A cruel joke about Brazil is that it is the country of the future and that it always will be. The encouraging way that Brazil has come out of the recession of 2014-2016, however, has given investors renewed hope. Perhaps this time, they have been reasoning, Brazil might actually live up to its potential. Lately, however, that prospect has been dealt some serious blows. Petroleo Brasileira – the Brazilian oil company more commonly known as Petrobras – was having a fantastic year. The forecast for growth in Brazil was strong, oil prices were steadily increasing, the company’s divestment process initiated a couple of years earlier was going smoothly, and the company – so highly leveraged only a few years ago – was exceeding its deleveraging objectives. The stock was up 50% YTD. Until the 17th of May. Since then it is down more than -40%. What happened to the Brazilian oil giant? To understand the predicament currently faced by Petrobras and its investors, we need to turn time back to 2014. Oil prices were at 110 USD/Bbl, outlook was positive, and appetite for risk was high. The company was thriving on higher oil and fuel prices. Profit was growing at double digit rates and an expansionary strategy coupled with cheap financing turned Petrobras into the world’s most indebted oil company. But in Brazil, fuel prices are not inconsequential. They are essential. Due to bad infrastructure, highway transportation by trucks accounts for more than 70% of all transportation in Brazil. Highway transportation is of such importance that more than one million Brazilians make their living on driving trucks. And they don’t like high fuel prices. Fearing a political backlash, the then President Dilma Rousseff – a left-wing politician – ordered that Petrobras sell fuel at a cheaper price than market prices. This sent the company’s stock to a freefall. A year and a half later it was down -90%. By then Brazil was deep into a recession. President Dilma was ousted and replaced by her Vice-President, Michel Temer. The new President’s market friendly approach was just what Petrobras and the market needed. Petrobras was allowed to decide its own fuel pricing policy and adapted one in which prices were to be at a parity with international prices, adjusted for risk and taxes. A new, reputable management was also installed. They announced an ambitious turnaround plan aimed at decreasing leverage by half. The plan worked perfectly. In two years’ time, the stock price surged. While no doubt aided by higher oil prices, which increased a respectable +175%, Petrobras did better, posting a massive +620% gain in the same period. Yet in a few weeks’ time it has gone from being a top performer to being a perfect illustration of how difficult it can be to navigate the emerging markets. As Petrobras kept increasing fuel prices in line with higher oil prices and a strengthening USD, truck drivers saw its profitability pressured. When oil prices started creeping towards 80 USD/Bbl, the truckers resorted to extreme measures in desperation. Threatening a strike unless fuel prices were reduced substantially, the truckers started blocking all major roads until their demands were met. The blockade stopped virtually all economic activity in Brazil. Transport of goods ceased. Production shut down. Livestock were slaughtered to avoid cannibalization (starving chicken tend to eat each other). People were hoarding food at supermarkets, where prices soared. A standoff ensued. Petrobras, who saw the potential damage a strike could cause to the economy and its business (and probably trying to garner some much-needed goodwill from the population), voluntarily reduced its diesel prices by 10% for 15 days. A day later the government announced they had reached a deal with the strikers’ representatives for a suspension of the strike for 15 days until they could come to a long-term agreement. The largest association of the truckers, on the other hand, was not content and so chose not to adhere to it. They desired long-term solutions. The government proposed measures to reduce the tax on diesel to zero. Not enough, said the truckers. They were warned that transportation companies striking would face fines of R$ 100,000 (equal to approx. 27,000 USD) an hour. The strike continued. The Supreme Federal court authorized the use of force to remove the blockades. The strikers did not flinch. The government did, however. In the end the government decided to cut diesel prices by 12% for the next 60 days (and which is almost certain to be extended). It also agreed to let empty trucks pass toll booths for free. And it agreed to take the bill for it, meaning that it will reimburse Petrobras and the toll road companies for their losses. It was reiterated multiple times that Petrobras would not have to change pricing policy: the subsidy on the diesel prices would be paid by the government (or rather the tax payers). Petrobras would be unaffected. But questions remained. What would happen to the prices after the 60-day period? Was the company’s autonomy threatened? Management was quick to assert that any change in the pricing policy would mean the immediate resignation of the management. Pedro Parente – the acclaimed CEO of Petrobras and the man recognized for leading Petrobras’ back from the depths – held daily conference call with investors to assure them of his intention to stay on as CEO. He would only consider leaving, he said in a conference call held Tuesday the 29th of May, if the government would intervene in Petrobras’ operations. The following Friday he resigned as CEO. While the rest of the management remained in place, the CEO’s resignation stirred investors’ fear that Petrobras will go back to being a populist instrument of the government. The current administration is opposed to such a solution, but 2018 is an election