Brazil – The Great Comeback
Things have not been easy for Brazil in recent years. Despite hosting the world at the 2016 Rio Olympics, the surge in tourism and associated stimulus had little effect on Brazil’s economic woes. In fact, international confidence has hit rock bottom, following three long years of recession and political turmoil. But could 2017 see a return to form for Brazil? Yes, the political risks remain meaningful and the structural reform agenda remains uncertain but higher commodity prices, a large real currency depreciation and the impact of very high interest rates have led to a significant improvement in the current account on the back of much reduced domestic demand. As a result, we believe Brazil is poised to turn the corner and start its great comeback.
The stabilisation in the Brazilian Lira as well as the political situation allowed the central bank to keep rates on hold for the first three quarters of 2016. This ended the hiking cycle that took the SELIC rate up 325 basis points, from 11.0% in mid-2014 to 14.25% (a nine-year high) in the third quarter of 2015. In the fourth quarter of 2016, the central bank actually made two cuts of 25 basis points each, meaning the SELIC rate finished at 13.75% at the end of the year. Looking ahead, the market is expecting the benchmark rate to be cut by a further 300 basis points over 2017 (to 10.75%), pricing in cuts of 50 basis points for each of the first five meetings in 2017, and another cumulative cut of 50 basis points for the remainder of the year. While we agree that an improved outlook on inflation and better investor sentiment towards Brazil should allow the central bank to lower rates substantially, we believe that market expectations are fairly aggressive. Cumulative cuts of between 200 and 250 basis points seem more likely, however we concede that market expectations could materialise if the inflation picture improves faster than expected.
Given the above, we do not see much value in the front-end of the interest rate curve in Brazil at present. However, the mid- to long-end seems more appealing. In our minds inflation can trend lower over a multi-year period and beyond 2017, not much is priced in in terms of interest rate cuts. Apart from nominal interest rates, we also see potentially interesting opportunities in real rates, which are currently among the highest globally and should also benefit from a prolonged decline in inflation.
We also feel that the expected decline in interest rates offers significant value in Brazilian equities. At current valuations, MSCI Brazil is trading at 13 times 2017 forward earnings. Although this valuation does not flag up as excessively cheap based on the trailing averages (for example, the 10-year average of 11 times earnings), we expect this earnings growth to continue into 2018. We predict Earnings per Share of $130 in 2017, rising to $160 in 2018. Without the effect of multiple expansion, we expect MSCI Brazil to return 20% in 2017 in US Dollar terms, providing ample opportunities for equity investors. Our preferred sectors are Energy, Metals and Mining.
Lennart Kaltenbach
Lennart is a member of APQ Global’s management team. He started his career on the Risk Management graduate program at Dresdner Kleinwort Wasserstein in 2006, and shortly after joined GLG Partners where he gained further experience in risk and asset management.