During a recent research trip to Brazil, we visited the heartland of Brazilian manufacturing amid a febrile political climate. As the flailing economy emerges from the worst recession in its history, we asked: what does the future look like for Brazil?
“It is time to invest in our country. Brazil is ready to start growing again.”
So said President Michel Temer after he garnered enough support to block a corruption trial in a congressional vote earlier this month. The president won a comfortable victory: 263 to 227 votes. But his troubles are not over. There is a chance that further indictments will be brought against him. Nevertheless, with support from the lower house, Temer pledged to “pass all the reforms the country needs”.
Temer’s victory comes weeks after the Senate passed an important labour-reform bill and the sentencing to nearly 10 years’ jail of former president Lula da Silva for corruption. If the conviction is upheld, Lula da Silva will be rendered ineligible to contest next year’s presidential elections. This would remove a major obstacle to the reform agenda.
With unemployment peaking and consumers starting to spend again, the mood in the country has changed. During a research trip to the country in July, we made site visits to well-established businesses in the heartland of Brazilian manufacturing. Like the nation’s political climate and economy, which show signs of storm damage but clearing skies ahead, what we found was mixed.
The electric-motor industry lacks power
Our first stop was WEG, Latin America’s largest producer of electric motors. It is based in the southern state of Santa Caterina, from which it distributes products domestically and internationally. The factory, though automated, was not very busy. Business is stirring from the catatonia of the recession but demand is largely sourced from maintenance orders, with occasional brownfield-expansion projects. WEG’s end-customers are currently operating at a very low level of capacity, as expected, given the country’s incipient recovery from its worst-ever recession. As such, the electric-motor is in need of a charge.
Seeing the wood from the trees
We then proceeded to the state of Parana, where we found Brazil’s largest paper producer and exporter, Klabin – a holding in our portfolio. At less than two years old, the pulp mill benefits from advanced technologies, while its location provides a significant advantage – a steady calendar of rainfall which helps eucalyptus and pine trees thrive. Klabin’s domestic outlook shows tentative signs of a recovery, but nothing has yet taken root.
The international outlook, however, is improving. This was evident from discussions about the possible purchase of a new machine that converts excess pulp into paper. Previously, Klabin was hesitant about such an investment. But things have changed. In July, it said global customers were willing to, in effect, underwrite the expansion, allowing Klabin to reduce its exposure to pulp. No decisions had been made during our visit, but the mood was upbeat.
Out in the open
We also visited rental car firm Movida and retailer Cia Hering, a company akin to Gap, which caters to middle- and upper-middle class consumers. Both sectors appear to have bottomed, though their recoveries are tentative.
For Brazil, there are challenges ahead: commodity demand from China is likely to slow, the economy has lost competitiveness relative to Asia following a decade of under-investment under the Workers’ Party, the education sector is starved of resources and saving rates are low. Reforms are critical to cap the upwards spiral of debt the country is experiencing. The good news is that the bad news is known and widely accepted by most of those in government.
For investors, however, the question remains: At what rate should business cash flows be discounted? This hinges on long-term interest rates, which are dependent on the long-term government policies of those in power, and thereby the effectiveness of promised reforms.
We believe Congress is finished acting its own version of House of Cards (or this series at least). If our view is correct, there is hope that the policy framework will strengthen, long-term interest rates will continue to decline, inflation will subside further and the Banco Central do Brasil will cut rates even further.
We have witnessed the impact that the Great Moderation had on developed-market stock markets in the last three decades. If the global economic backdrop remains benign, it is possible that Brazil may enjoy a similar transformation.