Brazil: Great optimism among companies and investors

Brazil’s equity market has risen by 11.4% and its currency by 18.8% since the beginning of the year (as at 13 April), which places them among the best-performing equity/currency markets worldwide. In the first quarter of 2022, the equity market saw record inflows from foreign investors of USD 14.8 billion, compared to just USD 21.8 billion for the enire emerging markets equity universe during the same period. In contrast, Brazilian hard currency corporate bond spreads narrowed by just 12 basis points, which corresponds to a spread performance of 1.7%.

Against this backdrop, we sought to find out if there is any fundamental reason for the weaker performance of corporate bonds or whether this situation represents an investment opportunity. To help answer this question, we undertook a research trip to Brazil. We met 25 companies across a variety of industrial sectors and spoke with economists, local investors and other financial experts to gauge their views on the country. Ultimately, we were positively surprised by the optimistic expectations of most companies for the current year.

The positive market environment is not restricted to commodities exporters
Exporters of commodities such as oil, ethanol, pulp and paper, as well as the metal and mining sectors, and the related transportation companies are clearly benefiting from current upheavals in commodities markets and expecting strong turnover on the back of higher prices. Meanwhile, industrial companies have so far been able to pass on higher input costs to clients, by virtue of consistently stable demand. Some margin compression is expected, but starting from the basis of sometimes record earnings levels last year, tighter margins should nevertheless be above the historical average. We were surprised to find that even companies operating locally, such as airlines and car hire companies, have not yet seen any weakening of demand and are mostly able to pass on higher input costs to end customers. Thanks to relatively inelastic demand, local air traffic in Brazil is already at pre-pandemic levels and airlines have been able to push through price increases of around 15% over the course of a month. At the same time, the appreciation of the Brazilian real has partly offset the rise in kerosene costs, which are paid in US dollars. And although the business model of car hire companies is capital intensive, they too have so far been able to raise rental prices. Where necessary, they are also able to adjust the growth and pace of renewal of their fleets, to limit their capital requirements. Particularly for these companies operating in the local market, we believe that there is performance potential, as the corporate bonds market is not yet pricing in these factors.

Companies with improved fundamentals and sound debt levels
But Brazilian companies are also in extremely good shape on a fundamental basis. The companies we visited had an average net debt ratio (net debt / EBITDA) of 1.9x at the end of 2021, versus 3.1x at the end of 2019. Refinancing in the international bond market has been difficult since the start of the year due to geopolitical tensions and the resulting volatility. However, many of the companies we met – and remarkably, those operating in the local market in particular – have already managed to raise the liquidity required for the year ahead. Accordingly, the new issue volume in local currency bonds since the beginning of the year has constituted a record of almost USD 20 billion.

Election volatility likely to create buying opportunities
The forthcoming presidential elections in October were also a major topic of discussion. A polarised election is expected between the challenger Lula and the incumbent Bolsonaro – few believe that a strong third candidate will emerge. The outcome, and in particular support for Bolsonaro, will be strongly dependent on economic performance in the run-up to the election. It is also expected that the risk of populist headlines will increase as election campaigns gain momentum during the summer. Nonetheless, the politically centrist Congress should be in a position to hold such populist ideology in check. Against this backdrop, we expect increased volatility for the rest of the year but believe that there should be good buying opportunities in fundamentally sound companies.