed the Real to weaken over the past six quarters. The country's currency strategy has shifted to provide support for Brazilian exports and attract investment to modernize the country's infrastructure. The challenge for the government will be controlling inflation through rate increases that will potentially provide lift to the Real while managing to an overall need for a weaker currency to support local industry growth.
Brazil supplies approximately:
41 percent of the world's soybeans
and one-third of the world's coffee
GDP growth and broader fiscal policy
Brazil is a highly regulated market and the government uses a variety of tools to control demand and market activity. An array of taxes on imports, domestic manufactured goods, capital inflows and energy production are used at varying times throughout the economic cycle. Over the past several quarters, Brazil has significantly reduced taxes on capital inflows to provide additional incentives for investors focused on infrastructure projects. The government has also removed capital inflow taxes focused on "hot money" (defined as foreign capital chasing high, short-term interest rates). It has converted a sizeable payroll tax to a smaller domestic sales tax. The government has also implemented a 20 percent tariff reduction on electricity prices.
Although a number of measures have been installed to attract capital to critical areas of the economy, reduce employment costs and reign in prices, Brazil's economic performance will reflect the performance of its key trading partners. Further slowdowns and muted recoveries among the countries listed in figure 8 will have an adverse impact. Government policies and fiscal strategies can position the country for a recovery, but downstream linkages to certain key countries mustn't be overlooked.
Diversification through globalization
Inasmuch as the Brazilian government has taken an aggressive stance to combat inflation while providing stimuli necessary to jumpstart its economy, investors need to determine whether the risk/reward profile of a highly concentrated portfolio of Brazilian assets can be justified on a risk-adjusted basis. Key drivers of local economic performance and GDP growth have recently been under pressure. Rising interest rates will offset previous government efforts to inject capital into the economy and stimulate demand. Relatively high tariffs on imports put additional inflationary pressures on consumer goods and higher inflation will negatively impact real rates of return. Falling commodities prices will impact important agricultural and mining segments of the economy. Several complex economic issues need to be addressed and the government is using its available tools to balance these moving parts.
Global markets and indices have outperformed Brazilian equity markets in each of the previous three years. Major asset owners in Brazil have significant pools of capital that have been largely invested within the country's borders. The nearly $2 trillion of capital held by Brazilian insurance companies, pension funds and investment managers is minimally invested offshore. Part of this is due to regulatory restrictions that limit the amount that can be invested outside of the country.
Another driver is lack of experience and unfamiliarity with structuring vehicles and strategies necessary in providing diversification while safeguarding investments. Properly structured vehicles domiciled in jurisdictions with transparent investment fund regulations allow asset owners to efficiently execute global investment strategies that will help them offset "Brazil-only" country risk. Whether individually (single participant in a single vehicle) or collectively (multiple participants in a single vehicle), Brazilian asset-owners should explore offshore investment strategies as a complement to their overall asset management goals. Following a full Brazilian recovery, offshore investment strategies should continue to receive allocations as part of overall diversification.
Trade and Exports
- Accounting for only 6.7 percent of Brazil's exports in 2007, trade with China has grown significantly in recent years.
- China consumes 45 percent of Brazil's iron ore and related products exports, as well as 66 percent of grains, seeds and fruits, of which soy is the largest component.
- Roughly 22 percent of mineral fuels and oils exports and 28 percent of iron and steel exports are destined for the U.S.
- Russia takes in a large portion of Brazil's meat and sugar exports, at 11.3 percent and 12.3 percent respectively.
Special thanks to Julia Harrigan for research contributions.
1 Banco Central do Brasil.
2 IPCA: Inflation rate, standing for Índice Nacional de Preços ao Consumidor Amplo = Brazilian Consumer Price Index.
3 BCB: Denotes median of Central Bank of Brazil survey on inflation expectations.
4 The "asset allocation" portfolio assumes the following weights: 25 percent in Real Rates, 25 percent in Nominal Rates, 10 percent in Brazilian Equities, 10 percent in World Equities, 10 percent in Risk Free, 10 percent in Commodities and 10 percent in EM Debt. All asset class returns are in BRL currency. Past performance is not indicative of future returns.
5 International Trade Center, USDA, GlobalData, Brazilian Ministry of Development, Industry, and Foreign Trade, National Petroleum Agency.