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Political Crisis Threatens Brazil’s Recovery

Corruption charges have caused share prices to dip in Brazil, but could this ultimately bolster returns over the longer term?

Cherry Reynard 12 July, 2017 | 12:48PM

This article is part of the Morningstar's Guide to Emerging Market Investing. Click here to find out just what an emerging market is and which regions hold the potential to boost your investment portfolio.

Brazil appears to be careering towards another constitutional crisis. President Temer has been indicted for corruption, after he was taped by businessman, Joesley Batista - the former chairman of Brazil’s largest meatpacker JBS (JBSS3)- apparently discussing bribes. It is the first time a Brazilian leader has faced criminal charges since the country embraced democracy in the 1980s.

It is less 12 months since Brazil laid to rest its last political scandal, with the impeachment of Dilma Rouseff over connections to the Petrobras scandal and economic mismanagement.

Markets were happy to see the end of her administration and the main Brazilian stock market -  the Ibovespa - has risen 61% since impeachment proceedings began in early 2016. Brazil’s resurgence has also helped shore up confidence in wider emerging markets. The question now is whether this new crisis will reverse the gains seen since the start of the year.

The new scandal has already prompted a wobble. Markets have dipped around 5% at a time when other developed and emerging markets have been flat. Partly this is because, in Brazil, politics and the corporate sector can be uniquely entwined. The company at the heart of the Rouseff scandal, Petrobras, is also the largest constituent of the MSCI Brazil index.

Nevertheless, it is clear the economy in Brazil has made progress over the past 12 months. Ross Teverson, manager of the Jupiter Global Emerging Markets fund, says: “At the start of 2016, inflation was in double-digits and interest rates were at 14%. Today, inflation is below 4% and interest rates are around 10%. We are also seeing real signs of economic recovery. Brazil is in a much better place to 18 months ago. Equally, there is a broad consensus that fiscal reform is necessary, even if Temer is not the man to see it through.”

Political Problems May Delay Economic Reforms

There is broad consensus that Temer’s corruption problems may delay reforms. A recent vote on labour rights was rejected by the Senate and the Government has some difficult pensions legislation ahead.  Nevertheless, the Brazilian economy outpaced expectations in the first quarter, rising 1% on a quarter-on-quarter basis. This was its first expansion in two years. The economy has contracted 8% during the recession. 

There has also been a notable stabilisation in the banking sector. Tom Smith, manager of the Neptune Latin America fund, says: “Public banks were being forced to lend at very low spreads – there had been a risk that they would need to raise new capital. This problem has dissipated and the earnings outlook has improved dramatically.”

This is important, he said, for both the flow of capital in the country, and the stock market, of which financials are a significant slice. 

The other key difference for investors is that valuations in Brazil are no longer at rock-bottom as they were at the start of 2016. However, Smith believes they still don’t look expensive: “The market has been very strong, but is currently trading on a little under 11x earnings, a discount to wider emerging markets.

“At the same time, earnings growth is much higher because the country is coming out of recession. The return on equity for the Brazilian market as a whole, is in excess of emerging markets and developed markets.” 

Pockets of Value In Brazilian Stocks

However, Teverson believes the market requires discernment, and there are risks in holding companies whose fortunes are too linked to those of the government. He says: “For companies such as Petrobras, there is a misalignment of interest between the management team and minority shareholders. They tend to be a tool of government policy rather than trying to create shareholder value.”

Nevertheless, he is finding plenty of value in companies such as Kroton (KROTF), which provides private university education across Brazil. On a low valuation with a compelling dividend yield, the company is seeing double-digit growth and looks stable whatever the political weather, he says. ITAU (ITUB), another holding in the Jupiter fund, has a ‘strong banking franchise, and strong asset quality’.

The Brazilian market is also moving away from its traditional reliance on commodity exporters. Smith says: “The market is diversifying. The commodity sectors materials and energy represent less than 25% of the Brazilian market, down from nearly 60% in 2007, and financials is now the largest sector. There are also some big consumer stocks, but the index is well-diversified and there are plenty of opportunities."

There is an argument that Temer’s indictment is actually good news for Brazil in the longer-term. It comes after a three-year wave of investigations into corruption at top of Brazilian politics and business, which started with the Petrobras scandal.

Teverson says: “It is no surprise that further allegations of corruption have come to light. Even if the exposure of corruption creates volatility, it is symptomatic of a change in Brazil, and that lawmakers have the ability and will to see these investigations through to their conclusion.” Brazil may see some short-term pain, but this may help it deliver longer-term strength.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Itau Unibanco Holding SA ADR12.57 USD-4.92
JBS SA8.66 BRL0.00-
Jupiter Global Emerging Markets Acc72.22 GBP-0.19
Kroton Educacional SA4.20 USD59.45-
Neptune Latin America C Acc GBP1.04 GBP0.48
About Author Cherry Reynard

Cherry Reynard  is a financial journalist writing for Morningstar.co.uk.