Oh, Brazil! What ails thee?
We have not been convinced of any scenario in which Brazil emerges as a growth economy. We believe it simply has too many self-inflicted impediments to support material structural growth. There are always cyclical swings and in Brazil – as an example of what we call the Latin American funk – these swings are volatile, brief and brutal. Nevertheless, we believe there is a very strong investment case for investing in a handful of structurally advantaged companies in Brazil. In a market characterized by extreme excesses, prices on offer today represent terrific value.
I. The Case for Investing in Brazil amid this crisis
Brazil was truly the poster child of the “emerging market century.” The widely touted view -— amplified for a few years after the 2007-2008 global financial crisis — was that the developing world would be the dominant global growth engine, with larger emerging market (EM) economies converging toward G-7 income and productivity levels. While we are critical of this view as heuristically naïve, as we explain in greater depth in “False narratives: The myth of ‘superior’ emerging market growth,“ we have explained at length why superior economic growth is not a necessary premise for unearthing compelling investment opportunities in and around the developing economies.
Figure 1: Brazil market capitalization, in billions of US dollars
In our view, Brazil is clearly one of those economies that offers what we consider to be inferior structural macroeconomic growth, but it still has some potentially spectacular investment opportunities. Despite Brazil’s being the third-largest EM economy, its growth in the past decade was meager. On a compound annual growth rate (CAGR) basis, it retreated by close to 2%. As for its capital market, the Brazilian stock exchange’s total market capitalization has yet to rebound to the historical peak of the US$1.5 trillion it achieved in 20101. Beset by the coronavirus outbreak, returns of Brazilian equities have contracted by 54% since the beginning of the year, compared with the 25% retreat of the broad MSCI EM Index during the same period.2 In the past decade, while emerging markets saw a narrow 7% rise in returns, Brazil’s equities took the hardest hit by sinking more than 50%. The trick in Brazil is timing – and timing is all about appropriate prices.
Figures 2-3: Brazil historically has consistently underperformed broader EM equity markets
II. Self-inflicted ailments
What ails Brazil? The list is lengthy, but fundamentally we believe these are the most notable self-inflicted inhibitors to more sustainable and higher levels of growth in Brazil.
Figure 4: Brazil’s growth lagged all major EM peers over the past decade
1. Private Investment/Productivity. Investments accounted for only 15% of Brazil’s GDP in 2019, around the same level of the past four years. Foremost, growth suffers the most from unreasonably low levels of private investment. Brazil’s private investment has remained, for decades, at levels unable to beat back economic asset depreciation and support sustainable growth. In all developing economies, private investment is the lubricant to income growth, both directly and through productivity improvements.
Figure 5: Investment rates in Brazil remained uninspiring in the past decade.
2. Fiscal Challenge. Brazil struggles with an outsized state, and one that spends in what we believe are all the wrong places. Brazil’s clumsy state and prohibitive cost of capital have been crowding out private investment for years. At 38% of GDP,3 Brazil’s fiscal expenditures topped all major EM countries in 2019, while its private capital investment has been steadily falling in the past decade, hovering around 15% of GDP4 in 2018.
Figure 6-7: Brazil has one of the highest fiscal expenditures among the emerging markets
Ever since President Fernando Henrique Cardoso administration’s passage of the Fiscal Responsibility Law in 2000, Brazil has been preoccupied with taming fiscal expenditures. After recklessness during the Dilma Rousseff administration, there have been notable legislative efforts to return Brazil to fiscal sustainability. Markets cheered both the impeachment of President Rousseff in 2017 and the hard-won passage of social security reform in 2019. Social security reform which, alongside caps on real budgetary growth over the next 15 years, was estimated to help Brazil onto a path to debt sustainability. However, the cyclical budgetary requirements of the coronavirus and the political inability to enact more material cuts in civil servant wages (which account for 13% of total fiscal spending5) mean that the outsized fiscal deficit will continue to crowd out private sector investment.
3. Despite a big state presence, Brazil has been spending in the wrong places. Brazil has only about 42% of its GDP in government capital stock, well below China’s level (165%) and that of most of its other EM peers. (Figure 8) Brazil also has one of the lowest levels of infrastructure investment, which is crucial for eliminating production bottlenecks and expanding access to social services. Specifically, Brazil has invested less than 2% of its GDP over the past two decades in infrastructure, while the rest of Latin America spent 5%, on average, and the other EM countries devoted more than 6% of their GDP. A recent survey6 found the Brazilian population to be the most dissatisfied with their infrastructure services among all of the 28 major economies covered in the study.
