Real Good News

Following the devaluation of the Brazilian Real in January, the BOVESPA index staged an apparently spectacular recovery from a level of 4,797 at its nadir to 12,530 in early May. Despite the dramatic upswing in prices, however, the rally represented merely a recovery from crisis valuation levels to depressed valuation levels. Since May, most of the major companies that comprise the Brazilian market have traded in a range – a depressed range. Today, at around 11,200, the BOVESPA trades at a P/E ratio of approximately 8.0x 2000E net income versus 25.0x for the S&P. Why? The threat of rising U.S. interest rates and their potential impact on capital flows and capitalization rates has been a constraining factor on valuations. But the most important factor explaining depressed equity valuations is the high sovereign risk premium ascribed to Brazil by international investors, which is clearly reflected in the price of the sovereign C bond, a dollar denominated instrument, which currently has a yield to maturity of 15.5%.

One has to wonder whether such a steep risk premium is justified. During the week of September 6^th, I visited with a dozen of Brazil’s major publicly traded companies and banks, as well as certain government officials, in order to update my assessment of Brazil's prospects. My conclusion is, in short, that the risk premium is overdone – and that it masks the fact that the Brazilian economy is showing strength in several areas that point to an equity market recovery.

Following are a few observations, analytical and anecdotal, that serve to underpin my assessment.

Key sectors of Brazilian industry are highly competitive on a global basis. I met with Aracruz, a leading global producer of short fiber wood pulp for the paper and packaging industry. At $135/ton, Aracruz’ cash production costs are the lowest in the worldwide pulp industry. Aracruz exports 95% of its production to major international customers such as Procter & Gamble and Kimberly Clark. I also met with CSN, Brazil’s #2 producer of hot- and cold-rolled steel. At $115/ton of hot band, CSN’s cash production costs are the lowest in the world, lower even than those of the major Korean and Chinese producers. CSN sells its steel to the Brazilian market as well as the European, Asian and U.S. markets, and would sell a great deal more to the U.S. if they had not been cajoled into voluntary export restraints by U.S. steel interests. The competitiveness of Aracruz and CSN reflect broad competitive advantages that are enjoyed more generally by several sectors of Brazilian industry. First, Brazil is rich in low-cost natural resources. For Aracruz, this means that eucalyptus trees mature in 6 years in Brazil compared, for example, with 15 year cycles in the U.S. and northern Europe; for CSN, Brazil has vast reserves of high quality iron ore that can be easily mined. Second, labor costs are cheap in US$ terms. Finally, and most importantly, many of Brazil’s private sector firms are very well managed. In the case of Aracruz and CSN, both companies have invested hundreds of millions of dollars to ensure that their production technologies and processes are first rate and efficiency maximizing. Brazil’s competitiveness bodes well for its ability to export into a growing world economy.

Brazil’s major private sector banks are very healthy. To take one example, Unibanco, the country’s third largest private sector bank, has a Tier 1 capital ratio of 13.8% (before a recent capital increase.) This compares with an average rate of around 8.0% among the U.S money center banks. At the same time, Unibanco has $4 of reserves for every $1 of non-performing loans, as conservative a provisioning policy as I have encountered at any major bank. These strong balance sheet indicators have lead to commentary that Unibanco and its major rivals are overcapitalized and do not make optimal use of their capital. This may be true, but excess capital and conservative provisioning provide financial strength and, in contrast to Mexico, will enable the banks to play a major role in financing Brazil’s companies as the economy recovers and growth accelerates.

Brazilians are confident in their own future. The relative values of Real-denominated sovereign debt versus dollar-denominated instruments seem to suggest that Brazilians are confident about Brazil’s prospects. As we have noted, the C bond is trading at a yield to maturity of 15.5%, while shorter dated Real-denominated sovereign paper is trading at a yield to maturity of approximately 19%. This spread is narrow in historical terms. If Brazilian companies were very concerned about the macroeconomic outlook, then the yield differential would be greater. Seen another way, investors would forego the small yield differential in order to capture the C bond’s dollar cash stream. This would seem to indicate that sophisticated market participants in Brazil perceive that the macroeconomic and political risk in Brazil is somewhat benign, or less troubling than do their international counterparts.

