Investors in Brazil have had the dubious pleasure of undergoing one of the more stomach-churning rides in 2014. In U.S.-dollar terms, Brazilian equities rallied roughly 40% from their spring lows through early September, before surrendering all of those gains following a disappointing election outcome. Although the sell-off of the past few months has pummeled valuations, bargain investors might be better off looking elsewhere for a more promising emerging-market opportunity. Here are the reasons why:
Brazilian equities currently appear undervalued, but they have been cheaper before. The market is recently trading at about 10x price-to-earnings ratio and 1.20x price-to-book value, making valuations low, but we have seen lower prices in early 2003. On a relative basis, while Brazilian equities now trade at a 15% discount to other emerging markets, this is still above their long-term trend. Over the past 15 years, the discount was typically around 22% and swelled to 35% in the summer of 2013.
Bad fundamentals. Even with inexpensive equity valuations, I believe fundamentals don’t support a value play. Corporate profitability for Brazilian companies is below its long-term average and that of other emerging market companies (return on equity of 8% vs. 12% for the broader EM universe). Equally problematic, Brazil’s economy is struggling under the double weight of sluggish growth and relatively high inflation. Growth for 2015 is expected to be around 1% (growth peaked at over 7.5% in 2010), while inflation is expected to remain stubbornly high at 6.3%, just below the upper-end of the central bank’s target. The problem: Brazil suffers from a combination of poor infrastructure and declining demand for commodities.
Mediocre prospects for reform. The equity market rally in the spring and summer was predicated on investor optimism for a change in government. Hopes of policy changes were shed when President Dilma Rousseff was re-elected in late October. Adding to the gloom: the delay on the nomination of the next finance minister (signaling difficulties in attracting reputable figures) and a significant corruption scandal surrounding the state-controlled oil producer Petrobras.
Negative momentum and sentiment. From a top-down perspective, momentum continues to look negative going into 2015. Global investors are favoring other parts of the EM space, notably Asia, and local investors prefer bonds as short -term interest rates are over 11%, some of the highest rates in the world.
That said, while we look for equity opportunities in other parts of emerging markets, investors may want to give Brazil’s fixed-income markets a second look. To the extent that the government has already expressed that that it will strive to maintain an investment grade credit rating, fiscal austerity will likely trump growth in the short term. In addition, Brazil has one of the lowest debt to gross domestic product ratios (approximately 19%) and one of the largest foreign currency reserves balance (about USD 370 billion) in emerging markets. Thus, Brazilian sovereign bonds in local currency with rates at 13% and above seem particularly attractive in a yield hungry world, with an important number of the key risks already reflected in the price.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
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