I have spent the past 23 years involved in emerging markets, particularly on the fixed income side. I have always loved travelling and experiencing new things, especially if there is a bit of adventure involved. Being responsible for Latin America means I have the perfect region and the perfect job. My trip to Brazil on the eve of the Football World Cup took in much of the country. The thing that struck me most was the excessive gloominess of the locals. I am more optimistic. Debate around the issues that face Brazil is vigorous and the government realises what the challenges are.
Focus will turn to Brazil
As a sovereign, fixed income investor, it is definitely a very interesting time to travel in Brazil. We are in the run up to the 2014 Football World Cup and the world will turn its focus in June not just to the competition, but also to all the broader issues that are part and parcel of Brazil in 2014: a presidential election later this year, an uncomfortable economic backdrop that sees inflation higher and growth lower than is ideal, and the compounding effect of some of the driest weather on record.
There was a gloominess permeating my meetings with many locals working in the private sector. The extent of this was evidenced in the market’s reaction to the recent Standard & Poors’ ratings downgrade. Rather than sell off, the markets actually rallied, as they responded to the ‘relatively good news’ that the outlook going forward was stable. In fact, in our meeting with S&P, it appears they are comfortable with Brazil at a low investment grade going forward, even with growth in the 2-2.5% range, and inflation sitting up towards the top of the inflation band at around 6% over the next few years. It’s not a particularly bright outlook and one that seems to be the base case, with risks to the downside factored in by the locals, who are generally downbeat on Brazilian asset prices, from bonds to currency to equity.
Need to spend on infrastructure
While President Dilma Rouseff remains the favourite to win the presidential election later this year, the players on the ground like the idea of a closer election and a political outcome that would push the agenda towards one that they perceive as more market friendly. Across the entire political spectrum though there is plainly a focus on what needs to be done to raise investment in the country, and increase potential growth levels. The message is clear: spending on infrastructure needs to be a priority. The population is pressing hard for better roads, better hospitals and better education.
The continuing protests into the World Cup emphasises this point. While no doubt football fever will overtake the Brazilian people when the competition actually begins, roads and airports are creaking under the strain of systems that desperately need upgrading.
Our discussions with the Ministry of Finance and the state-owned Brazilian Development Bank (BNDES) highlighted both the progress that has been made to date and how much has yet to be achieved. Although limited in terms of the actual projects completed, the improvement in the infrastructure concession auctions implies that a marked acceleration in spending is expected from here. While there is a clear push for more private sector involvement in a lot of these projects, it is painfully obvious that certain projects will have to remain the domain of the government, even though the current model of financing through the state-owned banks is not optimal.
Government officials are keen to point out where progress has been made, in contrast to the market where the emphasis is on the shortcomings of the current administration. The need for reform is acknowledged from all quarters, but the reality of the Brazilian system is that significant reform is difficult to achieve. The current approach of piecemeal measures that can be done by decree, rather than face the difficulties of pushing something more substantial through Congress, will remain in place at least until the election. Opinion is divided about the strength of the post-election reform agenda. The question, as one economic consultant put it, is ‘which President Dilma will we get: the one who embraced Castro, or the one that went to Davos?’ The appointment of the next Minister of Finance is going to be key in answering this question.
Not surprisingly, with economic forecasts for this year consistently seeing revisions down to growth and inflation expectations edging up, there is huge concern regarding the ongoing drought and the historically low levels of reservoirs in a country where power generation is largely hydroelectric. Private sector analysts have been highlighting the increasing risks of power rationing and drawing parallels to the situation in 2001/2002. The government, on the other hand, is quick to say that the issue is not one of capacity, but rather one of price, where more reliance must be placed on accessing the thermal electricity.
The reality is somewhere in between. Although seen as politically unpalatable in the run-up to the election, if it does not rain heavily soon the prospect of power rationing will become increasingly probable. In fact, some districts are already on water rationing. Widespread rationing would have a knock-on negative impact on an economy already struggling with insipid growth. The increased cost of placing higher reliance on more expensive thermal generation has further negative implications for both headline inflation and the fiscal position. While our meetings with the government made it clear that they will try and limit the impact on all fronts, they do not have much room for manoeuvre.
More optimistic than the locals
My key take away from my time spent in Brazil is probably a bit more optimistic than these paragraphs might suggest. Debate around the issues that face Brazil is vigorous. The government realises what the challenges are. The social fabric is one that is likely to drive change. The Brazilian population has seen its middle class explode in the last two decades and is increasingly demanding its government to deliver. To date progress has been slow, but there has been progress and President Dilma Rouseff, or whoever else may next be at the helm, will need to focus on these challenges and help Brazil achieve at least some of its huge potential.
How does this view translate into investment opportunities over the shorter term? The Brazilian authorities have helped to strengthen the exchange rate in a bid to contain inflation, and raised interest rates sharply. In our view this means that despite the high carry rates, the currency looks expensive. On the local bonds, however, the exceptionally high real rates, against a backdrop of a relatively steep curve where the market is pricing in even higher short-term rates, looks like good value. For this reason we remain constructive on the outlook for hedged returns over the remainder of the year.
Vivienne Taberer is Portfolio Manager, Emerging Markets Fixed Income, Investec Asset Management. This information discusses general market activity or industry trends and should not be construed as investment advice.