Download A Puzzle in Portuguese

Perspectives
April 2013
Emerging Markets Debt
Quebra-cabeça—A Puzzle in Portuguese
Brazil’s Macroeconomic Challenges and Relative Value Opportunities
Arvind Rajan
Managing Director and
International Chief
Investment Officer
Prudential Fixed Income
From 1900 to 1980 Brazil was one of the world’s fastest growing economies,1 but for
roughly the past three decades the country has had to overcome a string of crises to
arrive at its present state—a tantalizing mix of opportunity and challenges. Today,
investment opportunities remain, but they are less obvious and far more dynamic.
We believe that successful fixed income investing in Brazil requires an in-depth
understanding of their economic and policy backdrop, combined with a rigorous
bottom-up research process and strong technical knowledge of Brazil’s sovereign
and corporate debt, as well as currency instruments in order to take advantage of the
many relative value opportunities that it presents.
Structural Gains
One of the more successful chapters in Brazil’s recent history was the reduction of
external vulnerabilities in the economy. This was accomplished by a reduction in external
indebtedness, the adoption of a floating exchange rate regime, and a significant build-up
of foreign exchange reserves. Such external resiliency was demonstrated during and
after the 2008 crisis, and the Euro-zone crisis which followed. An inflation targeting
regime helped anchor the economy, bringing down interest rates, tempering inflation, and
fostering growth through renewed confidence. This complemented the improved fiscal
resolve to generate primary surpluses to reduce government debt. Policies aimed at
liberalizing the financial sector and allowing for the development of the domestic capital
markets also helped. By far, the key puzzle piece of success for the political economy
was the improved income gain which helped support the development of a large middle
class. Brazil has a low unemployment rate that most developed markets can only envy.
All of these achievements solidified Brazil’s place in the top tier of emerging economies—
providing stability and a seemingly attractive place to invest.
1
Source: Angus Maddison 1995, “Monitoring the World Economy 1820-1992.”
Perspectives—April 2013
Current Stagnation and Challenges
But Brazil’s status as a darling of the emerging world is being challenged. Economic successes—
including the gains from a positive terms-of-trade shock—masked the imbalances. In recent years,
particularly 2012, growth has lagged and is below potential, underscoring production inefficiencies and
competitive and productivity challenges, despite strong domestic demand. In our view, some of the earlier
structural gains did not go far enough. Arguably, the public sector is still too large, non-discretionary
spending too big a piece of the budget, and crucially, investment is too low. This is most apparent in the
deficiency in the country’s infrastructure. Also, Brazil’s very high taxes create distortions and hurt
competitiveness. Likewise, labor rigidities and confusion about the degree to which policymakers are
willing to interfere in the economy creates uncertainty. While leadership at the top is very capable and
policy management in general held in high regard, there is the perception that things have veered off the
path. One need only review decisions regarding the exchange rate level, the role of policy banks, capital
controls, and government policy in the mining and energy sectors to see the basis for this skepticism.
Future Macroeconomic Challenges and Risks
In the very short-term, the challenge is re-anchoring confidence. This can be achieved with very clear and
consistent policy signals with regard to monetary policy, the exchange rate, and the fiscal realm. Equally
important over the medium to long term, we believe that an increase in investment and savings will be
key to sustainable growth. The Brazilian government has a well articulated plan to increase infrastructure
investment, and to improve the structural competitive challenges facing the economy. The challenge is to
implement it—and falling short in this important dimension risks lower potential growth with higher
inflation.
While exceptionally capable in our view, the credibility of Brazil’s central bank has been undermined. It
has been criticized for trying to target too many objectives at once—inflation, growth, and the exchange
rate. That said, recent announcements may help improve this perception and we believe that the market
has not duly credited the central bank for cutting rates when they did. Other challenges include the
potential creation of an asset bubble, or a framework that does too little too late to avoid a boom/bust
cycle.
Better Value in Real-Denominated Government Debt
These challenges notwithstanding, we believe Brazil’s government debt remains safe, and we expect its
ratings, currently Baa2/BBB/BBB, to remain investment grade. Nevertheless, with slightly more than a
120 basis point spread over U.S. Treasuries, and limited spread compression potential, Brazil’s dollardenominated sovereign 10-year bonds offer mediocre value, especially relative to other highly rated
sovereigns with upgrade potential such as Mexico and Indonesia. Longer dated 30-year bonds offer only
slightly better value at a spread of approximately 160 basis points.
In contrast, local government debt remains compelling. Both sovereign hard currency and local
government yields have rallied strongly over the past decade. Yet with nominal yields over 9% and real
yields of over 3%, the Real-denominated debt offers considerably better value than the external debt as is
illustrated in the chart below. It also offers good relative value compared to developed country
government bonds. Brazil’s local curve remains one of the steepest in the world and offers the likelihood
of long term convergence given Brazil’s ongoing commitment to prudent fiscal policy and relatively strong
inflation-fighting credentials. As inflation converges toward that in the developed world, we believe there
is a high probability of a long term reduction in rates of several hundred basis points.
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Perspectives—April 2013
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USD Brazil Sovereign Curve
12.0
Rate (Mid Conventional %)
10.0
BRL Brazil Local Curve
USD Brazil Sovereign Curve
US Treasury Curve
8.0
6.0
4.0
2.0
0.0
1M 6M 2Y
4Y
7Y
10Y
15Y
20Y
25Y
30Y
Source: Bloomberg. As of 3/18/13.
Currency—A Real Riddle
Until early 2012, the Brazilian Real enjoyed a strengthening trend, driven by a confluence of factors—
strong capital accounts from foreign direct investment and portfolio flows, high nominal and real yields,
rising external reserves, and the benefits of being a commodity exporter during a commodity super cycle.