Figure 8: Brazil’s government capital stock to GDP ratio has lagged most EM peers
4. Rent seeking and state directed capital allocation. Big government extends beyond the budget in Brazil. The influence of the leviathan is nearly everywhere, creating distortions in capital allocation. Brazil maintains direct ownership of many of the pillars of industry (Petrobras, Eletrobras, etc.) and much of the banking industry, including control of giants Banco do Brasil, Caixa, and the Brazilian Development Bank (BNDS). Although there has been a retreat post-impeachment of President Rousseff, public sector credit still represents 47% of total bank credit.6 And the state’s power to influence capital allocation runs far deeper than its direct intermediation. Private-sector banks (including foreign-owned banks), which currently contribute to about 53% of national loans, must comply with directed (“earmarked”) lending requirements, which represent nearly 30% of total private-sector bank lending.7
Figure 9: Brazil’s loan market breakdown
5. Brazil is also notorious for its unusual level of administrative complexity, including one the most challenging tax systems of any significant economy in the world, featuring more than 80 different taxes at the federal, state and municipal levels. All of these forces amplify the problem for the private sector and result in corporate incentives focused as much on rent-seeking concessions as on market-driven competitiveness. It is a testament to the leviathan power that Brazil has such limited competition in product markets and thereby structurally low levels of productivity and innovation.
6. The dual economy/inequality nexus. Just like India — as we noted previously in “India is not the next China” — Brazil has a pronounced dual economy, perpetuated by extremely unequal income distribution. The state’s hefty tax revenues amount to as much as a third of its GDP,8 a level similar to that of European welfare states. But unlike in Europe, where taxes and wealth transfers greatly reduce inequality, Brazil’s distorted social spending exacerbates the dual-economy circumstance. The imbalance is epitomized by the country’s problematic distribution of healthcare and education resources. Specifically, Brazil’s total expenses associated with healthcare added up to 8% of its national expenditures,9 or 12% of GDP in 2016,10 above the global average of 10%. However, its private sector health care, which stands as the second largest in the world after the US,11 and accounts for 2/3 of Brazil’s total health expenditures,12 is available to only 20% of the Brazilian population. In turn, the remaining population is left to suffer because of insufficient public sector disbursement.
Education is the other widely recognized structural problem in Brazil, and it is also a derivative of the country’s dual-economy structure. A typical Brazilian student spends less than 8 years at school, compared to the 8.5-year average across Latin America.13 Brazil’s education expense is overwhelmingly skewed towards tertiary education with strong “meritocratic” public universities, which are free and are populated by the upper middle class and the wealthy. On the other hand, the poor are relegated to private universities with not only lower quality but also expensive tuitions.
Figure 10: Social security and payrolls accounted for over 70% of Brazil’s national expenses in 2018
7. Brazil’s socioeconomic inequality has also decimated its growth momentum. While income inequality across Latin America fell partly as a result of labor market shifts, inequality in Brazil has been rising since 2014, with Gini coefficient/index hitting 0.54 as of 2018. Although by some definition more than half of Brazil’s population is considered middle class,14 the richest 10% of Brazilians control about 55% of national wealth, and the top 1% own 28%.15 In recent years, inequalities are further aggravated by President Jair Bolsonaro’s slashing of its landmark poverty reduction program Bolsa Familia, which has never cost the government more than 0.5% of GDP since its creation in 2003 and helped alleviate poverty for 13.5 million families through conditional cash transferring.16
Figure 11: Gini index across emerging markets
8. The closed continental economy. A final noteworthy problem in Brazil is its deliberate insularity from global competition. Brazil has been designed — since the military dictatorship in the 1960s — as an import substitution economy. After decades of this experiment, the population has been left with protected industries (capital equipment, automobiles, white goods) that amplify inequality and comparatively high price, low-quality products. There is an enormous opportunity for this continental sized economy to open up and receive much needed foreign direct investment.
Figure 12: Brazil is one of the most closed economies in the world
III. The Opportunities for Brazil
As a result of all this, we believe that Brazil will likely continue to suffer from self-inflicted obstacles to growth and progress. Nevertheless, there remains hope. The President’s cabinet — and in particular the very capable Minister of Finance, Paulo Guedes — has a very ambitious program of structural reforms intended to address many of the most pressing obstacles outlined above, including deepening fiscal responsibility (with durable cuts to public sector wage expansion), tax reform, privatization of non-core state assets, and ultimately opening up Brazil’s hermetically sealed economy to greater foreign competition and investment. We believe it is unlikely that the most ambitious parts of this program will get enacted, given the current focus on battling the coronavirus, as well as the lingering political opposition to such deep-seated reform because vested interests are particularly against wholesale tax and administrative reforms. But, as noted, we still believe there remains some hope. It is a powerful observation that the only time real structural change happens is when there is a moment of crisis, when the alternatives are limited and the pressure most intense. Brazil is one of these periods, coming after a long and extremely painful recession over the past half-decade. We expect more to come.
