Assignment: Emerging Markets – Brazil in Focus

Introduction

The two most recent decades have seen dramatic growth from numerous emerging countries. As the number of countries grew so were the opportunities to invest, but while the exceptional returns of China may seem of easy reach, one has to remember the shortfalls of Argentina or Russia defaults that wipe out hoards of reckless investors. Following sharp declines in equity markets in Canada and U.S in 2008, institutions and individuals are looking more than ever for enhanced profit opportunities. Although the picture for 2010 looks significantly better than 2009, high returns are not expected anytime soon in North-American markets as economic recovery is slow to take place. At the same time emerging markets, with the exception of Russia, have proved resilient to the financial crisis and fared much better than the developed markets of Canada, the U.S., Europe and the so called Asian tigers, Singapore, South Korea, and Japan.

In 2000, Brazil, Russia, India and China (BRIC’s) accounted for less than 8% of global output, but BRIC share has since grown to more than 14% of global output (or US$8.6 trn) in 2008 and is expected to grow to 20% by 2013 (The Economist Intelligence Unit, 2009). According to forecasts, by 2020, all BRIC countries will be in the list of the top 10 largest economies of the world. The BRIC countries have woven an interesting story in recent years that has made them standouts among the pool of emerging markets. A handful of emerging market focussed funds have delivered returns of more than 70% from 2003-2007(iShares.com, 2009), and even though the recession of 2008 has slowed their growth, they are awakening from their slumber and offer investors now more than ever new opportunities that hold incredible growth potential (Lydon, 2009). In a time of financial turmoil characterized by credit expansion cycles and financial bubbles in much of the West, BRIC countries offer the prospect of sustainable growth over the next decades, with massive government spending in infrastructure, industry, education, healthcare, housing and tourism.

Investor Profile

As a team of professional investors we have the mandate to allocate $100MM in emerging markets for a leading Canadian pension fund. Following the damages incurred in the 2008 financial crisis, our team is seeking higher, risk-appropriate returns commensurate with the mandates of a typical pension fund. .. This typically excludes non investment-grade securities and high yield instruments. Moreover, the fund likely has neither the expertise nor resources to actively manage this portfolio, thus ruling out active trading in highly volatile equities or debt markets. Finally, the short investment horizon and limited funds are key barriers to diversification across the potential countries, due to the costs associated with entering into a previously untapped market. For example, the fund will be subject to fees charged by its local custodian bank to service its investments and legal firms or agents for services related to performing the appropriate due diligence. Furthermore, the cost of hedging against foreign exchange and country risks through derivative contracts will add significant expenses as the fund diversifies into different regions. Therefore, a diversification strategy not only narrows the investment opportunities in each country ($16M per country is rather limiting), but also dilutes the potential returns as expenses pile up. We have chosen to preserve returns by targeting one nation only, using criteria to identify an opportunity which first minimizes risk, but also providing outsized returns. By carefully analysing six potential countries against key criteria described below, we were able to recommend the best nationa nd industries that meet the requirement of our client.

Evaluation Criteria

With an investment horizon of 5 years and a focus on sustainable and stable growth in the emerging markets, we have chosen Brazil as the top choice based on a number of risk factors that included political, economic, social, cultural considerations, as well as a composite measure called the Global Environment Score (GSGEG, 2007). GES is an objective summary of a broad set of conditions that help to achieve growth potential, a pre-requisite for any investment decision in a country, that are based on 13 components. Some of these components are inflation, investment rates, education, and political stability in the country. However, it is important to note that GES does have some limitations. Since it weighs all 13 components equally as a measure of growth in a particular country, it is not a true optimal measure, as some factors affect growth more than others. Moreover, the difficulty in quantifying some of the complex components such as political stability and education remains a challenge. Additionally, the Economist Intelligence Unit’s Business Environment Rating was used as a broad based indicator of the opportunities and hindrances to investing for the medium term. This index covers ten disparate categories ranging from macroeconomic factors to the political environment, with up to eleven indicators per category. In order to stress the importance of transparency in potentially difficult markets, we also considered the Corruption Perceptions Index, which measures the degree to which corruption exists in the public sector. Taken together, he preceding three indices cover a wide range of factors which impacts investment decisions within any emerging market, and formed the basis of our quantitative assessment. However, as certain risk factors cannot be captured in such analysis, we also identified the relevant political, social, and cultural trends that may influence the investment climate. This combination of quantitative and qualitative risk factors was then balanced with economic growth opportunities of each nation in order to identify the emerging market most suitable for investment.

