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Betting On Brazil

Pedro Bastos discusses why Indians are better off ignoring HSBC's newly launched Brazil Fund…

HSBC Mutual Fund has just launched the HSBC Brazil Fund, an open-ended Fund of Funds (FoF) scheme that will invest in the units of HSBC Global Investment Funds Brazil Equity Fund. Pedro Bastos discusses why he thinks Indians should not ignore this market.

Goldman Sachs came up with the idea that four countries would become so important in the world economy that they could be viewed as a single group. What is the USP of Brazil amongst the other BRIC nations?
For a while after Goldman Sachs introduced this concept, there were critics talking against it. There were many who felt that Brazil did not fit in with the other three countries - Russia, India and China. Today, Brazil has the spotlight. It is one of the best markets in the world to be looking at. There are basically four major drivers.
Domestic Consumption: Brazil has 62 per cent of its GDP coming from domestic consumption. The major driver of consumption in Brazil is demographics. Around two thirds of the population is between the ages of 16 and 64 - that is a sweet spot in terms of demographics because most people are in the productive age group. As a result of personal income growth and low unemployment, there has been a huge migration of people - around 20 million over the past few years - from below the poverty line to the middle class. Today, Brazil has 60 per cent of its population in Classes A, B and C*. To put it more graphically, a country the size of Uruguay joined Class A and a country the size of Argentina joined Class C.
Infrastructure: The second driver is infrastructure, where a lot needs to be done. The country needs to improve its logistics and it is the focus of the government. The highways, railroads, roads and public services are one type of infrastructure in focus. Also, the Soccer World Cup will be played in Brazil in 2014 and the Olympics in 2016. In terms of absolute numbers it is not huge but it does facilitate the process of approving and implementing projects.
Energy is also part of infrastructure and hence, I would like to talk about the oil sector. We have found pre-salt oil reserves along the coastline and that, in itself, will be a major driver for development and growth over the next few years. We will be producing 2.5 million barrels of oil by 2015 and the number will go up significantly by 2020.
Commodities: Though commodities contribute to only 6 per cent of Brazil’s GDP, it is the world leader in production of a number of hard and soft commodities - iron ore, sugar cane, coffee, to name a few.
Well-diversified export dependencies: Brazil is not dependent on the US or China alone for its exports. Hence, any impact on these economies does not impact Brazil significantly. Since 2009, China has replaced US as the largest buyer of Brazilian exports.
At a macro level, I guess it’s just economic karma. Last century, Brazil was known for its defaults, low growth amongst emerging economies and runaway inflation. Now, the time has come for Brazil to grow and have civilised interest rates. So, after the current interest rate hikes we are going to see convergence to more rational rates.

In March 2011 Brazil once again raised interest rates because of inflationary concerns. Deputy Central Bank Governor Luiz Pereira da Silva told a bankers’ forum in Canada recently that “too much of a good think can be a problem” referring to the flood of international liquidity. How big a problem is inflation?
Brazil has a very transparent inflation target model and it is controlled by the central bank. It is 4.5 per cent +/- 2 per cent. Right now, it is running at around 5.8 per cent. So, it has raised a yellow flag in the market and within the central bank. The latter has been very active in raising interest rates starting last year, paused for a while, and now has continued on that trend. It will continue this year and in 2012 we should start seeing the beginning of the reduction cycle.
Rising interest rates are not a big threat to the economy because it has all been built into the prices - equity and the fixed income curve. The challenge is how to balance growth and inflation.
We see industrial inflation coming down because of production in China and a blip on soft commodity inflation in Brazil. That was also impacted by the fact that we had heavy rains in January. We should have a strong harvest so we should see a reduction in inflation.
I think the concern of inflation is a bit overdone. If you take the impact of food inflation in the lower income brackets, compared to what it was 10 years ago, it is much less. There were specific items that witnessed price increases.

Brazil achieved economic growth of 7.5 per cent in 2010 - the highest rate since 1986. Can the country sustain that?
The population in Brazil grows a lot less than in China and India and the income per capita is much higher too. So logically, we must have lower GDP growth. So it’s reasonable to expect something between 4 and 5.5 per cent, 6 per cent at most. More than that would require serious expenditure to increase excess capacity. But, we cannot have a year of 7.5 per cent like it was last year. That was an abnormal number because of the recession in 2008.

In 2008, the market fell much less than Russia, India and China. But last year, despite such high growth, the market delivered very low returns compared to Russia and India. Why?
Locally, it was the start of the interest rate cycle. The Brazilian market is highly concentrated in fixed income. About 85 per cent of pension funds and individual’s income is in fixed income. So, the migration into equities has not yet happened. We also had some outflows with the US economy going into recovery mode. Money moved from emerging economies to developed markets.
The transaction in Petrobras, which has a huge weight in the index, also affected the returns. But to give you a broader perspective, the emerging markets story is by no means over. West Germany is doing well but the rest of Europe is treading water. The US is facing a lot of uncertainty regarding home prices. There will be another 10-15 good years for emerging markets.

Brazil lags behind China and India in terms of trade as a percentage of GDP.
True. Brazil is a very closed economy. Net exports in Brazil are only 10 per cent. About 40 per cent of the exports are manufactured goods while the rest is commodities. What works for Brazil is a very strong financial system. Our RoE is around 20 per cent, on an average and our capital ratios are in excess of 16-17 per cent. Credit is extended at 20 per cent on an annual basis when the rest of the world is starving for funding.

With regards to Brazil’s growing reliance on imported Chinese manufactured goods, James Bacchus, a WTO official, said that going forward the challenge is the composition of that trade on a bilateral basis.
China imports a lot of commodities from Brazil. As Brazil builds its infrastructure, China is turning out to be a strong competitor in terms of capital market goods such as cranes and heavy machinery.
China became Brazil’s largest trading partner last year, followed by the US and then Europe. The trade basket of Brazil is extremely well diversified in terms of geographies and products. It is not hugely dependent on any single economy.

Regarding the HSBC Brazil Fund, what is the benchmark and how closely do you follow it?
The benchmark is MSCI Brazil 10/40. This is a high conviction portfolio so we can take substantial bets on various plays and can even include names outside the benchmark.

Is your portfolio by default tilted towards commodities?
Not at all. It is very much tilted towards domestic consumption, healthcare, education as well as construction. One of our success stories was a retail company whose price increased 10-fold. The other was a laboratory company - the one where one does various pathology tests. We are slightly underweight in oil and market weight in steel and mining.

What is the logic of an Indian having an exposure to Brazil?
It is a perfect fit. These are the two best markets in the world in terms of growth. There are very high levels of returns in both countries. But India does not have the energy resources that Brazil has. So every time there is a commodity hike or energy scare, the local market in India may suffer. On the flip side, Brazil may benefit from that. So that is a natural hedge.
India has had the convergence of interest rates which Brazil has not yet had. When that happens, asset prices in Brazil will have to be revalued. Brazil always traded at a discount to emerging markets but in the future that will change and it will trade at a premium.

BRIC: Brazil, Russia, India, China /GDP: Gross Domestic Product / RoE: Return on Equity / WTO: World Trade Organisation
Brazil’s social classes are divided based on monthly income. The richest classes are A and B while the poorest are D and E. Class C comes in the middle.