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Key points

  • We continue to see some of the best potential opportunities within emerging markets (EM) in Latin America, although we recently downgraded EMs overall to neutral from overweight.
  • The region’s largest economy, Brazil, has seen a wave of relatively recent political optimism buoy its equity market. Brazilian equities are up +40% over the last 12-months as a fiscally responsible reform agenda has outweighed the balance of populism and macro uncertainty.
  • Now, with pension reform awaiting approval by the Senate, investors must weigh the trajectory of fiscal reforms to support growth prospects with a relatively challenging environment of weak macroeconomic conditions and high valuations.

Background

After years of weak economic growth and political uncertainty, developments in 2019 have redirected investor attention to Brazil, Latin America’s largest economy. Although economic growth has been challenged by weak domestic indicators, two words have supported investor optimism for Brazil’s equity prospects year-to-date: Pension reform.

On Wednesday July 10th, Brazil’s lower house of the National Congress passed a bill in favor of pension reform that would free up nearly $265 billion over the next 10 years. This legislation is now in the hands of the Senate, where it will likely go through 45 to 60 days of debate before a final vote.

The importance of pension reform for the fiscal capacity of the economy cannot be understated. Brazil spends roughly 13% of its GDP on social security spending, well more than the average of 8% for G-20 nations.1 This is a particularly burdensome dynamic for an economy with lackluster growth, an aging demographic, and high levels of liabilities. Note that Brazil has some of the highest constitutionally mandated spending in the world (93% of the government’s budget is mandatory) and the highest government debt to GDP ratio out of all EM countries (90%).2

We believe the positive reach by investors of the reform bill has driven the country’s outperformance over the last year. The MSCI Brazil Index has outperformed the MSCI Emerging Markets (EM) Index by 19 percentage points since April (figure 1).

Figure 1: MSCI Brazil has outperformed MSCI EM by 19 percentage points since April lows

Figure 1: MSCI Brazil has outperformed MSCI EM by 19 percentage points since April lows

Source: Thomson Reuters, as of July 17, 2019. Based to 100. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

However, recent market activity suggests pension reform may be “priced-in.” Interestingly, Brazilian-focused equity exchange traded products have experienced primary market outflows despite the rally in the secondary market (figure 2). But, even the secondary market has weakened since the lower congress passage on July 10th.

Figure 2: Investors have withdrawn from Brazil focused ETFs recently despite secondary market outperformance

Figure 2: Investors have withdrawn from Brazil focused ETFs recently despite secondary market outperformance

Source: BlackRock, Markit, as of July 17, 2019.
Notes: Flows are U.S. listed ETFs with a geographic focus of the designated region.

Going forward

Will Brazil live up to expectations or will its politically driven rally fade? Here are three key factors to consider:

The fiscal reform agenda beyond pension reform faces challenges: Pension reform is seen as critical to stabilize the country’s spending levels. It also enjoys broad political support, but this is not the only measure necessary to foster private sector growth. The Minister of the Economy, Paulo Guedes, and Congressional partners have voiced an ambitious agenda which includes simplifying the Brazil’s complex tax system. Other priorities include measures to incentivize private investments and lower trade barriers.

Weak economic conditions may find gain a boost from monetary policy: Brazil’s economy remains strained despite exiting a mild recession in 2016. First quarter GDP growth in 2019 was just 0.46% YoY.3 Industrial production and retail sales indicate this weakness continued into Q2. Relatively weak confidence indicators have contributed to these disappointing growth readings. Fortunately, inflation continues to run below the Brazil Central Bank (BCB)’s target rate. This provides room for the BCB to cut the benchmark policy rate and add stimulus at their upcoming September meeting.

Valuations are high relative to the 10yr history: While Brazil’s forward P/E at 12.4x appears attractive relative to broader EM at 13.5x, the country’s P/E is still higher than its own average of 10.9 over the past ten years.

Conclusion

Brazilian equities could gain a boost from further pension reform efforts, the ongoing economic recovery (albeit at a gradual pace), along with the potential for accommodative policies from the central bank. However, investors should be aware of risks, which include equities that are currently at high valuations, and the possibility that any reversal of reform efforts could have a negative impact on the markets.

Christopher Dhanraj
Director
Head of iShares Investment Strategy
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