The Real seems to be too cheap. Since Brazil let the currency float freely, the Real has traded as high as 1.30/US$ (right after the announcement) and as low as 2.15/US$, and is now trading at around 1.88/US$. In light of these major swings, there is naturally a debate regarding the correct relationship between the currencies. The devaluation since January has been on the order of 36%, while inflation during the same period has been approximately 7%, suggesting that the currency may be undervalued. Casual observation of the dollar-based cost of living in Brazil would suggest that the Real is indeed cheap. One simply has to purchase goods or services that have primarily local content, like food, to realize that the dollar gets you too much. I came away with the sense that the forces of purchasing power parity should cause the Real to strengthen in the medium term, or to remain static as inflation slowly catches up with the Real’s valuation. Either outcome would be good for the value of dollar-denominated investments in Brazil.

Local interest rates will likely decline. Brazil’s SELIC (discount) rate has declined from over 40% in the wake of the January devaluation to 19.5% today, as tamer than expected inflation and an IMF accord enabled the Central Bank to reduce rates without undermining the Real. Recently, however, there has been concern that Brazil could have difficulty cutting rates further, which could slow or jeopardize an incipient economic recovery. In conversations with government officials, I detected a clear commitment to lower rates significantly during the next 12 months, with a year-end target of 13.5%. With inflation for 2000 projected to be a tame 5%-6%, they may well be able to do it. The private sector banks generally expect that rates will be in the 14%-15% range by the end of 2000. This is obviously bullish for the economy and stock valuations.

The critical macroeconomic and political challenges have been clearly identified. During late 1998 and 1999, the government has succeeded in passing the tax increases and spending cuts sufficient to meet the IMF-imposed requirement of a 1999 primary fiscal surplus of 3% of GDP. However, due to the government’s large debt burden and high interest charges, the government is running a fiscal deficit of 9% of GDP for 1999. Despite its industrial competitiveness and a recovery in global demand, Brazil has yet to see a significant surplus in its trade account, largely due to the depressed level of agricultural commodity prices. For 1999, the current account deficit will be plugged by foreign direct investment in the government’s privatization program coupled with a reasonable flow of private corporate investment from abroad. But more permanent structural changes need to be made to provide a strong foundation for Brazil’s economy. The good news is that there is a common understanding as to what the problems are, as well as the reforms required to address them: social security reform, fiscal reform and administrative reform. One merely has to look at projections of government expenditures and receipts under the current social security program to understand that Brazil’s fiscal situation is unsustainable. The problem is, of course, politics. While President Cardoso and his economic team seem to possess the political will to motivate required changes, they must coalesce support for their reforms within a Congress that is fractured and partisan in the best of times. In today’s environment of 7.5% unemployment, such measures as increasing the retirement age for pension benefits and eliminating government jobs are particularly unpopular. The doubt concerning the government’s ability to push through reforms and provide a long-term solution for the fiscal situation explains the high risk premium ascribed to Brazil by international investors.

Reform is a question of timing. Cardoso and his team have mitigated the short-term fiscal problem by crafting a FY 2000 budget that complies with IMF requirements and requires Congressional approval for only $2 billion of adjustments. With respect to the process of instituting more permanent reforms, there is a consistent view within business and government regarding the outcome: the reforms will be passed, but it will take longer than hoped for by themselves and foreign investors. More than one person correctly pointed out that it has taken decades for the U.S. to manage social security more efficiently. So reform will come, and the principal malady effecting Brazil’s risk premium will be cured, but it will take a few years. I tend to agree with this point of view. We have seen evidence in Brazil, as in Argentina and Mexico, that when reform is a necessity, even a recalcitrant Congress will submit to the dictates of economic reality. With the economy picking up, it should become somewhat easier to get reforms passed.

This all leads us to conclude that Brazil is poised for a strong recovery in equity valuations, and that the primary risk to this recovery is a failure of the government to make progress on fiscal reform. Of course, other risks do exist that could negatively impact Brazilian equities - an unexpected spike in U.S. interest rates, a downward re-rating of U.S assets, a faltering of the recovery in global demand and commodity prices, for example. But the primary drivers will be Brazil’s fundamental strengths and the nation’s ability to take action on the fiscal deficit.

James E. Hunt

September 1999