The Brazilian Cycle Has Turned
I was bearish on Brazil for a few years and, after talks with 2 friends, smart local investors, I changed my mind somewhere in 2H16.
As the name of my website says, I am a believer that for one to get out of a tough situation there’s rarely a shortcut. Inspiration or desperation. Brazil lacked the foundational inspiration (cilivity/roots), so we needed an implosion of the system before a chance of its reconstruction. And that’s what kind of happened.
A strong fight against corruption started by the Car Wash probe (corruption involving Petrobras), with huge ramifications, coupled with very high inflation and the exhaustion of an unsustainable macroeconomic model ran by the PT/Leftist government, helped the economy nosedive into its worst crisis in many decades.
After Dilma Rousseff was impeached things started to change. Brazil got a non-elected President, too old to want to be re-elected, but driving forward much needed, but unpopular, structural Reforms, aided by a very good Finance Minister and Central Bank chief and somewhat allied Congress [that apparently corrupt, possibly serving as White Knights/martyrs or trying to save their skins?]. Temer might go down in history as the most unpopular leader that made the best long-term, sustainable changes to a country.
What do I think changed? I will try to keep it very objective as I think the rest is noise:
1/ No chance of Brazil becoming Venezuela with the Left dead. The Worker’s Party (PT) lost something like 2-3rds of its municipalities in the local elections of October 2016. And now its leaders (ie, Lula) are in trouble/heading to jail. It means no funding for presidential campaign or even a candidate with any decent chance to win in my view;
2/ I am convinced that a violent economic crisis, coupled with multi-decade highs in Unemployment and in Consumer Debt will drive down inflation considerably = lower structural inflation, desinflationary inertia, converging with global trends.
3/ Despite its Fiscal problems, without the chance of a Leftist government that “doesn’t care about the government’s financial statements”, with a Center-Right leadership Brazil can perhaps follow many Developed Countries: as long as inflaton remains below-average, the country will be able to run high debt/GDP and primary deficits for a few years while we see the results of the changes made in this 2016-2018 period.
These are game-changers that will give room for much lower structural nominal and real rates -> lower debt service -> stronger entrepreneurship -> virtuous cycle. Finally the private sector will have cheaper funding to allow for higher investment and, unfortunately (personal philosophical opinion), labor substitution. Some productivity will show up now.
Add to the mix:
– healthy External accounts + not-too-high a share of foreign holders of brazilian debt + high FX reserves + net-creditor in foreign currency debt -> little room for a steep currency devaluation that could bring sustainably high inflation back;
– jobless recovery -> profit margin expansion;
– productivity will increase given much lower cost of capital that will substitute expensive labor for cheaper innovation/automation/new business models;
– the fight against corruption looking so effective -> fearful crooks, smaller government and renewed political class.
– privatizations + much better leadership at big state-owned companies like Petrobras, BNDES, Eletrobras, CEF + Banco do Brasil, etc.
What can go really wrong?
– Lula not in jail, re-emerging from the dust, winning 2018 presidential elections AND taking a turn to the Far-Left (Maduro/Chavez/Kirchner). I see this as very low probability now.
– Meirelles + Ilan Goldfajn leaving the current Government.
Some ask me about “more corruption charges on political leaders” and I say that, if these guys go, at this juncture, ain’t too bad as it’d mean the schemes currently in place fall, crooks get more fearful, a new generation of honest politicians seeking positive change rises, etc.
Again, absent a strong external shock* that could detonate Brazil’s strong Net-Exports + FDI combo, hitting the BRL and allowing sustainably higher inflation, the above factors should be enough for a multi-year virtuous cycle.
I expect expanding profit margins and valuation multiples, growing profits, an appreciating currency and lower long-term real rates. Something like what happened the US since 2009?
Good luck to all. Especially the brazilians. It’s never easy.
* US/Europe/China, I don’t see these risks as too small, certainly not low magnitude.