BRAZIL ECONOMICS PANEL: Fundamental thinking

Growth expectations for Brazil have been revised downwards and the stock market has been volatile. Increasingly, Brazilian growth is linked to China' growth, which has slowed too. Though interest rates have been decreasing, which should be good for growth, inflation has been creeping upwards. Funds Global polled economic opinions about the world's sixth-largest economy.

FRANCESC BALCELLS, PORTFOLIO MANAGER, AND BRIGITTE POSCH (BELOW), MEMBER OF EMERGING MARKETS PORTFOLIO MANAGEMENT TEAM, PIMCO

What is the right way to deal with the slowdown in Brazil’s economy and how effectively are policymakers doing this?

Pimco expects Brazil growth to continue supported by domestic demand and strong fundamentals such as low debt levels. In addition, proactive public policies and strong support for expansion of infrastructure projects are at the core of Brazil’s plans to boost growth. Inflation in 2011 came in at the very top of the central bank's 4.5-6.5% range. Nevertheless, the central bank has clearly assigned more weight to the deflationary impact of the global deceleration.

Since then inflation has come down to 5% (as of May 2012). The unemployment rate has been decreasing in past years, reaching 5.8% (as of May 2012). We expect the Brazilian central bank to continue normalisation of the policy, bar negative global financial and economic shocks.

Additionally, some specific sectors targeted by stimulus measures might see continued benefits in the longer term. In particular, exporters may benefit from the government’s willingness to intervene in the currency exchange markets in an effort to prevent appreciation of the Brazilian real, and also from further regulation and loosening monetary policy that ultimately could result in a weaker currency and cheaper and more competitive Brazilian exports.

What should investors make of the argument that Brazil is more stable now, yet five-year government bonds are yielding 10%? Does this not indicate a lack of confidence in Brazil’s economic outlook?

Brazil has undoubtedly made great progress over the past ten years, especially when it comes down to the structure and composition of the public sector debt, the strengthening of the institutional framework, and the ability of the central bank to deliver on its inflation targets.

We think the market has recognised that by allowing the level of real interest rates to drop to historically low levels, they still remain abnormally high relative to other emerging market countries. For this real rate convergence to narrow further, Brazil needs to continue on the path of reforms and make sure the balance between monetary, fiscal and structural policies is one conducive for sustainable non-inflationary growth.

As the Selic [the central bank’s overnight rate] declines, it makes it harder for local institutional investors to meet their actuarial target, which has been around inflation plus 4% to 6%, since a large part of their investments are allocated to fixed income. Therefore, we expect a greater demand for Brazilian corporates and other asset classes. According to Bank of America, pension and mutual funds are two of the major investors in Brazil with 597 billion Brazilian reales ($292.5 billion) and 2,080 billion reales in assets, respectively.

By reducing the Selic rates, the government also reduces the amount of debt linked to the Selic interest rate, and tries to promote more lending either through individual or corporates. Ultimately, they want to increase demand for long-term bonds and foster GDP growth.

How ‘decoupled’ is Brazil from the economies of the European Union and the US?

Brazil is a well-diversified and globally financially integrated economy and, as such, it can’t be immune to developments in the EU and the US. That said, from a trade perspective, Brazil is a relatively closed economy, with exports to GDP accounting for a little more than 10% – small for international standards. Of this 10%, less than 5% accounts for exports to Europe and the US. Financially speaking, developments in Europe and US can impact Brazil via two channels: deleveraging by European and US financial institutions on Brazilian credit exposures; and a hit on Brazilian financial assets stemming from global risk aversion derived from risks in the eurozone and the US.

On the former, international cross-banking exposures in Brazil are relatively small and we don’t expect this to be a major issue looking forward. The latter is more significant, and will continue to pose a challenge to Brazilian financial assets in terms of performance.

On the corporate side we believe the credit fundamental impact is minimum since only 1.8% of GDP is exported to the eurozone. However, on a technical perspective, credit product in general will be impacted on a mark-to-market basis.

Is the Brazilian consumer in a healthy position?

Elevated loan growth should be considered in the context of relatively low credit penetration across emerging markets, which we believe supports a strong secular loan growth profile. For instance, loan penetration in Brazil – approximately 49% of GDP as of 2011, according to the central bank – still pales in comparison to over 135% across developed economies (Source: Bradesco). Although the payment-to-income ratio in Brazil is greater than in the US, the total household debt-to-income is significantly lower: 38% as reported by the central bank versus 130% of GDP in the US, as of 2011, and according to data from the Federal Reserve Board and Haver Analytics. And though Itau Unibanco reports that housing loans also increased six-fold from 2006 to 2011, they still only represent around 5% of GDP.

