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iShares MSCI Brazil Capped ETF (NYSE:EWZ) has traded exceptionally volatile in recent weeks based on disappointing political developments out of Brazil. EWZ has now under-performed broad emerging market equities among the global rally this year. April 10th marked the 100th day of Jair Bolsonaro’s term in office as Brazil’s president. The new administration came in riding a wave of enthusiasm with a reform agenda and business-friendly mentality but has largely stumbled out of the gates. 2019 thus far has been defined by a number of policy-messaging snafus, continued dysfunction in the Brazilian Congress, and overall disappointing economic data. Nevertheless, there are reasons to be optimistic with a path to a stronger recovery still in place. This article provides a macro update on Brazil and my view on where Brazil stocks are headed next.
EWZ price performance chart. source: Finviz.com
The First 100 Days Of Bolsonaro
Brazil’s President’s visit to White House. Photo source: Agência Brasil.
One of the highlights of President Bolsonaro’s first few months was his visit to Washington D.C. The President who spent 30 years as an ideologically conservative castaway in Congress ran a successful campaign capitalizing on the broad resentment of the status-quo and animosity for the left-wing political elite in Brazil. Much of his tactics and campaign style were molded on the blueprint laid out by Donald Trump’s 2016 victory in the U.S. including unfiltered use of social media and even the use of borrowed terms like “fake news.” For this reason it was an almost surreal moment when the “Trump of the Tropics” stood next to the real Donald Trump at the White House in Bolsonaro’s first overseas state visit. While no major trade deal or treaty was announced, a number of items were discussed that served to strengthen diplomatic relations including:
Overall the message of the trip along with the other major overseas visit to Israel has been that Brazil is open for business and looks to pursue a reform agenda.
Economic Indicators
The story thus far has been weaker-than-expected growth. The Central Bank publishes a market survey of various economic forecasts among Brazilian Investment Banks updated weekly. In terms of annual GDP growth, expectations for 2019 and 2020 have trended lower in recent weeks to the current level of 1.95% and 2.58% each year, respectively. Longer term forecasts out to 2022 remain stable at 2.5% but leave a lot to be desired. Economic indicators this year among consumer confidence, retail sales, industrial production, and employment data have mostly disappointed.
Brazil GDP Growth Consensus Expectations. Source: Central Bank Brazil
The official government position according to statements by the Finance Ministry is that the current weakness is simply a holdover from trends of the previous administration while the reforms remain on track. Still it should not be understated that the current government has had its share of hiccups this year already, including statement inconsistencies. Last week Bolsonaro appeared to oppose a fuel price increase by Petrobras SA (NYSE:PBR) which gave the appearance of government interference. ADR shares of PBR fell nearly 8% on the comments. The government quickly went into damage control mode leading to Bolsonaro releasing a clarification stating, “I cannot and I will not interfere in Petrobras.” Shares of PBR have since recovered but the incident highlights the “live wire” nature of Brazilian politics.
March CPI inflation came in at an annual rate of 4.58% from 3.89% in February. Higher food prices and seasonal effects help explain the jump. Still the level is within the Central Bank target of 4.25% with a tolerance level of +/- 1.5%. Importantly, services inflation and core measures remained stable at around 2.5% y/y. The expectation going forward is that the current weaker-than-expected growth environment should help contain inflation in the months ahead along with a reversal of the seasonal effects. Central Bank market surveys include an inflation expectation by year end of 3.5% which would be a historically comfortable level. Investors should be aware that the volatile and weaker Real currency in recent weeks represent the main risk to the forecast as it could impact fuels and import prices.
Brazil Inflation. Source: TradingEconomics.com
In March, the Central Bank of Brazil maintained the monetary policy rate SELIC unchanged at 6.5% in its latest meeting. The statement released signaled that the balance of risks for inflation is now symmetric but acknowledged that recent activity indicators point to a slower-than-expected pace to the recovery. The SELIC rate has been held constant for a full year since March 2018 at the historically record low level 6.5%. Low interest rates and relatively stable inflation remain one of the more positive aspects in the macro outlook for Brazil that should help support local credit growth and investment demand.
February Industrial production grew 2.0% year-over-year in February but below published market consensus of 2.4% y/y. The apparently strong y/y growth is skewed given the timing impact of the Carnival holidays which fell in February in 2018 but will be part of March’s data this year. The current underlying data suggests only tepid growth. Auto manufacturing rebounded in February following weak data in January. This area continues to be a weak spot in the economy as total automobile production remains well below historical high levels in 2013 and even down 0.4% compared to the two-month period of last year. Also important in terms of industrial production is the significant contraction in the mining industry, triggered by the collapse of Vale SA (NYSE:VALE) Brumadinho dam in February. Sector activity plunged -9.9% y/y and should remain a drag on broad industrial production in the next few months.