Still, we do not invest in hope, but rather from the result of reasoned analysis. Even in the absence of further reform, Brazilian equities are remarkably cheap, in our view. While Brazil will not be able to escape the “gap” year in growth and corporate earnings that this dreaded virus has thrust upon all global equities, there will eventually be a recovery. And the survivors — those with ample balance sheet capacity to invest in brands, channels, capacity and innovation — will win even more materially as competitors exit or fade into greater obscurity. In addition to Brazil’s having attractive equity valuations, its currency is near rock bottom, in our view. The Brazilian real has fallen sharply this year (-30% YTD17), compounding the close to 70% decline in the past five years. Against the favorable environment of structurally lower interest rates in Brazil, stocks look broadly attractive.
Figure 13: Brazilian Real vs other EM currencies (by commodity exporters vs. manufacturing countries)
Ultimately, we are investors in what we consider to be great companies and not really countries. Opportunities in Brazil include companies like Lojas Americanas, the omnichannel discretionary retail giant, and B3, the vertically integrated futures and cash exchange monopoly. We believe both have significant real options, embedded in their already powerful businesses, that are unappreciated, particularly at these valuations. We believe that sustainably advantaged Brazilian leaders in food retail (Atacadao) and iron ore (Vale) also present opportunities. We believe that valuations are a key component of returns and this crisis has afforded investors an opportunity to find attractively valued companies, including: Itau, the largest private sector bank; PagSeguro Digital, a leading fintech company; and AmBev, the Pan-American beer behemoth.
While Brazil may likely continue to disappoint the optimists, we do not think its equities will disappoint the cautious.
As of December 31, 2019, Invesco Oppenheimer Developing Markets Fund had assets in the following companies: Petrobras, 0.00%; Eletrobras, 0.00%; Banco Do Brasil, 0.00%; Caixa, 0.00%; Brazilian Development Bank, 0.00%: Lojas Americanas, 1.61%); B3, 0.94%; Atacadao, 0.95%; Vale, 0.94%; Itau, 0.44%, PagSeguro Digital, 0.33%; and AmBev, 0.00%.
As of December 31, 2019, Invesco Oppenheimer Emerging Markets Innovators Fund had assets in the following companies: Petrobras, 0.00%; Eletrobras, 0.00%; Banco Do Brasil, 0.00%; Caixa, 0.00%; Brazilian Development Bank, 0.00%; Lojas Americanas, 1.98%; B3, 0.00%; Atacadao, 0.00%; Vale, 0.00%; Itau, 0.00%; PagSeguro Digital, 2.46%); and AmBev, 0.00%
1 Source: Bloomberg, MSCI, as of 4/03/2020
2 Source: Bloomberg, MSCI, as of 4/03/2020
3 Source: IMF, 12/31/2019
4 Source: The World Bank, as of 12/31/2018
5 Source: National Treasury, JP Morgan, 12/31/2019
6 Source: Bank of America, 12/31/2019
7 Source: Bank of America estimates, 12/31/2019
8 Sources: JP Morgan, National Treasury of Brazil, as of 12/31/2018
9 Sources: JP Morgan, Brazil government, 12/31/2018
10 Source: JP Morgan, data as of 12/31/2016
11 Source: The Economist Intelligence Unit. 12. Source: JP Morgan, data as of 12/31/2016
13. Sources: JP Morgan, HDR – UNDP, 12/31/2018
14 Source: CIA, the World Fact Book, updated 4/1/2020
15 Source: World Inequality Report, 2018
16 Source: JP Morgan, as of 11/30/2019
17 Source: Bloomberg, as of 04.02. 2020. All data is subject to change and past performance is no guarantee of future results.
For the Ginni Index the as of dates for the data from each country are: South Africa, 2014; Brazil, Colombia, Mexico, Turkey, Argentina, Indonesia, Russia, and Thailand, 2018; Chile, 2017; Philippines and Malaysia, 2015; United States and China 2016; Korea 2012; India 2011.
Gross fixed capital formation (GFCF), also called “investment,” is a term used to describe the net capital accumulation during an accounting period for a particular country.
The Gini index (also known as the Gini coefficient) is a statistical measure developed by the Italian statistician Corrado Gini in 1912 and is often used to gauge economic inequality, by measuring income distribution or, less commonly, wealth distribution among a population. The coefficient ranges with 0 representing perfect equality and 1 representing perfect inequality.
Capital stock is the aggregate of government-owned assets that are used as a means of productivity, and is constructed based on government investment flows
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Investments in securities of growth companies may be volatile. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.
The opinions expressed are those of the author as of April 6, 2020, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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