Despite a strong rally over the past year, the Brazilian equity market remains undervalued. Experts say that discount could evaporate quickly if interest rates fall.
With a gain of more than 33 percent, the Bovespa Index ranked among the best-performing equity markets last year. According to Pablo Riveroll, emerging markets specialist at Schroders, the rally mainly reflects a rebound from deeply undervalued Brazilian stocks.
Speaking to Investment Officer, Riveroll noted that investors had long questioned the sustainability of Brazil’s public finances. Government spending now appears to be stabilizing, while a series of rate hikes has sharply reduced inflation.
External factors have also supported Brazil. A weaker dollar has boosted market sentiment, while US trade tariffs turned out to be lower than initially feared. At the same time, the crucial Chinese export market has remained resilient. Riveroll notes that, despite an interest rate of around 15 percent, the Brazilian economy has now grown for a third consecutive year and unemployment remains low.
Rate cuts as a catalyst
Although inflation has fallen to 4.5 percent and expected inflation of 3.8 percent is already within the target range, Brazil’s central bank wants to further anchor inflation expectations. Even so, markets expect the policy rate to decline to 12.5 percent by the end of next year. Riveroll believes rates will fall somewhat further and that equities will respond positively.
“We are already seeing the first cracks in the economy, with bankruptcies here and there, sometimes unexpectedly.”
Pablo Riveroll, Schroders
“We are already seeing the first cracks in the economy, with bankruptcies here and there, sometimes unexpectedly,” he said. “Because loans in Brazil often carry variable interest rates, companies and the government benefit immediately from lower rates. Lower rates also stimulate credit growth.”
Fiscal risks ahead
Riveroll still considers Brazilian equities relatively cheap. “Based on expected earnings over the next twelve months, the price-to-earnings ratio is around 9, below the historical average of 10 to 11. Emerging markets as a whole are trading at a P/E of 13.5, which is actually a premium compared with history.”
According to Riveroll, profitability in several sectors remains under pressure. That combination of low earnings and attractive valuations offers significant upside potential. “At some Brazilian banks, credit losses have weighed on results, but earnings prospects improve as rate cuts come closer.” He sees a similar picture in other sectors. “A recovery in currently low oil and pulp prices could boost profitability in the commodities sector. In retail, high interest costs weigh heavily on margins, meaning rate cuts flow directly through to the bottom line.”
What is currently holding back a re-rating of the Brazilian equity market is the medium-term fiscal outlook, says the Schroders specialist. This outlook is crucial for the Brazilian real and long-term interest rates. Ten-year yields currently stand at 13.6 percent, while long-term inflation expectations are around 5 percent. “The very high real rate shows that the market is still concerned about the long-term sustainability of the fiscal situation.”
Riveroll does not think those concerns are unfounded. “Because of high interest costs, the budget deficit has now reached 8.5 percent of gross domestic product. Without rate cuts, that deficit will increase further. The current, relatively low public debt level of around 60 percent of GDP would also deteriorate,” he said. Much will therefore depend on the elections in October. “If a new government genuinely addresses the budget deficit, the market’s price-to-earnings ratio could gradually return to historical levels.”
Adding quality stocks
Eduardo Figueiredo, head of the Brazilian equity team at Aberdeen, also still finds the Brazilian stock market attractive. “Brazil is valued about 30 percent lower than other emerging markets. Even after adjusting for sector composition, there is still a significant discount of 10 to 15 percent,” he told Investment Officer.
He attributes that persistent discount mainly to political uncertainty and the lack of structural growth. “Not only are public finances a concern, but corporate balance sheets are as well. Brazilian companies fund themselves domestically and therefore face interest rates of around 15 percent. The same applies to consumers. Those high borrowing costs are suffocating the economy.”
Still, Figueiredo has been surprised by the strong rally in Brazilian equities. “We were constructive on Brazil because of valuations, but not particularly optimistic about the economy. It has nevertheless held up better than expected, despite high interest rates and the trade war.”
If interest rates fall, a large amount of capital could flow into the market very quickly, Figueiredo argues. “We saw that between 2017 and the pandemic, when ten-year yields fell below 10 percent and both domestic and foreign investors rotated en masse from bonds into Brazilian equities.”
In the short term, uncertainty dominates ahead of the upcoming elections. The Aberdeen specialist believes there is a strong chance that incumbent president Lula will be re-elected, and he sees limited scope for extreme policy shifts. “History shows that strong centrist parties in Brazil intervene in such cases and force pragmatic solutions that are likely to be acceptable to investors as well.”
Aberdeen therefore maintains a cautiously optimistic base case, assuming declining interest rates. “That gives us the opportunity to further build our positions in Brazilian quality stocks,” said Figueiredo.