JH Explorer: Brazil navigates rough economic seas

The JH Explorer series follows our investment teams across the globe and shares their on-the-ground research at a country and company level.

 

It has long been our opinion that the most optimal way to view the emerging market (EM) equities landscape is through the complementary lenses of country, company, and governance. All require deep research, and none can be entirely carried out from a distant office. An investor must be on the ground to understand the policies that impact an economy and hear directly from business leaders about how they intend to navigate a complex marketplace with the aim of growing earnings.

It’s for these reasons that I traveled to Brazil earlier this year to learn how the country and its corporations are faring under higher interest rates and slowing growth, and to assess the government’s new fiscal rules’ chances for success in stabilizing the country’s sometimes unruly fiscal situation.

A pivotal country in a pivotal period

With its large population and abundance of natural resources, Brazil rightly commands a place in EM equity allocations. But the country has a complicated history of fiscal management, which has resulted in numerous crises.

As with other countries, Brazil’s COVID-era stimulus programs resulted in myriad economic distortions that must now be sorted out. Brazil’s fiscal largesse in the wake of the pandemic was among the most generous in the developing world, with much of it geared toward stimulating consumption. A permissive regulatory framework allowed for the rapid expansion of fintech companies, which provided credit access to previously underbanked segments of the population. Between 2018 and 2022, the number of bank accounts per economically active person rose from 2.2 to 5 – far higher than in Latin American peers. Consequently, credit card debt exploded, climbing by 65% and 47% in 2021 and 2022, respectively.

The hangover

Brazil is now dealing with the aftereffects of its credit excesses, including the air pocket that inevitably forms when consumption is pulled forward to such a degree. Debt service ratios have climbed to over 28% and the total household debt to GDP ratio sits just below 50%, up from 39.3% prior to the pandemic.

Further aggravating the situation was Brazil not being immune to the recent global wave of inflation caused by pandemic-driven supply chain disruptions and Russia’s war in Ukraine. Unlike developed markets, EM central banks did not have the luxury of making a “transitory” inflation call then hoping for the best. Understanding all too well the pernicious nature of inflation, the Central Bank of Brazil aggressively raised its policy rate by nearly 1,200 basis points, resulting in the country having among the world’s highest real interest rates.

The higher cost of capital was the second blow to an economy already teetering due to weakening consumption. Our analysis indicates that when excluding the energy, agricultural, and mining sectors, the remainder of Brazil’s economy is already in recession. Nonperforming loans on the country’s banks’ books are rising and loan growth is slowing. Had debt capital markets not frozen, loan growth would likely already be negative.

Voices from the trenches

The mood of corporate executives with whom I met was somber. Such interactions, in our view, provide some of the most candid commentary on an economy’s near- to mid-term prospects, as these are the decision makers that must allocate capital and make other strategic decisions in the face of gathering headwinds. Given the economic uncertainty and high borrowing costs, bank executives spoke of slowing credit demand. On the supply side, banks are shunning riskier borrowers.

Executives at consumer-focused businesses are dealing with the fallout from the credit binge. One commented that the share of new cars purchased on credit slid from 70% to 33% between 2021 and 2022. Others noted that consumers are downtrading from steak to chicken and sausage.

Even signs of optimism were tempered. For example, an e-commerce leader said that, although cyclical factors won’t derail longer-term investment initiatives, they have deployed capital conservatively in 2023 and tended to concentrate on the highest quality customers when doing so.

Righting the fiscal ship

Another objective of my trip was to assess the chances of success of the new fiscal rule put forth by President Luiz Inácio Lula da Silva’s administration. The previous iteration – a constitutional amendment – was necessary after years of fiscal mismanagement, which had led to a cycle of inflationary spirals and debt crises. By forcing spending restraint and stabilizing primary budget deficits, the country was able to win hard-fought favor with global investors. Then it stopped working.

We rightly fear “creative” EM politicians when it comes to fiscal matters, and the administration of Jair Bolsonaro proved especially creative in sidestepping fiscal constraints. This only aggravated the country’s deteriorating fiscal condition owed to mismanagement in the previous decade. The upshot was a reversal in the multi-year decline of the SELIC¹ benchmark rate, which in turn increased risk premia across all Brazilian assets.

We were concerned that a second Lula administration would be more ideological and seek to dilute the new fiscal framework. Countering that, however, are institutions that are stronger than what Lula encountered in his first term: The central bank is now independent, and the fragmented congress has greater center-right representation.

We believe Lula’s administration based its initial proposal on overly optimistic GDP and interest rate assumptions. Had a pliant congress passed the initiative outright, we’d have expected to see a fierce market reaction. Instead, since last month’s passage, the country’s benchmark stock index is only down roughly 5.0% and the 10-year sovereign yield has rallied. On the surface, this indicates the market’s acceptance of the final framework, despite what many say is an overreliance on revenue increases to maintain budget stability. To be determined is whether the focus on spending is grounded in realistic economic assumptions or higher taxes will be needed to fill the gap.

One part of the equation

Whether Brazil ultimately proves successful in trimming its budget deficit matters to equity investors. We believe investment outcomes tend to improve when one focuses on countries with reformist governments that recognize the importance of a thriving private sector and maintain fiscal discipline. Brazil does have a rich history of innovative companies servicing a large and upwardly mobile population. By recapturing the fiscal discipline that had previously broken the cycle of jumping from crisis to crisis, Brazil’s government can ensure a landscape that allows its companies to thrive, thus making them even more attractive components within an EM equities allocation.