Though we regularly caution emerging market banks not to aspire to developed market credit penetration levels, we do believe upward social mobility warrants an accompanying order of magnitude shift in credit availability. Brazil’s relatively low unemployment rate, strong real wage gains and a stable macroeconomic environment continue to be drivers of credit penetration.

SEBASTIAN LUPARIA, PORTFOLIO MANAGER, BRAZIL EQUITIES AT JP MORGAN ASSET MANAGEMENT

What is the right way to deal with the slowdown in Brazil’s economy and how effectively are policymakers doing this?

We are cautious on the short-term outlook for Brazil. Despite significant policy measures a recovery in industrial and manufacturing activity is not yet evident. Economic and earnings growth expectations are being adjusted downwards. The long-term trajectory of government policy is also a concern for investors, particularly when it impacts important equity market sectors like banks, and companies like Petrobras, while failing to address concerns about long-run competitiveness.

Despite these risks, the equity market has already discounted a lot of bad news. The recent correction in the Brazilian real has taken the currency closer to our fair value target and is bringing relief to the industrial sector.

From a portfolio management perspective, we believe the right way to deal with this is to focus on businesses that are generating strong cash flows based on having their own drivers (that is, benefit from increasing penetration) and are less dependent on the macro-economic environment.

What should investors make of the argument that Brazil is more stable now, yet five-year government bonds are yielding 10%? Does this not indicate a lack of confidence in Brazil’s economic outlook?

Yields of 10% are indicating improvements in government financing cost combined with lower inflation rates, which today is significantly lower than five years ago. Today, the government balance sheet is much stronger – net debt/GDP is at 37% versus 46% in 2007. As such, confidence should be stronger about the country’s risk profile.

It should not be linked with the economic outlook and growth. Growth has been lacklustre at a time when rates have been declining.

How ‘decoupled’ is Brazil from the economies of the European Union and the US?

Today, Brazil is more linked to China than to the US. China represents 17% of total exports versus 13% for the US, so whatever happens in China will have an impact on Brazil. Europe has been extremely strong in terms of foreign direct investment (FDI), accounting for 50% of FDI over the past ten years.

Is the Brazilian consumer in a healthy position?

Yes, we believe so. There are some concerns that consumers could be overburdened if the current rapid loan growth continues, but we believe that private sector banks understand the risks and are therefore not pushing growth in this area.

MARCO A SPINAR, ASSOCIATE PORTFOLIO MANAGER, GLOBAL EQUITIES, HEAD OF EMERGING MARKET EQUITIES, NEUBERGER BERMAN

What is the right way to deal with the slowdown in Brazil’s economy and how effectively are policymakers doing this?

Like every economy in the world, Brazil would like to sustain higher growth without causing inflation. And like every other economy in the world, Brazil has some endogenous, structural impediments to achieving higher growth. Relative to other emerging markets, Brazil scores below average in terms of a sound foundation for sustainable growth. I would argue the three major endogenous challenges are a low savings rate, a complicated and inconsistent tax code, and rigid and under-productive labour.

One key driver of growth for all emerging markets is investment in infrastructure and the broader capital stock. The soundest way to support that investment is through domestic savings.  

Brazil rates below average on this metric – largely for cultural and historical reasons. Although Brazil can supplement its savings with foreign savings – FDI or portfolio investments – the cost creates challenges to sustained investment.

On the tax code, there are significant differences between states on value-added tax and other taxes. This complicates business for foreign and local companies while also encouraging tax-competition between states that often leads to a poor capital allocation.

In terms of the labour market, Brazil is marked by two very different factors. On the one hand, unemployment has been on a steady decline for nearly a decade boosting consumer confidence significantly. On the other hand, Brazil has had very little productivity growth. Given that wage growth has generally exceeded inflation, Brazilian labour has become much less competitive.

It’s also important to point out the negative impacts of Brazil’s highly volatile, and, arguably, overvalued currency, the real.  Although there have been some benefits to Brazil’s appreciating currency (most importantly the downward pressure appreciation has had on inflation), it has exacerbated Brazil’s competitiveness ‘problem’ and impeded development of the industrial sector, which is highly sensitive to imports.

Of these three challenges, Brazil appears most likely to make headway on its tax problems. Unfortunately, the low savings rate and under-productive labour are unlikely to get addressed during the current administration in a meaningful manner.

What should investors make of the argument that Brazil is more stable now, yet five-year government bonds are yielding 10%? Does this not indicate a lack of confidence in Brazil’s economic outlook?

The high yields on government Treasuries reflect two factors. First, low savings; and second, a history of hyperinflation. Yields have been on a steady down trajectory as inflation has sustained below the 10% level. I would expect that to continue – as long as inflation does not reassert itself above 10%.