Brazil Industrial Production. Source: TradingEconomics.com
External accounts are supported by a trade balance surplus that continues to run near historically record levels. Elevated commodity prices helped exports reach $5 billion in March and $57 billion over the last twelve months. The weakness in the Brazilian Real currency coupled with tepid consumer demand has helped contain imports.
Brazil External Accounts Data. Source: Itau Bank Economics Research
The external accounts position here along with firm foreign direct investment and the sovereign position of foreign reserves is in sharp contrast to recent episodes of currency collapses observed in Turkey and Argentina, for example. Brazil has its issues but there’s little to suggest an impeding capital flight or debt crisis. The Brazilian Real looks to have some good value here around the BRL $4 per USD exchange rate.
Data by YCharts
The ongoing fiscal crisis in Brazil based on nominal deficit running at approximately (-6.9%) of GDP remains the most concerning weakness of the macro outlook. On a primary balance basis (excluding interest payments), the deficit of -1.7% in February over the last twelve months is actually running better than the full-year government deficit target of -2.3% based on relatively robust tax revenues while government expense growth has been held flat. While the pullback in government expenditures, and otherwise austerity, is necessary it also helps explain some of the weakness in economic activity lacking the so-called fiscal impulse. Gross public debt to GDP was recorded at 77.4% in February but seen stabilizing around the current level. The possibility of the public-debt ratio trending lower will require recurring fiscal surplus that depends on the approval of the pension reform.
Brazil Fiscal Data. Source: Itau Bank Economics Research
Brazil Pension/ Social Security Reform
The priority of the new government has been the passage of a sweeping pension/social security reform that is necessary to correct the structural imbalance in the fiscal account and return the governments’ budget to a primary surplus position. One of the factors leading to recent volatility in Brazil among asset classes including EWZ is current difficulty in the government’s ability to build consensus for the passage of this reform legislation. Opposition is largely related to details like settling on a retirement age for men and women and implementation of a transition period.
Source: Santander Brazil Bank Research
Originally, the government’s proposal estimated savings of BRL $1,082.9 billion (1.1 trillion) over 10 years. Approximately USD $280 billion over the period or USD $28 billion per year on average at the current exchange rate. Santander Brazil Bank Economics Research now estimates that a final version will be “watered down” by approximately 43%. Still the report linked above goes on to say that the approval of such a reform, “would be positively perceived by market participants, as it would provide a signal of the government’s commitment to fiscal discipline and its capacity to mobilize the Congress to approve further austerity measures, much-needed, in our view.” The baseline at this point is that a first round vote in Congress takes place in August. My take is that a final bill will be bullish for Brazil equities as it will remove one level of uncertainty allowing the government to focus on other areas of reform such as taxes and trade that support growth.
EWZ Analysis – Buy The Dip
Across a number of actively traded Brazil stocks ADRs in EWZ, Centrais Elétricas Brasileiras S.A. “Eletrobras” (NYSE:EBR), up 29% YTD, has been one of the best performers in part on the expectation the government-controlled company will divest some generation assets amid a broad privatization remarks. Petrobras SA is up 19.7% in part on the worldwide rally in energy prices but also the government’s pledge at deregulation and continuation of the firm’s divestment plan. On the other hand, Itaú Unibanco Holding S.A. (NYSE:ITUB) has been one of the biggest losers this year, down nearly 9%, with a larger exposure to the credit cycle and consumer spending that has been tepid.
Data by YCharts
My inclination here is to buy the recent dip around $40. EWZ and Brazil are difficult markets to analyze and for that reason it is understandable investors stay away or simply tie the story together with the recent equity market disasters in Turkey (NYSE:TUR) or Argentina (NYSE:ARGT). I’m confident that the Brazil story here is more positive than appears and now represents value following this latest pullback. There is no sign of a currency crisis. Better-than-expected outcomes from economic data or the reform agenda going forward would be bullish for equities. The consensus is that some type of pension reform will still be passed with uncertainty related to how deep or watered down the final bill is. Risks investors should monitor include inflation dynamics as it relates to the Brazilian Real. A move in the dollar above BRL $4.20 would signal a deeper and more series deterioration although I’m optimistic that won’t happen.
Conclusion
To recap the macro data, it’s not all bad. Weaker than expected growth and poor fiscal position are balanced by a still strong external account position and favorable inflation/interest rate dynamics. The overall outlook continues to be positive. A resolution to the pension reform saga, regardless of how watered down the final legislation is, should help reinforce investment flows and allow the government to focus on more pro-growth measures.
Disclosure: I am/we are long ITUB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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