Looking beyond Brazil’s political headlines

The election did not want for colourful candidates. The right-wing candidate, the son of a former president convicted of attempting a coup, is under investigation for money laundering and corruption. The left-wing candidate is the incumbent president whose own past conviction for corruption was later annulled. After the incumbent triumphed at the polls, a supreme court justice ordered the right-wing candidate to surrender his passports. He declined, instead fleeing to a politically-friendly neighbouring country before emerging from a private jet in Florida a few days later.

Welcome to Brazil, where political headlines make the US midterms look tame. In the immediate aftermath of the election, the headlines jarred investors. Luiz Inácio Lula da Silva (known as Lula), the left-wing candidate, promised endless government giveaways—a fiscally risky proposition given Brazil’s ever-ballooning pension obligations. Flávio Bolsonaro, the right-wing candidate, hoped to get the state finances in check, alongside other market-friendly policies. After Bolsonaro’s surprise win in the first round of the election, investors were optimistic that he could win. When he didn’t, a result that would have surprised few people a month ago came as a nasty shock.

Investors swiftly punished Brazil’s currency, bonds, and stockmarket, as the chart shows. This was painful for the Orbis Strategies which have positions in Brazil.

It is worth reiterating that our positions were not a play on the election. A victory for Bolsonaro may have provided a nice boost to Brazilian asset prices, but we are fundamental investors, not election bettors. If the individual securities in the Funds did not offer what we considered to be attractive valuations for their fundamentals, we never would have bought them. What do we make of them now?

Broadly, the initial market reaction looked excessive to us. While Bolsonaro failed to win the presidency, the political right did win many seats in Brazil’s legislature. With powerful opposition in the legislature, Lula will face significant constraints on irresponsible spending. This is no one’s idea of a fiscally reformist government, but investors are pricing Brazilian assets as though the outlook is much worse than a month ago. In our view, it isn’t.

Brazil’s currency, the real, looked cheap on a purchasing power basis before the election, and is only cheaper now. This is despite some significant strengths. Brazil is a major exporter of iron ore, oil, coffee, soybeans, beef, and a raft of other commodities. Strong exports help to support the real, as foreigners buying your goods must first buy your currency. Defending that currency is Brazil’s central bank, who has shown a discipline and independence that its developed market peers would do well to copy. Interest rates in Brazil are near 14%, against inflation of less than 5%. Domestically, such high interest rates will eventually exert their own gravity by encouraging saving and discouraging spending. Internationally, high interest rates provide an incentive to hold Brazilian assets.

The appeal is even more stark in Brazilian government bonds. In September, the country’s 10-year sovereign bonds yielded 14%, which we found compelling. Following the election sell-off, they are now above 15%. In the Multi-Asset Strategies, we have added to our positions in Brazilian bonds.

In equities, positions vary across the Strategies, but our largest overall holding in Brazil is Itaú Unibanco, Brazil’s largest bank. Over the very long term, Itaú has generated returns on tangible equity exceeding 25%. Recent years, under a Lula government, have been no exception. For Itaú, Brazil’s high interest rates are likely to matter more. Should economic gravity prevail, lower rates would mean lower funding costs for the banks, and higher asset prices. Getting there could be bumpy, however, as lower rates also tend to compress the spreads between what banks pay for deposits and what banks charge for loans. High real interest rates are also burdensome to stretched borrowers, which can lead to loan losses. But Itaú has dealt with all this and more over its history, and survived with its record of strong profitability intact. At its current valuation, we continue to find Itaú attractive, and we have retained the Strategies’ positions in its shares.

Jarring political headlines, and the volatility that accompanies them, are par for the course in Brazil. As ever, we focus on finding individual securities trading at discounts to fundamental value. In time, the volatility may feel like noise, and the prices like bargains.