How ‘decoupled’ is Brazil from the economies of the European Union and the US?

Relative to the EU and US, the Brazilian economy is one of the more decoupled in the emerging markets. Brazil does not have significant trade with these economies and it also boasts a very large domestic market, which supports growth when exports are weak.

There are two important caveats. First, Brazil is highly dependent on foreign capital (because of a low savings rate), which itself is highly driven by EU and US sentiment. Second, Brazil’s terms of trade and the stock market are highly dependent on commodities (especially base metals), which are in turn dependent on Chinese and global growth.

Is the Brazilian consumer in a healthy position?

In terms of propensity to consume, the Brazilian consumer is healthy.  Unemployment is low, wages are growing and consumer confidence is at the top end of its range for the last couple of decades. The capacity to consume, however, is constrained by a very high proportion of income which goes to servicing the recent explosion in household debt.

LARS PEDERSEN, SENIOR ECONOMIST, GLOBAL ECONOMIC RESEARCH, ALLIANCEBERNSTEIN

What is the right way to deal with the slowdown in Brazil’s economy and how effectively are policymakers doing this?

If we see the problem of Brazil as an extended boom of higher real wages and social safety nets, amplified with consumer debt, then Brazil has a problem of justifying the high real incomes that have been created. That implies higher investment in productive industries, and higher savings. That in turn means getting interest rates down and getting the currency down in value in a way that allows interest rates to stay low.

What should investors make of the argument that Brazil is more stable now, yet five-year government bonds are yielding 10%? Does this not indicate a lack of confidence in Brazil’s economic outlook?

This is the result of a tax on foreign investment of 6% on funds going into longer dated bonds, and will have to come off eventually. It was imposed while every effort was made to stop capital inflows that were keeping the currency too high. The absence of local buyers at the long end is due to the long history of a dual-interest rate system (low official lending rates and high market rates). Unifying these rates is a precondition for a business investment expansion.

How ‘decoupled’ is Brazil from the economies of the European Union and the US?

A large share of Brazilian iron ore and agricultural exports go to China. So the coupling we should worry about is three-sided. If Europe has a problem and that hurts China’s exports, then its imports in turn from Brazil will be affected. It’s a small world.

Is the Brazilian consumer in a healthy position?

Consumers in Brazil are not in a healthy position after a long consumer credit expansion. Most vulnerable will be certain segments of the poorest part of the work force that have incurred high debt service ratios. Recent banking data shows rapidly rising late payments that probably arises from this segment of borrowers.

JEROME BOOTH, HEAD OF RESEARCH, ASHMORE INVESTMENT MANAGEMENT

What is the right way to deal with the slowdown in Brazil’s economy and how effectively are policymakers doing this?

Growth and equity valuations are not directly linked. In my view, equities are fundamentally cheap in Brazil. Growth has slowed but is now rebounding, and the major infrastructure investment programme announced should help raise the non-inflationary sustainable growth rate.

The infrastructure investment being planned is still too small. The lack of infrastructure is causing major bottlenecks. Domestic savings alone are insufficient to meet this challenge and should be complemented by better efforts to harness foreign portfolio inflows from stable institutional investors – the very investors currently dissuaded from investing due to taxation on fixed income inflows.

What should investors make of the argument that Brazil is more stable now, yet five-year government bonds are yielding 10%? Does this not indicate a lack of confidence in Brazil’s economic outlook?

No – it simply indicates still high, though reducing, interest rates! And in our view is a great opportunity for investors.

How ‘decoupled’ is Brazil from the economies of the European Union and the US?

The term decoupling is highly misleading. There is no decoupling in a globalised world, but Brazil is one of the safest investment destinations, along with a number of other emerging markets, in the worst North Atlantic depression and currency-crash scenarios. Brazil is a closed economy with domestic factors overwhelmingly significant for its future economic progress. Of its international trade, only about 30% is with the HIDCs (Heavily Indebted Developed Countries) of the US and EU which pose more risk.

In 2008 Brazil was impacted in two main ways.  First, cross-border finance was suspended yet EU and US banks have now been largely replaced by Brazilian banks. A repeat would not be as damaging. Second, uncertainty caused a delay in investment projects, causing a quick one-year business cycle. Again, the country is more prepared this time. 

Is the Brazilian consumer in a healthy position?

At the moment consumers are fine and pose no significant systemic risk. While there is talk of the consumer being over-levered, the interest rates on debt are coming down and terms are getting longer. NPLs [non-performing loans] are correlated to employment and GDP.  Yet salaries are still rising, unemployment is low, and growth is rebounding. 

Demographics and improving income distribution point to buoyant consumer markets in Brazil.

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