Tuesday, 19 March 2013

A Brazilian school report

Having recently reviewed my nephew’s first school report, I was highly amused by the reference that 'though his written work is the product of an obviously lively imagination, it is a pity that his spelling derives from the same source'. I applaud the teacher’s assessment of the situation, let’s hope the latter improves and the former is not stifled.

If I were charged with compiling a similar periodic update on the progress of the Brazilian government, and its handling of economic affairs, I’m afraid I would probably harp back to the age old adage 'could do better'. As investors will be so acutely aware, both the Brazilian economy and stock market have experienced a dramatic fall from grace over the past two years. Whilst in 2010 economic GDP came in at a meteoric 7.5%, in 2011 this had slumped to 2.7%. Last year was worse still - a measly 1%. Stock market returns have been equally weak with an accumulative 25% wiped off the Bovespa (its flagship equity market index) over the same 3 year time horizon. This is all the more disappointing given the S&P 500 has rallied by an almost equal amount.

Though the deceleration in Chinese economic activity has likely been a key factor in the malaise of resource-rich emerging markets, Brazil’s issues have been compounded by the impact of meddling government. The government’s keenness to regulate the profit structure in the resource part of the economy has been long understood; however, more recently the net has been cast further afield. The sectors of the economy now coming under the sphere of ‘government regulation’ and that have also been heavily punished in share price terms, include utilities, telecoms, infrastructure and the banking sector.

Whilst much of the imposition on corporate activity has been in an attempt to reduce the cost of doing business (loan rates, utility bills etc), government interference is rarely well received. Indeed in this instance, the generally stimulative measures government has taken in regard to wages, combined with regulation on pricing, has resulted in a significant contraction in profitability. This toxic mix has, in turn, lead to a reduction in capital investment and, ultimately, weak economic performance.
Source: Bloomberg
Noises made by government appeared remiss late last year when Guido Mantega, the finance minister made the following statement, 'It’s not true that we are interventionists, but we have done reforms…. Some of them hurt and would go against very minority interests.' To our mind this places shareholders (minority interests) quite far down the list in terms of government priorities.

President Dilma Rousseff’s popularity does not seem to have waned as, despite weak economic growth, the country remains near full-employment and wages continue to rise. Rousseff and those around her will know, however, that growth rates of 1% will not be sufficient to support the current level of stimulus, and it could just be that early signs of government withdrawal are underway.

In February this year Mantega and the head of Brazilian investment bank (BTGPactual), took the ‘Brazilian Infrastructure Investment Case’ on a global road show, in attempt to attract much needed World Cup and Olympic infrastructure funding. Such an audience will have undoubtedly passed on concerns regarding profit regulation and the need for greater ‘concessions’.

In 2013 we have also seen the failure of high profile highway construction auctions, in which a number of firms were expected to keenly contest. No doubt the returns on offer did not reflect the risks associated with the investment, and the government must now come back with a better offer. Whether such changes reflect government enlightenment or simply the market saying ‘enough is enough’ we are not sure. Regardless, the outcome is rewarding for investment prospects.

Another positive, particularly for the stock market, has been that Petrobras has finally made a ‘shareholder friendly’ announcement. For years the company has been a tool of government policy, resulting in significant wage inflation and the undertaking of increasingly risky, expensive and longer term oil projects. These cost issues climbed whilst revenues were stymied as government capped prices at the pump. In March this year, however, Petrobras announced, much to the joy of shareholders, that it would at last be raising diesel prices.

Whilst these measures are favourable, more evidence is probably needed to abate market fears of government interference, and the negative feedback loop this can have on equity returns. The Chinese cyclical recovery also looks a little shaky given recent leadership announcements aimed at cooling real estate performance.

Investors might be better rewarded sitting on the sidelines for a little while yet and, instead, focus their efforts on the core markets. Or, in teaching parlance, 'perhaps Ben should start focusing on more important subjects such as maths and English, rather than whether Mrs McGinley does or does not have a beard'.

Ben Gutteridge
Divisional Director - Research

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