Comparative Analysis and Recommendation

Infrastructure, agriculture, and oil and gas are the top three industries in Brazil in which to invest our funds. Brazil is currently preparing for the 2016 Olympic Games, and federal, state, and municipal governments have committed to invest $14US billion in hosting the Rio Games and in improving the city’s infrastructure. In addition, there will be huge investments in transportation, hotels and urban development (Briefing, 2009). Brazil also has large oil reserves and newly found deposits off its coast could turn the country into one of the biggest producers in the world. As per Brazil’s national oil company Petrobas, the Tupi field contains between 5bn and 8bn barrels of recoverable light weight oil, making it one of the largest fields discovered in the past 20 years (Duffy, 2007). As for agriculture, Brazil has grow into a superpower in the past two decades, becoming the world’s biggest exporter of beef, chicken, orange juice, green coffee, sugar, ethanol, tobacco and the “soya complex” of beans, meal and oil, as well as fourth biggest exporter of maize and pork (Wheatley, 2009). World food demand is expected to grow significantly in the next decade and Brazil will most likely be one of the largest exporters.

And, in many ways, Brazil outclasses the other BRICs. It has the lowest corporate tax rate of the six countries (The World Bank, 2009). Most importantly, Brazil, unlike China, is a democracy with little government influence within the capital markets. Moreover, Opportunities for foreign investors are limited in China and represent the major drawback to any investment in the country. The central government imposes strict limits on foreign investments and stakes in government owned companies, which represent the largest and most secure holdings (A-share market) Currently, investments in such firms are limited and restricted to selected partners, which prevents firms such as our client from entering the market . Unlike India, Brazil resides in a relatively stable region with no insurgents, ethnic and religious conflicts, or hostile neighbours. Its strong domestic demand shelters the economy from sharp downturns, in contrast to the export dependent economies of China and India. . . India also faces major risks, both in political and financial stability which does not make it an investment grade country sound enough for pension funds. On the other hand, the political longevity of Russia’s ruling elite poses an equally potent threat due to their penchant for meddling in the markets and history of nationalizing key assets such as the Sakhalin oil projects and Yukos (The Economist, 2009) Russia relies heavily on oil and gas resources for its success, and will be at the mercy of cyclical trends of such markets. South Africa, while favourably in terms of stability and risk, offers limited growth opportunities and relies heavily on commodities such as minerals that are also too cyclical for our needs. Finally, Mexico was rejected due to the level of contagion with respect to the U.S. economy, which will likely lag in the coming years as a result of the market correction in 2008. Domestically, the country offers limited growth opportunities, and is plagued with an ongoing drug war that threatens to drive foreign investment away. In comparison to these countries, Brazil offers a sound investment possibility, both measured by financial and political stability and interesting growth opportunities . Finally, it has also showed a strong commitment to fiscal policies which not only stimulate growth but prevents excessive speculation that leads to asset bubbles as currently seen in China .

In order to track our investments, we are proposing that senior managers compare the portfolio on a monthly basis to a balance scorecard that incorporates key indicators for financial growth, economic stability and financial risk measures. We further assume that any political risks will be translated into financial risks by the debt markets and do not offer any indicator for that matter (political risk is hard to assess and would be qualitative more than anything). The portfolio returns will be compared to the Brazil Bovespa benchmark index, which is a total return index weighted by traded volume and is comprised of the most liquid stocks traded on the Sao Paulo Stock Exchange, and to the MSCI All Country World Index, which includes a collection of stocks from both developed and emerging countries and is used as a benchmark for global funds. It will also be important to track debt ratings from Moody’s, Standard & Poor’s and Fitch to make sure Brazil retains its investment grade mark from each rating agency which is essential for investment by pension funds. Credit risk will be evaluated with the extra yield from Brazil denominated bonds over U.S. Treasuries. Macroeconomic indicators such as real GDP growth, outside debt as percentage of GDP, current-account balance, inflation and government deficit will be assessed to make sure our investments are secure and that no value is eroded by economic instability. Even though we do not expect exchange to play a significant role, we would strongly consider buying derivatives to hedge against any risk that could deflate profits following shift in the Real against the Canadian dollar. While any negative change in credit rating would force liquidating our investment right away, any negative change for the other targets would be evaluate on a three month basis in order to see if any trend can reverse course. If at any point three or more measures are off targets, the investments would be liquidated.

Brazil Risk Analysis

Political

Although President Luiz Inácio Lula da Silva term of office comes an end with the October 2010 elections, the continuing economy recovery in the country has positioned his Partido dos Trabalhadores (PT) party to retain power in the upcoming elections^[i]. This will ensure that the favourable political, economy and social policies in place will remain similar throughout the duration our 5 year investment in the country. However, even if the leading party were to cede power, the opposition party has indicated that they will not veer far from current fiscal policies^[ii]. Unlike many other emerging market countries, Brazil has gone a long history of political and economic learning which has led to its current stable and predictable macroeconomic environment^[iii]. This institutional memory will serve the country well in the long run.

