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Real trouble

18 September 2015

Ajay Krishnan of Wasatch Advisors says Latin America’s leading economy is struggling to find its way out of a sharp downturn.

Falling prices of oil, minerals and food.  Declining commodity exports as worldwide demand softens.  Political and corporate scandals.  A contracting economy.  Increasing unemployment.  Currency weakness.  Rising inflation.  High interest rates.  Downgrading of government debt to non-investment-grade status.  Since mid-2014, Brazil has been struggling through the economic drought known as ‘stagflation’, whereby economic growth stagnates but inflation continues to rise.

Falling commodity prices have been the subject of many financial headlines in the last couple of years, and all the more as the oil price dipped in recent months. More recently, news of an economic slowdown in China, together with the government’s handling of it, has exacerbated the commodity-price declines; China is a major importer of raw materials from around the world.

As a globally significant producer of oil, minerals and food, Brazil is especially vulnerable to the weakness in commodities.  To make matters worse, Petrobras - Brazil’s state-run oil company - has become engulfed in accusations that company executives colluded to inflate prices on various contracts, thereby enriching corporate insiders and facilitating bribes to political figures. The fact that Dilma Rousseff, current Brazilian President, was chair of the Petrobras board at the time has sent her ratings to record lows and sparked calls for impeachment.

Amid all of these challenges, Brazil’s inflation-adjusted GDP is expected to decline by 2.3% in 2015, which is a major disappointment after the relatively robust growth in the years following the end of the global financial crisis.  Along with negative economic growth, there’s been significant weakness in the Brazilian real relative to developed-market currencies such as the US dollar and sterling. The real ended 2014 at R$2.66 to the US dollar, but on 15 September this year it closed at R$3.86, approximately 45% lower.

Brazil’s central bank has responded by periodically raising interest rates, which now sit at 14.25% (although its September decision left the rate unchanged). But this move created problems for government debt, and what was formerly merely a burden has since rapidly evolved into a threat.

This was part of the reason ratings agency Standard & Poor’s downgraded Brazil’s credit status to BB+, thereby pushing it into the non-investment-grade bracket. In fact, Brazil’s inflationary woes are not the offspring of interest rate policy but of poor economic policies, such as the imposition of an excess of import tariffs. Yet now, while so much of the world is facing disinflationary challenges, Brazil is caught in stagflation, something not felt in the US and UK since the early 1980s.

Perfect storm

Did we see it coming, you might ask? The answer is that, while we foresaw the commodities dip, we hadn’t expected the perfect storm of economic and political problems that suddenly appeared on the horizon.

Brazil’s salvation as an investment destination is its size, and we believe it is worth remaining invested in the country for that reason. We actually chose to remain overweight in Brazilian corporate stock at the end of 2014. But we avoided commodity stocks, preferring to hold insurance, personal care and electrical equipment companies as their respective industries are relatively insensitive to local economic growth rates.

We have been invested in five Brazilian stocks during 2015.  We sold one of these early in the year as we saw rising input costs affecting the company’s profitability. (This was food products sales and distribution company, Dias Branco).  Of the four that remained, two have since enjoyed positive returns when denominated in the Brazilian real.  Thus it has been the significant decline in the currency relative to sterling that has caused much of the pain for our Brazilian holdings. 

You might therefore think we should be finessing our exit strategy. In fact, we believe Brazil remains too important to ignore – opportunities have narrowed but not disappeared. Thus, we have now reduced our allocation to just three companies and are slightly underweight relative to the benchmark. We hold Raia Drogasil, Seguridade Participacoes, and WEG, reflecting our belief in high-quality consumer-oriented and industrial names.

When investing in Brazil, we have to be especially mindful of potential currency fluctuations.  Brazil doesn’t have a robust manufacturing base and many of its manufacturing companies have commodity-related components – as a result, a cheap real doesn’t help them much. Unfortunately, this is a long-term challenge that results from Brazil’s failure to properly diversify its economic base.

 

Wasatch Advisors is a fund manager for St. James’s Place.

The information contained is correct as at the date of the article. The information contained does not constitute investment advice and is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.

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