“In Brazil, a poor man goes to jail when he steals. When a rich man steals, he becomes a minister.” – Luiz Inacio Lula da Silva

• Brazilian Equities (EWZ) have underperformed Emerging Markets over the last 10 years

• Thoughtful Pension & Economic Reform is urgently needed

• Financial Markets are signaling optimism

• Current multi-factor analysis ranks Brazil #2 out of 35 countries

The MSCI Brazil Index outperformed the MSCI Emerging Markets Index by 957% from the start of 2002 to mid-2008.  However, the last 10 years (ending May 31, 2019) have witnessed Brazilian equities (EWZ) underperformance of -47.8% versus the MSCI Emerging Markets (EEM).  Over the last decade, Brazil has transitioned from rising power to fallen star. 

What happened?

Brazil enjoyed prosperous years under President Luiz Inacio Lula da Silva, whose tenure coincided with a global commodities boom.  Now Lula is in jail, his successor has been impeached and her replacement has been charged in an on-going corruption investigation.  Street crime is epidemic, and the country has endured its deepest ever recession, -3.54% Real GDP growth in 2015 followed by -3.30% Real GDP growth in 2016. 

What now?

Fed up, Brazilians in 2018 elected a former Army captain, Jair Bolsonaro, to reverse the decline.  Ending the 13 year rule of the leftist Workers’ Party, he promised to remake Brazil with an aggressive approach to crime and pro-market economic policies. 

Bolsonaro’s University of Chicago-trained economy minister, Paulo Guedes, set out to privatize some of Brazil’s long-protected stable of 400 state-owned companies.  Within 5 months, a newly minted infrastructure ministry had auctioned off 23 of them, including airports, port terminals, and a railway, raising 8 billion reais ($2 billion USD). 

What next? 

The Bloomberg consensus Real GDP growth forecast for 2020 is +2.20%, but an annual fiscal deficit of ~7% of gdp still weighs heavily on the economy.  Outsized government spending and inefficiency results in higher interest rates for private borrowers. Importantly, pensions account for one third of total public spending, and are a primary reason why the government spends so little on Brazil’s depleted infrastructure.

It turns out Brazil is one of the most generous countries in the world when it comes to pensions. Men retiring with full benefits get 70 percent of pre-retirement earnings, while women get 53 percent. By comparison, workers in developed economies get full pensions averaging 53 percent of pre-retirement earnings.

On June 13th, a draft bill was presented to overhaul of Brazil's social security system.  The government’s reform bill imposes a minimum retirement age, raises contributions, closes loopholes, and is expected to generate savings of 913.4 billion reais ($237 billion) over the next decade. 

Those savings will increase a further 217 billion reais with transfers from a workers protection fund to state development bank BNDES, bringing the total fiscal impact to 1.13 trillion reais, according to lawmakers.

As this daft bill was presented on June 13th, the Brazilian financial markets responded optimistically: the benchmark Bovespa stock index rose 0.9% to a three-month high above 99,000 points, the real firmed 0.6% to 3.8400 per dollar, and 2020 interest rate futures contracts fell below 6.0% for the first time.

The reform bill will now be debated, voted on and sent to the lower house plenary for a vote. If passed in the form presented on June 13th, it will be seen as a success for the Bolsonaro administration.

However, the timing of ratification remains unclear.  The pension reform seems certain to suffer both delays and dilution.  Approval will require leadership from the top, and Bolsonaro faces an uphill task to get congress to approve an “unappetizing” pension reform despite the benefits to Brazil’s fiscal health. 

“We have two alternatives,” President Bolsonaro’s spokesman said. “Approve pension reform or sink into a bottomless pit.”

Earlier in the year, Vice President Hamilton Mourao said he expects the proposal to be approved by August.

Morgan Stanley economists expect a House vote in August, while Goldman Sachs does not see pension reform turning into law before October.

What to do?

Investors in Brazil and across the world appear hopeful that President Jair Bolsonaro will push through key changes to the social security system in Latin America’s largest economy.  The stakes are high because pension reform could boost the country’s flagging economy and give it some stability in the long run. Failure to enact the changes could stymie growth. Chart 1 below reveals Brazil’s positive momentum and technical improvement (testing support and breaking downtrends over the last few months)

Chart 1: EWZ ETF (MSCI Brazil 25/50 Index) Price Chart – The Last 5 Years

The odds of successful pension reform remain uncertain, but current multi-factor analysis suggests Brazil is an attractive global equity allocation.  As of May 31st, Brazil (EWZ) ranks #2 out of 35 countries in Accuvest’s Global Core Equity – Country First Rankings. 

Brazil is highlighted by strong growth fundamentals, positive momentum, decreasing risk, and better than average valuations.  Default Risk in Brazil has dropped over the last 12 months (Chart 2 below), allowing investors to refocus on the country’s high profitability, strong expected earnings growth, and a very competitive currency.  A break through on pension reform and public finances would support Brazil’s constructive investment thesis.

Chart 2: Brazil 5 Year Credit Default Swap (CDS) Spread – The Last 5 Years (Lower = Less Default Risk)

In conclusion:

• After a decade of underperformance, Brazil appears poised for a rebound

• Brazil is an attractive global portfolio allocation based upon balanced multi-factor analysis

• Key social security & pension reforms are progressing towards ratification

• Financial markets and price momentum suggest optimism

Sources: MSCI, Thomson Reuters, CNBC, Bloomberg, Economist