Postcard from Brazil

Alasdair McKinnon looks for signs of turnaround in Brazil following his trip to São Paulo and Brasilia.

Ten years ago, Brazil was the darling of global investors and a major destination for international investment flows. Much was made of its emerging middle class and booming resources sector. What could possibly go wrong?
Too much cheap money, as it turned out. Brazil was a good fundamental story, but a credit bubble soon began to grow. The rot set in, with rampant corruption and spendthrift populist governments. Then, not only did the credit bubble burst, but global conditions meant that demand for Brazilian resources collapsed, and credit dried up altogether. The economy experienced an 8% real-term decline, and inflation rose as high as 11%.

So what’s happening now? The most obvious development is political change. Following Dilma Rousseff’s impeachment last year, Michel Temer’s administration is pursuing a reform agenda. Temer’s government has defended the currency and refrained from simply putting up wages – too often the response to past economic crises.

Corruption casts a huge shadow, of course. The Petrobras ‘car wash’ scandal has threatened to engulf just about every Brazilian politician – with Temer no exception. He’s currently mired in graft allegations, putting the future of his presidency in doubt.

‘there are clear signs of economic improvement. Growth has returned, and inflation is falling’

But there’s also a clear desire for corruption to be rooted out. All the bureaucrats we met were adamant about this, and the judiciary appears to agree – as the reach of the ‘car wash’ case shows.

Meanwhile, Temer’s government is pressing ahead with labour reforms. Laws from the 1980s and 1990s are being repealed, and bizarre practices, such as paying workers for an eight-hour day but having them work only six hours, are being rolled back. Much-needed pension reform is also on the agenda.

Brazil also now has a relatively stable currency. The real is weaker than in the boom days but hasn’t collapsed despite all the economic turmoil. And its modest recent weakness is making exports more competitive.

Meanwhile, there are clear signs of economic improvement. Growth has returned, and inflation is falling. From over 11% at the start of 2016, the consumer price index has reached an 18-year low of 2.46%.

This has allowed the central bank to cut interest rates to 8.25%. Rates are expected to fall to 7.5% by the end of 2017 – and possibly further thereafter. The implications for equities are obvious. There’s a clear contrast with the West, where interest rates can only really rise. So Brazil’s circumstances should provide plenty of investment opportunities.

Where might those opportunities lie? Growing consumer appetites offer one interesting avenue. The divide between rich and poor is still all too stark in Brazil. But the material wealth of everyone has improved.

Take the favelas, for example. The houses in these shantytowns used to be literally built of rubbish: cardboard, scrap metal and scavenged lumber. Today, favela houses are built of brick and have running water. Another sign of progress is how widespread air conditioning now is.

But there’s still plenty of room for further improvement. Only around a quarter of households have flat-screen TVs or microwaves. So there’s a lot of scope for people to improve their lives through simple measures – and a lot of energy and optimism about the future.

That’s why consumer companies like Ambev, which we hold in our portfolio, see ample opportunities for growth. Lots of Brazilian people are still drinking cachaça, the local firewater. That gives beer companies like Ambev plenty of space to expand.

Retail also offers opportunities. Interestingly, e-commerce isn’t the game-changer that it is elsewhere. Although Brazil now has broadband and adequate distribution networks, it lacks the capacity to allow online purchases to be returned easily. Also, for the poor, e-commerce is not an option. In the lawlessness of the favelas, leaving packages with neighbours is out of the question. Shopping malls are doing well, however; in Rio de Janeiro, they are seen as oases from urban unrest.

‘as economic conditions improve, these (manufacturing) companies are in great shape to exploit improving circumstances’

Meanwhile, manufacturing companies, which suffered during the downturn, have cut costs to reflect realities. As economic conditions improve, these companies are in great shape to exploit improving circumstances, and the weaker real means that exports are growing again.

Although commodity companies still dominate Brazil’s equity market, it also offers lots of infrastructure companies with big yields. These will become even more attractive as interest rates fall.

Finally, the country is tackling the distortions caused by state-owned giants like Petrobras, the company at the centre of the ‘car wash’ scandal. It is restructuring to reduce its debt burden and render itself less vulnerable to the politically motivated fuel subsidies that caused much of that debt. The Temer administration is also moving to privatise the state-owned power company Electrobras.

We see Brazil as an ‘ugly duckling’ market. It is currently unloved, and its opportunities are overlooked. But when the cycle turns – as it will – investors who have seized those opportunities early will stand to benefit the most.

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