December 2011

EQUITIES: The next chapter

BooksWith emerging market star Brazil set for slower growth fund managers will have to dig deeper to keep the Latin American growth story on tract, finds Nick Fitzpatrick. “There has been a sell-off in Brazil so it’s a good time to pick up stocks,” says Joaquim Levy, chief executive officer at Bradesco Asset Management, a fund manager with 129.9 billion reales ($124 billion) under management and based in São Paulo. Of course, there’s not much apart from this that you can say when a key part of your business as an asset manager depends on a market that has seen large falls. That is particularly the case when that market is one of the stars of the emerging world. Bradesco has a Brazilian “Megatrends” fund and a mid- and small-cap Brazil fund that it sells into Europe where the emerging market theme is now firmly entrenched as an investment story. Latin American markets saw a sell-off in June and Brazil also saw a weaker 2012 compared to regional peers. Brazil has been, and still is, a country with a key role in the emerging markets story, and to stretch the literary metaphor, the country is in fact one of three chapters being written about this story as it unfolds on American continent. In the northern most clime of the emerging Americas there is the Mexico story, which cleaves around the US as a key influencer. Much further south and it is the commodity and mining story of Chile and Peru. But Brazil has the consumer story, one it shares with many other major emerging markets and one that is broadcast most frequently by emerging markets investors. Yet when Brazilian equities served to drag the return of Latin America’s wider stock markets back to 8.7% in 2012 (versus a return of 18.6% from global emerging markets in US dollar terms), it’s likely this had a lot to do with commodities. For all its relation to the emerging-market consumer story, which is based on the growth of a middle class and a population largely unfetted by debt, Brazil’s main index still has a high relative weight to commodities and other cyclicals. These sectors are likely to underperform when concerns about global growth, and particularly Chinese growth, do the rounds. Getting around this is one reason some Brazil investors say it is important to look beyond the main stock market indices of the São Paulo stock exchange, such as the Bovespa index. This is the case with Bradesco. The small and medium-cap fund is self-explanatory. But both that fund and the Megatrend fund also buy Brazilian depositary receipts, certificates issued in Brazil on behalf of companies with publicly traded stock and headquarters overseas. Levy says: “BDRs let you get exposure to sectors that are not largely available in Brazil, such as Big Pharma.” Pfizer, the large US pharmaceutical corporation, is one example. Similarly, Jose Castellano, head of Iberia, North America Offshore & Latin American markets at Pioneer Investments, says opportunities in Brazil are “hiding” behind the benchmark. “Many investors are starting to identify this,” he says. “The index is heavily weighted towards everything that has worked in the past, like commodities, banks and utilities, and to a certain extent the consumer component. But there are some very good businesses that are not represented in the index.” He adds: “The dispersion between benchmark returns and those sorts of companies is enormous.” KEY VULNERABILITIES
Commodity prices are forecast to drop over the next year and, along with tighter monetary policy in Europe and the US, this will expose “key vulnerabilities in Latin America’s growth model”, says Capital Economics. In a report, Latin America Focus, published in July, Capital Economics says the Latin American economy has, in fact, been slowing down for two years but that liquidity injections by central banks glossed over weaker economic data. The region has “spent all its commodity windfalls”, says the report, which predicts 2013-2015 growth averaging 3%. It is expected that current account deficits in some countries will widen further, and higher rates of unemployment will result as domestic demand adjusts to stop deficits becoming unsupportable. But financial risks have not reached crisis levels yet, says the report. Falls in commodity prices are small compared with the boom of the past decade and monetary tightening overseas will be gradual. DEBT LEVEL
However, the report does say that private debt in Brazil is a concern. Private debt has built up to support the consumer boom, and though the debt level is still lower than in other emerging market countries, in the past emerging market debt crises have been triggered by a rapid growth in debt rather than by debt passing a certain thresh-hold. The report tarnishes the Latin American investment story, concluding that “hopes for a Latin American decade will go unfulfilled”. Low interest rates have driven the consumer story but rates are expected to come under pressure to control inflation. “Brazilian investors are probably as scared of inflation as the Germans are,” says Castellano. Bradesco, in a recent economic report, said it expects inflation of 6.2% and along with 2.3% GDP growth this year, the firm expects the Selic interest rate to be at 10% by the end of 2013, which is above an earlier forecast of 9.25%. “The escalation of interest rates around the world and devaluation of the currency generates an environment of greater inflationary risk and less confidence on the part of entrepreneurs and consumers,” the Bradesco report says. “Because of this, we understand that the battle against inflation will require higher interest rates until the end of the year – which, combined with the erosion of confidence, should produce less growth this year and next year.” It appears to be widely believed that Brazil should do more to boost its infrastructure in order to encourage real growth. In fact, much talk about this Latin American decade has featured infrastructure spend by governments. The research arm of BBVA, the Spanish bank, recently said that infrastructure investment has remained low in Brazil at close to 2.% of GDP during most of the last decade and more recently reaching around 3.3% of GDP. BBVA says this recent performance compares poorly with the level needed to keep infrastructure’s stock of capital constant (3.0%), and in comparison with the amount required for the country to replicate the development seen in South Korea and other Asian economies (4.0%-6.0%). The government has been trying to increase investments in infrastructure, but there are impediments, such as legal uncertainties. Brazilian pension funds, at 14.5% of GDP, could help, but according to BBVA currently allocate around 21% of their portfolio (3% of GDP) to the infrastructure sector – and no more than 1% of their resources are channeled into the sector through direct investments in infrastructure projects or funds. Around 20% of pension funds portfolios are made through equity and fixed income. HINDERANCE TO GROWTH
Levy, appears to reflect the view that pension funds could, and perhaps should, allocate more to the sector, which has a real-estate feature about it. “I see value for pension funds by investing in real estate, such as shopping centres and offices in Brazil,” he says. Bradesco created a real estate fund arm in 2009. Castellano says a lack of infrastructure in Latin America in general is a problem, hindering growth. As Pioneer looks beyond the index to tap into the other reality of Brazil that lies there and offers the growth that investment managers have promised, he highlights a number of companies, including Kroton Educacional, a large private educational company. Moving beyond the index may yet be what saves the Brazilian, and Latin American, decade. ©2013 funds global latam

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