Brazil is an emerging market with a compelling economic growth story. Though growth has moderated somewhat in recent years – we expect growth of 2.5% in 2012 – the slowdown is mainly in sectors that depend on the export market. Local demand remains healthy and employment is robust: Brazil’s Labor Ministry reports the country added more than 1 million new jobs in five of the past six years. Improved macro policies, a rising middle class, strong capital flows and regulatory changes contribute to the growth story. The government has also committed to major funding of infrastructure development to spur economic expansion, and for investors, the large financing needs accompanying these investments may present substantial opportunities.
In the following interview, Brigitte Posch, emerging markets portfolio manager, discusses recent developments in Brazil and considers the outlook and investment implications for the nation’s corporate and banking sectors.
Q: Following the financial crisis, Brazil enacted huge stimulus programs. How did these developments play out, and how are they influencing your positioning in Brazilian corporates in 2012?
Posch: Brazil’s stimulus programs from 2008 through year end 2011 have totaled about US$140 billion, according to the International Monetary Fund (IMF). They included funding through Brazil’s state development bank BNDES (Banco Nacional de Desenvolvimiento Economico e Social), tax reductions, the Brazilian Growth Acceleration Program, lower bank reserve requirements and other activities.
Public lending via state-owned banks and BNDES increased significantly: Earmarked credit expanded from 11.7% of GDP in 2008 to 17.6% in 2011, and BNDES provided almost 60% of earmarked total credit. Housing credit has also expanded briskly since 2008, according to Bank of America Merrill Lynch. In addition, bank reserve requirements were reduced by 81 billion reais between September and December 2008, according to the Banco Central do Brasil (BCB), and policymakers adopted measures to increase liquidity for smaller financial institutions. They began to reverse these measures in 2010.
These stimulus programs and liquidity measures have helped boost real corporate average earnings in Brazil – by more than 26% since 2005 compounded annually, according to Bank of America Merrill Lynch (as of April 2, 2012). Wage improvements are partially explained by increases of almost 140% in the minimum wage between 2005 and 2011, as Brazil’s Ministry of Labor reports, but are primarily the result of a robust labor market: Unemployment fell from 10% in 2005 to 5.7% in February 2012, according to IBGE (the Brazilian Institute of Geography and Statistics).
In 2011, Brazil adopted additional stimulus measures to help counter the economic slowdown, but on a much smaller scale than in the post-crisis years, owing to concerns about inflation, which peaked at 7.3% in September 2011 before moderating to 6.5% at year end, right at the top of the BCB’s inflation target band. Of course, several factors, including robust domestic demand and rising commodity prices, have contributed to the increase in inflation and, ultimately, higher labor costs.
Amid these cross currents, we believe some Brazilian corporate sectors and companies offer better potential sanctuary than others. We prefer those sectors that feature companies that have strong pricing power and attractive value vs. developed markets. For example, we have positive secular and cyclical views about sectors directly and indirectly linked to oil and gas, banks and utilities.
Q: Are the government programs stimulating the Brazilian corporate sector a positive or negative influence on the economy and investors?
Posch: Since Brazil’s story of consumer spending and investment will likely follow a relatively stable long-term trajectory, given a strengthening middle class and continued infrastructure needs, we believe the BCB’s interest rate cycles should have limited impact on Brazilian corporates.
Additionally, some specific sectors targeted by stimulus measures might see continued benefits in the longer term. In particular, exporters may benefit from the government’s willingness to intervene in the currency exchange markets in an effort to prevent appreciation of the Brazilian real, as well as from easier monetary policy that ultimately could result in a weaker currency and cheaper and more competitive Brazilian exports. Furthermore, companies engaged in infrastructure development are likely to benefit from projects scheduled to be completed before the World Cup in 2014 and the Olympic Games in 2016.
Q: What is your view on the Brazilian banking sector and how it compares with the U.S. banking sector?
Posch: Brazil’s three major banks – Itaú Unibanco, Bradesco and Banco do Brasil – rank among the top 35 global banks by equity market capitalization as of April this year, according to Bloomberg data. The largest, Itaú Unibanco, ranks 12th in the world with a market cap of US$78 billion.
