Despite the incredibly narrow margin of victory for former guerrilla and leftist leader Dima Rouseff over Aecio Neves Brazil is now facing many of the same questions it faced at the start of the election cycle.
Markets attempted to handicap the results for most of this year and certainly over the last 6 weeks. In the spring and summer when it appeared Dilma was losing her significant polling lead over the opposition, Brazil rallied in anticipation of some election change that was unclear but welcomed.
Large SOE’s and Brazil proxy plays like PetroBras (PBR, quote) and Vale (VALE, quote) outperformed the rest of the market. In the six weeks that led up to the second round runoff between Dilma and Neves Brazil sold off 24% as hopes for change dimmed.
The result does still leave some opportunity for change in Brazil at a time when the country needs healing. Clearly with such a tight outcome there needs to be some reconciliation and there is a country that is divided.
For many in Brazil the social net that supported the masses has hurt the broader economy and has also left many even more impoverished than they were a decade ago. On the flip side, the Dilma team campaigned hard that there has been a huge economic lift and prosperity for tens of millions into the middle class.
Employment is at record lows and ultimately those who have gained in the last decade in Brazil feel they are better off than they were. The election was a validation of that sentiment...but again, just barely.
The outlook for the economy is challenged to say the least. Growth in Brazil is stagnant without China driving commodity prices (commodities hit 5yr lows today).
And there is no global economy that will take up the slack China can’t pull. There is still high inflation concern (close to 7%) and a currency which needs to move lower to continue to adjust the economy. This will only add to inflationary pressure and without growth Brazil also now faces the risk of losing its investment grade.
The victory speech by Dilma included lip service acknowledgment that the country needs to come together and that she is open to dialogue from the opposition but didn’t send a warm signal of real reform. It is difficult to see a scenario today where Dilma will feel she will have to be less radical and moving to the “center” should not be expected in the near term.
The markets will be focused on the appointment of the Finance Minister as Mantega is out at the end of the year. By choosing a key Neves cabinet member (well known to EM investors) like Aminio Fraga for the FM post, Dilma can begin to restore some order to market sentiment.
Today the market has priced in a pessimistic view of an adjustment in policy and economic fortune in Brazil. As of mid-morning, while off the lows Brazil is -6.8% with 190bps of that negative performance coming from the reals move lower to 2.52. Now what?
As we like to point out, the challenge with investing into and out of election cycles is that markets rarely find the efficient pricing mechanism for measuring change or the potential for change. Or said differently: markets in a country experiencing a controversial election will often sell off into the event on post-election expectations. What we have seen over and over again is that these moments tend to be buying opportunities.
With few near term catalysts that will overcome the myriad of structural issues facing Brazil and its economy investors should focus on the following keys:
- Brazil on a P/E basis (10.6X ’14)is not terribly cheap relative to itself but it’s not expensive either
- Brazil is cheap to itself on a P/B level and offers investors a 4.7% dividend yield
- Some companies in Brazil will benefit from the weaker currency as they have COGS in BRL but revenues in USD – seek out some of commodity exporters and food companies
- Interest rate sensitive stocks will struggle until the currency finds a floor – which we think could be closer to 2.75BRL/USD
- SOEs in key sectors (utilities and teclos especially) are under the most pressure because they were the most attacked by Dilma in the last four years
Buying Brazil today with so much Dilma having been priced in may not be easy but it’s clear to say that markets have priced in slow to no growth, economic bottlenecks and currency weakness.
Markets have not priced in a massive downgrade and subsequent default in the largest corporate bond market in Emerging Markets (EEM, quote). Markets have not priced in social upheaval that comes from economic despair. You make the call.