year and the administration – with a disapproval rating very close to 100% – will be replaced. The aftermath of the strike on a macro scale has been reduced growth-estimates for Brazil as a whole and a deteriorating outlook for the Real (the domestic currency). The latter threatens to put a stop to the steep decline in interest rates over the last year and a half, and put further downward pressure on growth. The fear of more strikes and civil unrest is also a threat which seems to trouble investors and is likely to keep doing so in the short-term. As can be discerned from the latest turmoil in Brazilian markets, the Emerging Market-space can occasionally be hit by storms not easily anticipated by investors. While these can rage for a very short period, be concentrated to a single company or sector, and may not lead to any major changes in earnings outlook for the companies, it can shift sentiment and move money from one country/region to another. Despite the clouds gathering over Brazil, it is hard to be too negative to the South American giant. Brazilian companies have much stronger fundamentals than before the recession (from which they are emerging), yet are priced at near-recession levels. The growth outlook, despite recent downward revisions, is still very positive. Vulnerability to currency depreciation, in the past so high due to a predilection for USD-denominated debt, is much lower, and the central bank’s ability to intervene is far stronger. We remain constructive on Brazil, but have reduced the portfolio risk as sentiment has deteriorated and the market is likely to be especially volatile going into the election. Nonetheless, there is still time for Brazil to be the country of the future that it has always promised to be. (All stock performances in this article are measured in USD-terms.)
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2018 is an election year in Brazil. While the Brazilian market was dominated last year by political scandals and efforts to advance market friendly reforms, one of the main concerns for investors in Brazil for 2018 has been the re-emergence of the politician commonly known as “Lula”.
Former President Lula
Lula, whose full name is Luiz Inácio Lula da Silva, was President of Brazil from 2003 until 2011, and oversaw the greatest period of growth in the history of the country. While he undoubtedly raised living standards in Brazil during his tenure and helped reverse the historical inequalities in the country, many of the social programs that he introduced have left Brazil’s finance in tatters. The costs of the social programs have caused debt to GDP to increase at an alarming rate, and during the recent recession (2014-2017) the fiscal deficit dropped from -3% to -10%. The ratings agencies downgraded Brazil to junk-status in 2016, further deepening the country’s woes.
President Temer, who stepped in when former President Dilma (Lula’s successor) was impeached and removed from office in 2016, has spent most of his Presidency advocating market friendly reforms whilst fending off allegations of bribery. Despite the severity of the allegations, which caused the market to fall 10% when announced, he has been fairly successful in advancing reforms necessary for the revival of the Brazilian economy.
Regardless of the recent disappointments in passing the important pension reform, and despite the government facing historically low approval ratings (less than 10%), the pro-business agenda of Temer has resonated well with investors. The Brazilian stock index (Ibovespa) is up over 50% since his Presidency started.
Lula, on the other hand, having been vocal about running for office in the upcoming election, has pledged to reverse the reforms passed by the current administration and scrap the proposals currently in place. Although he is a polarized figure in Brazilian politics, Lula is still revered by many due to his efforts to reduce poverty. Proof of this comes from the polls: aside from being the most disliked candidate, he is also by far the most popular candidate. Consequently, it is no surprise that investors have been reluctant to go all-in on Brazil this year, however positive the short-term outlook is.
The market therefore breathed a sigh of relief on January the 24th when Lula’s conviction for accepting bribes whilst being President was upheld by a panel of judges, effectively sentencing the former President to more than 10 years in prison. He thus faces further challenges in resurrecting his bid to become President again. While the ruling does not keep Lula out of the race indefinitely (he has already promised to fight and appeal the sentence), it is proving less and less likely that he will be allowed to run.
“We believe the ruling has calmed the investment community as Lula’s resurgence is considered one of the main threats for the continued progress on important reforms”, says Erlend Fredriksen, analyst in DNB Global Emerging Markets. “We have confidence in the short- to medium-term prospects for Brazil, and with the election of a reformist candidate, it will renew our optimism for long-term progress as well.”
Currently, DNB Global Emerging Markets is overweight Brazil in the fund.
Investors’ sentiment improved considerably after the ruling, and the Ibovespa is up +6.4% afterwards. In comparison, MSCI EM and S&P500 is down -2.3% and -2.6%, respectively, in the same period. All returns are measured in USD as of the 13th of March.
The graph shows clear outperformance on the Brazilian stock exchange (green) since the ruling The race for President has been blown wide open by the conviction of Lula, and we expect the market to move with the polls going forward. The main concern, however, seems to have been removed – a weight has been lifted off Brazil’s shoulders.
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