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Is now the time to buy this rallying emerging market?

27 July 2016

Brazilian equities have returned almost 80 per cent this year, but manager of the Neptune Latin America fund Thomas Smith believes the asset class has only just got going.

By Thomas Smith,

Neptune

The outlook for emerging markets has changed quite dramatically over the course of 2016.

During January there was a growing consensus that we were heading towards a global recession, the Fed was going to hike interest rates several times in 2016, and there were real concerns over a looming crisis in China.

The tighter global financial conditions resulting from higher US interest rates was weighing on the stockmarkets and currencies of those emerging markets tackling current account and budget deficits, with the prospect of a balance of payments crisis.

Since then, there has been a huge change in the expectations for global financial conditions and the outlook for the global economy.

Performance of indices in 2016

 

Source: FE Analytics

The Fed is now responding more to global factors rather than focusing solely on the domestic economy, and the outlook for a more gradual rise in interest rates has caused the dollar to weaken and eased pressure on the emerging economies.

Global economic data has improved at the margin and stimulus in China has eased fears there. Latin America has been a major beneficiary of these developments with twin deficits in all of the major Latin American economies.

The Brexit vote has pushed yields down further with the response of even easier monetary policy from global central banks.

Above and beyond the more favourable global developments, Brazil has seen a huge improvement in the political landscape.

In May, Congress proceeded with the impeachment of President Dilma Rousseff and her Vice President Michel Temer took over as interim president. The impeachment will be voted on in August but it looks very likely that the Senate will vote to confirm the impeachment.


Temer’s appointment of a market-friendly cabinet, particularly with Henrique Meirelles as finance minister, has helped support the rally in the equity market and the currency.

Performance of index and currency in 2016

 

Source: FE Analytics

We have seen huge outperformance from those emerging markets pursuing a reform agenda in recent years. Mexico was one of the first in 2012 with the election of Enrique Pena Nieto, followed by India and Indonesia in 2014 with Modi and Jakowi, and most recently in Argentina with the election of Mauricio Macri in October 2015.

Brazil is now getting increasing attention from investors and the reform story is moving forward.

Slightly fortuitously, Temer has taken over at a time when the Brazilian economy is bottoming. Inflation peaked at nearly 11 per cent in December, has now fallen below 9 per cent, and could fall to less than 7 per cent by year end, approaching the Central Bank’s target range for the first time since December 2014.

The Brazilian real has strengthened by nearly 30 per cent against the dollar since January, which will further help the disinflationary trend. Brazil was slow to make the economic adjustment that was necessary and being made by other emerging markets, but the current account deficit has finally started to close after reaching 4.4 per cent of GDP in 1Q15.

It had closed to just 2.5 per cent of GDP in 1Q16 and both April and May data show Brazil running a current account surplus for the first time since 2007. Consumer confidence is rising and the more benign economic and political environment, along with an acceleration of the government’s infrastructure program, should lead to a ramp up in investment and help lift Brazil out of recession next year.

Consensus expectations for the economy to grow by just 1 per cent next year look very conservative.

The improved outlook for the economy, lower inflation, and material reduction in political risk has driven a significant reduction in long term yields, with the ten year yield on government bonds falling from a peak of nearly 17 per cent in February to 12 per cent now.

They still remain well above the levels of 9 per cent seen in 2012-13. In an effort to contain inflation the central bank doubled interest rates over the past three years from 7.25 per cent up to 14.25 per cent. As inflation moderates they are expected to begin an easing cycle later this year.

Performance of indices in 2016

  

Source: FE Analytics

Two sectors stand to benefit most from the fall in long-term yields, the banking sector and companies with bond like characteristics such as property and infrastructure concessions.


 

The private banks such as Itau and Bradesco are also benefiting from an improved competitive environment as the public banks over extended themselves in recent years trying to stimulate the economy and are now having to take a step back.

Spreads have been rising and return on equity has risen well above 20 per cent at Itau. This combined with a significant fall in the cost of equity should lead to a strong rerating, from the depressed levels of around 1x price to book in the first quarter for Itau, and below 1x for Bradesco.

The utility sector was caught in the eye of the storm and suffered most from Dilma’s interventionist policies in recent years. The sector wasn’t helped by the drought-induced water crisis in Brazil, and the prospect of electricity rationing, but the combination of factors caused earnings to decline by over 80 per cent from 2011 to 2015.

The share prices followed this decline, with the MSCI Brazil Utilities Index falling by over 80 per cent from its 2011 high. As Brazil emerges from the water crisis and reservoir levels normalise, and as the outlook for much more constructive regulation towards the sector, earnings are expected to recover along with share prices.

Performance of indices over 5yrs

 

Source: FE Analytics

With both global and domestic factors aligning, and with valuations only beginning to recover from the distressed levels seen in the first quarter of 2016 after six consecutive years of underperformance, the outlook is increasingly bright for Latin America’s largest market.

 

Thomas Smith is manager of the Neptune Latin America fund. All the views expressed above are his own and should not be taken as investment advice.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.