However, since February 2012, the Brazilian Real has transitioned from a free-floating to a managed float
currency. The government, dismayed by poor growth and an uncompetitive export sector, decided to
engineer a weaker Real. Together with the 500 basis point rate cutting cycle that began in late 2011, this
intervention policy decimated currency returns in 2012, making the Brazilian Real one of the worst
performing currencies in 2012 with a 9% depreciation in nominal terms.
Emboldened by a $350 billion war chest of reserves, central bank intervention became more aggressive
and more frequent, with the intent to depreciate the currency and deter speculative inflows into Brazil.
Currency volatility became a function of central bank policy and action rather than free market forces. In
2012, from February to May, the Real traded from 1.7 to 2.1, even as growth, confidence, and capital
flows deteriorated and inflation expectations rose. In late 2012, the Brazilian authorities, sensing the need
to tame inflation and restore foreign direct investment, declared themselves comfortable with the level of
the currency. From December 2012 to February of this year the Brazilian Central Bank allowed the
currency to appreciate from nearly 2.14 to below 2.
Going forward, we believe trading the Real is likely to remain tricky. A short hiking cycle is priced in for
2013, but rate hikes are likely to be slower and shallower than what the curve prices in, reducing
appreciation pressures. Inflation too will likely taper off gradually. Equally important, the currency regime
will continue to be managed-float and it will be important for investors to heed any central bank
communication concerning the level and trend of the exchange rate and the pattern of intervention. At this
point the Brazilian Central Bank has demonstrated that it has both the credibility and the tools to control
the foreign exchange market, and past important levels of perceived intervention targets will need careful
monitoring.
Perspectives—April 2013
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Corporates—Calling for Careful Bottom-up Analysis
If choosing government bonds and currency is tricky, the Brazilian corporate bond asset class can be a
real challenge. On the one hand, the major emerging market countries include a number of world class
companies and Brazil is no exception. However, in today’s world of easy money, lenders must be wary of
the fundamentals and do their credit homework, and here again, Brazil is no exception. While many
Brazilian corporations are high quality credits and offer significant spread pick-ups over comparable
developed country corporations, there are also situations where over-exuberant investors are demanding
too low a spread premium. To illustrate a relative value example, we contrast the basic credit data on two
Brazilian corporate issuers in the following table. It is our view that Odebrecht offers better risk/reward
than Oi. Odebrecht is an investment grade construction company, which being internationally diversified,
offers exposure to construction in Latin America (albeit focused in Brazil), low leverage, strong positive
free cash flow, a backlog of projects including hydro, ports and roads as well as those related to the 2014
World Cup and 2016 Olympics, a history of strong management and significant pick-up over the
sovereign. Oi, by contrast, is a relatively highly leveraged wireless operator facing pressure on margins
from strong competition, high capex needs, with a wireline business that is in secular decline, and
negative free cash flow—hence not as good a value despite trading at a somewhat higher credit spread.
We expect their relative spreads to widen as the market prices in these fundamentals. We believe this
comparison demonstrates the need for careful bottom-up credit selection, rather than a broadbrush
approach to emerging market corporate credit.
Corporates in Contrast: Odebrecht vs. Oi
Company
Odebrecht
Oi
Industry
Construction
Telecommunications
Rating
Baa3/BBB-/BBB-
Baa3/BBB-/BBB-
Bond Spread
+237 bps
+308 bps
Net Leverage
0.8x
2.9x
LTM Revenue
BRL 27.4B
BRL 28.1B
Net Debt
BRL 2.3B
BRL 25.1B
Free Cash Flow
Strongly positive
Negative
Characteristics










13th largest in world
35-40% Brazil +18 countries
Strong backlog of projects
2014 World Cup/2016 Olympics
Increased infrastructure spending
4th in wireless market share
Wireline business in secular decline
High capex needs
Large dividend
Competitive wireless industry
Source: Prudential Fixed Income. As of 3/19/13. Shown for illustrative purposes only and does not constitute a recommendation by Prudential Fixed Income to
buy, sell or hold any security.
Fitting The Pieces Together—In Depth Research Is Crucial
Brazil illustrates a dilemma for investors common to the fixed income assets of many emerging countries
today. The takeaway here, applicable to all emerging countries, is that intelligent investing calls for a
nuanced approach that is both macro driven and country and asset specific. On the one hand, the
fundamentals of emerging economies may be superior to those of the developed world in terms of
growth, debt sustainability, and credit trajectories. Prospects appear strong for emerging market bonds as
an asset class. On the other hand, emerging market bonds cannot replicate the past decade of stellar
returns, and in aggregate offer only steady mid-single digit performance, being more a safe haven than a
Perspectives—April 2013
risk-reward play. In this context, the need to choose the right local curves, currencies, and credits within
and across countries is now more important than ever to maximize returns.
We believe there are two key ways to take advantage of such relative value opportunities. The first is a
traditional long-only approach—selecting a broadly defined blended benchmark of hard-currency
sovereign and local bonds, and allowing a manager to freely add value by shifting between currency,
local yield and hard currency sovereign and corporate spread risks to find the best alpha opportunities.
An alternative, available to those willing to take a pure relative value approach, is a long-short strategy
that seeks to maximize exposure to specific mispricings in rates, currency and spread markets without an
explicit emerging market benchmark. The latter approach could potentially target a high single digit
absolute return over LIBOR utilizing all possible instruments and hedging out those risks that do not offer
good returns. Either approach has the potential to allow investors to find opportunity in what appears to
be a puzzle in Portuguese.
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2013-0673
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