EQUITIES: Falling flat in São Paulo

WaterfallBrazilian equities have had a difficult 18 months. Nick Fitzpatrick finds that despite a good first quarter, this asset class of the future is still troubled. What on Earth is the matter with Brazilian equities, a market packed with so much promise and which is meant to be growing as Europe and the US recede? Although along with China and India it is seen as a key investor destination of the future, the Brazilian market has sputtered along this year, just as it did in 2011. There were hopes in January when the Bovespa Index (IBOV) thundered into the new year that the difficulties of 2011 – when inflation weighed on stocks and a devaluation of the Brazilian real hit international investors – would be left well behind. Optimism only grew as the IBOV went on to have one of its best first quarters for years. But hopes were faltering by the summer. On June 5 the IBOV fell to 52,481.44, its lowest level so far this year. It had hit 68,394.33 at the end of the first quarter. By the beginning of September, the market was down around 7.4% year-to-date in dollar terms, and down 14% over 52 weeks. The message for investors appears to be: avoid Brazilian equities until positive signals emerge (for example, growth in China), or be careful what you buy. The trouble with the Bovespa is that a lot of it is exposed to commodity and oil prices. In the world market nearly all raw-materials values have declined in recent months thanks to China’s slowing growth. “China’s growth is very important for investor perceptions of Brazil,” says Nicholas Morse, who manages the Schroders ISF Latin American fund quoted in Luxembourg. China, the world’s second largest economy, is a major trading partner for Brazil, the world’s sixth largest. Around 17% of Brazilian exports are to China, its largest customer ahead of the US which accounts for around 10%. Though oil may be reasonably priced still, the huge Petrobras enterprise, Brazil’s semi-public multinational energy company headquartered in Rio de Janeiro, has had its problems, such as government interference and poor oil production, says Morse. Then there has been government involvement in telecoms and utilities – considered a defensive sector and another major segment of the market that was until recently performing well. To try to tackle the ongoing problem of inflation, the government tasked the country’s telecoms regulator with controlling prices. The government has also capped or reduced electricity prices to stimulate demand and promote competition in the industry. Inflation
You can’t blame the Brazilians for taking hard measures against inflation. Morse says: “Inflation was a bad problem in Brazil until the Cardoso plan in 1994 [created by then minister of finance, later president, Fernando Henrique Cardoso]. Inflation is ingrained in the Brazilian psyche. Whenever inflation expectations pick up, investors get jittery.” The weapon of stamping down on electricity prices has come at a time when the government’s interest rate action has been counterintuitive – to lower, not raise, interest rates. According to Morse, this is the government being “so worried about growth that it’s prepared to take a risk with inflation expectations”. He adds: “Many economists have revised their growth expectations downwards to 1.5%, which is not strong for a great economy that is said to be the future of the world. At the beginning of the year most people were expecting growth to be around 3%.” As well as commodities and oil, and telecoms and utilities, a third and final main segment of the Brazilian market, says Morse, is domestic stocks -those earnings tied more to Brazil. There is a divergence of performance in this segment, with some companies not only in poorly performing sectors, but which are also poorly run, the fund manager says. As an example, homebuilders are out of favour with Morse, while shopping mall operators are in favour. The latter are in a good sector and they are well-run companies, he says. As it has taken money out of certain areas like basic materials and oil, Morse’s fund has moved to an overweight position in financials, particularly those with exposure to property and shopping malls. In broader terms, says Morse, the fund is overweight mid-cap and underweight large caps, overweight domestics and underweight exporters. A good or improving free cash flow is also important. “Brazil is high risk. It is at the cutting edge of risk assets,” he says. It was a difficult market in the past year, but positive signals would be growth in China and stability in Europe. ©2012 funds europe

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