Unlike China, Brazil is a democracy. As well, unlike India, Brazil does not face the risk ethnic and religious violence, nor does it have hostile neighbouring countries. ^[iv] However, issues such as corruption, tax evasion and bribery are still prevalent amongst many government officials. According to Transparency International, Brazil ranks 75th out of 180 countries on the organization’s 2009 Corruption Perceptions Index^[v]. Although the press uncovers and exposes this corruption, many of the offenders go unpunished for their actions. ^[vi] With the increasing visibility of Brazil on the world stage due to its growing economy, the 2014 World Cup and 2016 Summer Olympics, there will be growing pressure on Brazil to crackdown on corruption.

Economic

Although Brazil was not immune from the recent recession, it was among one of the last countries to experience the recession and has been one of the first to emerge out of the recession^[vii]. In fact, foreign direct investment (FDI) in Brazil increased by 30% compared to last up on the year even though FDI inflows globally fell by 14% during the same period.^[viii] Its economy has being growing at an annualized rate of 5% and will likely increase with production from new deep-sea oilfields and its vast food resources and mineral deposits. In fact, analyst’s project that sometime in the decade after 2014 Brazil will likely become the world’s fifth-largest economy. As well, PwC consulting predicts that by 2025 São Paulo will be the world’s fifth-wealthiest city.^[ix] The government has implemented policies to curb runaway inflation and ensure stability. As well, cheap and effective income transfers programs, helped by low inflation, brought millions into consumer market. Furthermore, the banking sector is regulated by cautious and conservative rules, largely funded by local credit, and is mostly unharmed from crisis. The country suffers from a large public debt, however in 1999 the government made it a fiscal requirement to run a primary surplus the federal government has hit the target for it every year since^[x]. This has allowed the country to get rid of most of the dollar-denominated foreign debt, which had made the country so susceptible to economic fluctuations^[xi]. As a result, the three main rating agencies now classify Brazil’s government paper as investment grade.^[xii] This has instilled greater confidence in foreign investors. In fact, within the first 8 months of 2009, the country has received a massive inflow of capital (13.2B net to Sao Paulo futures and stock exchange, 2.5B to fixed income securities, 15.9B in real economy).

Although China’s has a faster economic growth rate, it is generally considered easier to invest in Brazil. As well, unlike Russia, Brazil exports more than oil and arms, and treats foreign investors with respect. Despite its economic success to date, Brazil still faces several economic challenges. First, government spending is outpacing growth and this spending is inefficient. The government’s payroll has increased by 13% in just the last 15 months. As well, despite relatively young population demographic, spending on social-security and pension increased by 7% during the same 15 month period. The country needs to focus on education and infrastructure, two areas trails behind China.^[xiii] We see infrastructure as a near-term priority for the country because of the 2014 World Cup and 2016 Summer Olympics. Brazil also faces challenging fiscal policy issues. The currency has risen the almost 50%, against the U.S. dollar, since December 2008^[xiv]. As well, the central bank’s interest rate is 8.75%, which is one of the highest rates globally^[xv]. This potential currency appreciation risk must be stemmed with sound fiscal policy. Another issue that Brazil’s domestic market faces is government intervention. Although a free and open market, there have been occasions where the government has intervened in the market. For example, it pressured Vale, a mining company, to go beyond its core business and invest in steelmaking. This type of intervention raises concerns about state involvement in the private sector, especially as the country seeks to grow aggressively.

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^[i] http://viewswire.eiu.com.proxy.queensu.ca/index.asp?layout=VWCountryVW3&country_id=1480000148

^[ii] http://viewswire.eiu.com.proxy.queensu.ca/index.asp?layout=VWCountryVW3&country_id=1480000148

^[iii] http://www.economist.com/displaystory.cfm?story_id=14829485

^[iv] http://www.economist.com/displayStory.cfm?story_id=14845197&source=most_commented

^[v] "CPI 2009 Table/2009/cpi/surveys_indices/policy_research." Transparency International. Web. 18 Nov. 2009. <http://www.transparency.org/policy_research/surveys_indices/cpi/2009/cpi_2009_table>.

^[vi] http://www.economist.com/displayStory.cfm?story_id=14845197&source=most_commented

^[vii] http://www.economist.com/displayStory.cfm?story_id=14845197&source=most_commented

^[viii] http://www.economist.com/displaystory.cfm?story_id=14829485

^[ix] http://www.economist.com/displayStory.cfm?story_id=14845197&source=most_commented

^[x] http://www.economist.com/displaystory.cfm?story_id=14829485

^[xi] http://www.economist.com/displaystory.cfm?story_id=14829485

^[xii] http://www.economist.com/displaystory.cfm?story_id=14829485

^[xiii] http://www.economist.com/displayStory.cfm?story_id=14845197&source=most_commented

^[xiv] http://www.economist.com/displayStory.cfm?story_id=14845197&source=most_commented

^[xv] http://www.economist.com/displayStory.cfm?story_id=14845197&source=most_commented