Challenges and Change in Brazil
When you think of Brazil, what immediately springs to mind? Carnivale in Rio? Beautiful people on beautiful beaches? Or maybe colorful investment opportunities? You read that right: investment opportunities. Turns out Brazil is just as interesting to investors as it is to tourists.
Brazil’s economy is grappling with some interesting challenges right now, such as shifts in monetary policy to cope with a possible economic slowdown and preparing to host two major events on the international stage—the 2014 FIFA World Cup Brazil™ and the Olympics in 2016. Marco Freire, Franklin Templeton’s CIO, Brazil Fixed Income for the Local Asset Management team based in Sao Paulo, isn’t sharing any locals-only secrets about either event, but he’s happy to share his insights on how Brazil is approaching these challenges, and to clear up some common misconceptions about Brazil’s markets.
- Instead of using only rates to control the economy, the central bank is also using regulations to go straight to the credit channel to try to control the economy.
- I think the reaction of the economy to these lower rates might be much smaller than in the past.
- In my view, growth in Brazil looks to be driven more by what happens inside the Brazilian economy than outside of Brazil.
- A flexible approach can be beneficial for investors in Brazil.
The history of Brazil’s fixed income market has been dominated by an environment of high inflation and high yield—the benchmark Selic interest rate was as high as 45% in 1999, for example1. Central banks, including Brazil’s, have typically increased interest rates to combat rising inflation, and when inflation isn’t of much concern, central banks typically have lowered rates to stimulate growth. Breaking with that usual strategy, on March 7, 2012, Brazil’s central bank cut the Selic rate by 75 basis points to 9.75%, despite the fact that the country’s inflation rate is well above the government’s inflation target of 4.5%, ending 2011 at 6.5%.2 What’s going on here? Freire explains.
“Now the big change is that the central bank is also using capital and credit controls on the banking system. So instead of using only rates to control the economy, the central bank is also using regulations to go straight to the credit channel to try to control the economy. I think this mix translates into lower levels of rates in Brazil as the central bank increasingly uses capital and credit controls in the economy.
What I think is going to change now in this new cycle is that the reaction of the economy to these lower levels of rates might be much smaller than in the past. And the rationale for that is that it’s very different from five or six years ago when credit levels in the economy were very low. I think now the levels of credit in the economy are much higher than what they used to be, so consumers are more leveraged; service debt ratios are higher.”
Still, even if Brazil’s interest rates decrease a bit more, they are still high by international standards, even when adjusted for inflation. (Compare Brazil’s 9.75% rate with rates in the U.S. and Japan, for example, which are near zero). That has attracted investors to Brazilian fixed income products.
“It’s very tough to find yields that compensate investors for inflation. When yields are actually lower than current levels of inflation, investors are being penalized and are losing capital through time. That’s not the case in Brazil, where nominal yields and real yields are high, so investors are being compensated by inflation plus 3 – 5% yields.”
With yield being as scarce as it’s been recently, the prospect of yield—even possibly high yield!—can certainly look enticing. But of course the story is never simple. Brazil is set to enter the international spotlight in a big way in the next few years, hosting the 2014 FIFA World Cup Brazil™ and then the summer Olympics in 2016. These are both huge events. The preparation has presented some challenges, particularly related to infrastructure, as the country readies itself for the events and the onslaught of fans from around the world. Most recognize Brazil’s infrastructure is in need of some improvements: the World Economics Forum ranked Brazil’s infrastructure 64 among 142 countries in 2011.3 Freire recognizes infrastructure is a “big deal” for Brazil, not just for these sporting events, but to promote foreign investment in the future.
“I think the government understands the infrastructure need and is making some changes to promote investment, not only in the public sector but also with private investment. The government has pledged significant spending on infrastructure in the next 3-5 years, and it seems likely it will need to be funded to some degree by foreign investors. Remember, Brazil is still a very low-savings economy. Domestic savings in Brazil is around 18% of GDP, 4 so achieving that high level of investment is going to require international investors’ funds in Brazil.”
Freire provides one example of private investment in action right now. The government started privatizing airports in Brazil, and in February, a successful auction saw investors from several countries bidding. Today, three of Brazil’s main airports are privatized.
“We have investors from Argentina, from France, even from South Africa, that were interested in managing airports in Brazil and are bringing in money so that we can improve our airports here.”
The Impact of China on Brazil
While Brazil is ramping up spending in infrastructure, it is simultaneously grappling with the possibility of slower economic growth this year should China, a powerhouse in purchasing many of the commodities Brazil produces, throttle down that demand. And yet, Freire isn’t overly concerned. He clears up some misconceptions about the relationship between China, Brazil and commodities. He says Brazil is a closed economy, and its fate is not as closely tied to exports as many believe.
“If you look at exports relative to GDP in Brazil, they are only 11% of GDP.5 That’s not a high number. Of the big emerging market economies, Brazil is one where foreign trading is less important. And even if you look at the broader sample of all emerging market economies, Brazil ranks among the ones where exports are even less important. So growth in Brazil, at the end of the day, is going to be much more driven by what happens inside the Brazilian economy than outside of Brazil.”
That’s not to say Brazil’s market isn’t impacted by global trends. More than a third of Brazil’s main stock index, the Bovespa index (Ibovespa), is comprised of listings related to commodities in some fashion,6 so the impact of the commodity price cycle is important to Brazil’s market. Freire opined that, as an investor in Brazil, it remains important to have a flexible strategy to move into different sectors of the market at a given point in time.
Sir John Templeton thought flexibility was important too. In his words: ”The fact is there is no one kind of investment that is always best.”
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What does Mark Mobius, executive chairman of Templeton Emerging Markets Group, have to say about Brazil? Read his recent blog post: “Order and Progress on the Rise in Brazil.”
What are the Risks?
All investments involve risks, including possible loss of principal. Generally, investments offering potential for higher returns are accompanied by a higher degree of risk. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Bond prices generally move in the opposite direction of interest rates. This means when interest rates rise, bond prices tend to fall, and conversely, when interest rates decline, bond prices tend to rise.
1Source: Banco Central Do Brasil
2 Source: Banco Central Do Brasil
3 Source: World Economics Forum, “Global Competitiveness Report,” 2011-2012.
4 Source: World Bank, 2010
5 Source: World Bank, 2010
6 Source: BM&F Bovespa Exchange