Brazil – Losing (a lot of) Steam

This should have been posted weeks ago, but I’ll leave a quick note here while I find time to write something more structured.

My macro optimism with Brazil has dwindled since 4Q19 and, with COVID, our troubles came back to the surface.

The main driver of optimism was a strong belief that inflation was going to crash when unemployment skyrocketed after 2014-2016 recession, then came the political shift away from Left’s Big Government to fiscally prudent Temer, followed by higher hopes that Paulo Guedes, under Bolsonaro, would accelerate shifting the engine of growth from the public sector to the private sector. Short-term slower growth, but more sustainable. More macro quality, more productivity offsetting our lack of skilled labor.

Out of those, only the breaking of inflation’s back I believe is extremely durable. Unemployment at 12-14% was necessary to break services inflation. Now we’ll see an even worse unemployment situation.

Since premium is gone from front-end real rates and growth is unlikely to help equities all that much it is time to reassess.

That deep political change I expected has proven much harder to implement. Bolsonaro clearly is not a liberal, but a bureaucrat. And not an able one, necessary to pave the way for a long-term change in Brazil. Paulo Guedes isn’t as political as needed either. And with high unemployment it is hard for Congress to cut spending, remain fiscally efficient.

So it’s a tough world for Brazil as the World itself has gotten much tougher too.

What does this all mean?

BRL: I think brazilians should diversify away from the BRL despite REER levels. If not comfortable selling it here, have a plan. Sell rallies in BRL. Last time we saw current valuation levels real rate differentials were what? 7% to 10% (2002-2004)? Will BRL from 2011 be like MXN from 1995, RUB from 2000s? Brazil looks like a country that will remain known for its commodity exports and a cheap currency from here. Foreign reserves will help, external accounts will help, but a bet we see USDBRL below 4-4.5 sustainably again absent a crazy global USD weakness story seems low probability. Equities rallied, US equities at record highs, USD credit at record low yields (and spread tights) and USDBRL is still here, a shit show.

Rates: I think both long-end Real and Nominal rates will carry and roll-down well over time, but there’ll be volatility. From effective Selic @ 1.90% sizing matters and trading matters. Curve is very steep and economy won’t sustain much higher real rate levels. The debt pile is large and the fiscal situation will be the argument of the bond bears, but external accounts + FX Reserves look alright with currency where it is and foreigners own very little of our BRL debt. Just keep an eye out for signs of an abrupt change in fiscal stance or politicians named Kirchner.

Equities: ERP is high, dividend yield very high as well, especially historically compared to brazilian yields now. Brazil has great companies, but a lot of the Ibovespa is in sectors that I don’t believe offer secular growth stories. Banks, being disrupted in my view, represent ~18% of the index. It is an index of champions, monopolies or oligopolies, businesses that seem cheap on a P/E, P/BV, even P/FCF. They offer great carry, but in a world I don’t see rebounding above 2017-2019 real growth levels it’ll be just that, more of a carry story than a “growth + multiple expansion” story. A lot of people point to the flood of capital into stocks from individuals suffering from TINA. I get it, but that isn’t the best argument to buy equities since such story doesn’t work in every country for too long.

To end on a positive note, low real and nominal yields and the deepening of capital markets brought forward by XP Inc and BTG Digital is helping the country. These fellas came to stay, taking a lot of market share from the lazy (Ita├║, Bradesco, Banco do Brasil). Capitalized competition breeds more transparency and cheaper products for investors. We are seeing much more capital available for venture capital (low base, yes). We’re seeing lots of new companies IPO their shares on B3 and some of these are great businesses growing fast, but they’re not yet representative inside of the Ibovespa. So good stock picking should beat Ibovespa until these new generation companies become the index, taking over from the old-economy index we have. That is good hope.

It was a good ride. Won’t be easy from here.

From Aug-2017, first post on this blog: https://www.no-shortcut.com/brazilan-cycle-has-turned/

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