Brazilian bank fundamentals remain generally solid, underpinned by favorable GDP growth. The banking system is closely regulated and well-capitalized: Based on our own research at PIMCO, we estimate the top three Brazilian banks boast an average total capital adequacy ratio of over 15%. We find that net interest margins are also robust – above 6% on average for the large banks, compared with roughly 3% for U.S. peers – a function of higher asset yields coupled with healthy deposit funding profiles. Asset quality has shown some deterioration, seen in rising delinquency rates in 2011. We expect this trend to continue in the first half of 2012, which at least partly reflects a natural progression of the current business cycle.
Although credit growth has decreased in the private sector bank channel, we believe consensus expectations of loan growth, typically in the mid- to high teens, exceed GDP growth forecasts by a factor of five and warrant concern. We are watching this closely.
Although Brazilian financial institutions have been able to consistently raise funds to maintain their credit portfolio growth, many depend on short-term funding. According to the Central Bank’s Financial Stability Report, in June 2010, 59% of total funding in the Brazilian financial system had debt maturity of less than 12 months.
Banks’ funding encompasses a complex alphabet soup of products tailored to operate within, and sometimes around, strict reserve requirements for traditional deposit categories. Relatively high nominal rates and firmly ingrained inflation memories tend to result in a shorter-duration bias in local markets, for both assets and funding. This represents a weakness vs. developed markets to some degree, but we see a significant divergence between Brazil’s big banks and its small- to mid-size banks, with the former representing a funding “flight to quality” in times of stress, while the latter are continually being squeezed.
On the other hand, Brazil has a highly consolidated banking sector with little space left for impactful mergers and acquisitions. Such a landscape has historically resulted in a supply/demand dynamic where monetary policy changes slowly affect the cost that customers bear when borrowing from Brazilian banks. So we expect Brazilian banks to enjoy attractive net interest margins over the longer term.
Q: Should we be concerned about a credit bubble in Brazil, and how is it different from the story in the U.S.?
Posch: Elevated loan growth should be considered in the context of relatively low credit penetration across emerging markets, which we believe supports a strong secular loan growth profile. For instance, loan penetration in Brazil – approximately 49% of GDP as of 2011, according to the BCB – still pales in comparison to more than 135% across developed economies (source: Bradesco). Although the payment-to-income ratio in Brazil is greater than in the U.S., the ratio of total household debt-to-income is significantly lower: 38% as reported by BCB vs. 130% of GDP in the U.S. as of 2011, according to data from the Federal Reserve Board and Haver Analytics. And though Itaú Unibanco reports that housing loans also increased six-fold from 2006 to 2011, they still represent only around 5% of GDP.
Though we regularly caution emerging market banks not to aspire to developed market levels of credit penetration, we do believe upward social mobility warrants an accompanying order of magnitude shift in credit availability. Brazil’s relatively low unemployment rate of 5.7%, strong real wage gains and a stable macroeconomic environment continue to be drivers of credit penetration.
Q: Based on all these factors, do you see Brazilian corporates as attractive on a credit fundamental and relative value basis?
Posch: Investment grade rated corporates show better net leverage ratios and compelling relative value compared with developed market corporates. (Please refer to Figure 1. Charts related to this and certain other data appear at the end of this article.) And Brazil’s corporate sector is expanding: J.P. Morgan’s Brazil sub-CEMBI Broad Diversified Index had 49 issuers – 70% of them investment grade – at the end of February 2012 vs. 22 issuers in 2008. In addition, J.P. Morgan reported that in 2011, there were 53 rating upgrades of Brazilian corporates vs. just 12 downgrades. Broadly speaking, many EM corporate issuers have had healthy profits, positive cash flows, low cost structures and manageable debt profiles, and many EM investment grade corporate indexes had higher total returns than comparable U.S. corporate indexes in the first quarter of this year, as illustrated in Figure 2.
All things considered, PIMCO believes that several key corporate sectors – oil, gas, utilities, infrastructure and major banks – will dominate the outlook for Brazil over a secular horizon thanks to stronger pricing power and improved profitability. Despite the threat of higher inflation and a stronger Brazilian real, we continue to believe that Brazilian corporates can offer attractive opportunities relative to EM sovereigns and developed market corporates as supported by their historical spread levels over LIBOR (Figure 3).
Richard Hofmann and Renato Loes contributed to this article.