So far, 2014 has been a great year for Brazilian corporate credit: its 9.2% total return to date makes it the best-performing region in the global credit universe. In comparison, emerging-market (EM) debt has returned 6.1%, developed-market (DM) high yield only 4.8% and global investment grade (including EM) returned 5.8%. What is driving this performance, and, more importantly, can it continue?
It’s not the economy: Brazil’s economy continues to deteriorate. Real GDP contracted by 0.9% year-on-year in the second quarter, worse than the consensus view of -0.6%. The Purchasing Managers Index, which gauges the health of the manufacturing sector, has spent most of the year in negative territory and is the lowest among the big four emerging markets. Inflation remains stubbornly high, trending at about 6% for most of 2013-14, and the worsening current-account deficit is not helping: by depressing the Brazilian real, it increases inflationary pressure as import prices are driven higher. Meanwhile, the Central Bank of Brazil has erred by lifting rates to 11% in a hawkish attempt to restrain inflation when it should be trying to support economic growth.
It’s not the outlook: Corporate Brazil is downbeat. At a recent conference for steel producers, the CEOs of the country’s two largest steelmakers, Gerdau and CSN, said business was tough. The investment hangover from accelerated infrastructure projects for the recent FIFA World Cup and the 2016 Olympics in Rio de Janeiro, Brazilian banks’ stricter lending standards, and the economic paralysis due to uncertainty about who will win the presidential election in October seem to be weighing on the economy. The CEO of CSN even said that a recession is a “strong possibility”. This was perhaps a bit alarmist, but the takeaway is that corporate Brazil wants stimulus – and we don’t expect much of a fiscal or monetary boost.
It’s the valuations: Given this environment, it's remarkable that Brazilian corporate credit has performed so well. The market has been driven by shifts in valuations and capital flows. In the March issue of Spectrum, we highlighted the fact that EM spreads – and particularly among Latin American corporations – had reached crisis-level valuations after a torrid 2013 in which investors, spurred on by tapering fears, withdrew capital. At the time, the ratio of EM credit spreads to DM credit spreads was 1.84, suggesting that EM had not been this cheap on a relative basis since Argentina defaulted in 2002 or the concurrent crises in Russia and Asia in 1998-99. Put simply, the market priced in a credit environment for EM debt that was far worse than what actually unfolded. Also, the rally in US Treasuries has helped to improve sentiment towards EM and likely aided in stabilising fund flows. To some extent, the conflict in eastern Ukraine has caused investors to move funds from Eastern Europe to other EM jurisdictions, including Brazil.
Seek strength: We fear that when US interest rates eventually rise – which data suggest they soon should – EM debt could experience another bout of outflows. In our view, any such move would be concentrated on those with the most fragile economies: Brazil, Turkey, Indonesia and South Africa. Within these markets, issuers that are most exposed to domestic economies are the most at risk. These are the types of companies to avoid. That said, as we laid out in a previous blog post on EM debt, we still see value in EM credit. Specifically, we continue to favour higher-rated businesses with global operations that reside in countries with stronger economic fundamentals, such as Mexico, India and the United Arab Emirates. These types of issuers can still perform strongly despite a weaker sovereign.
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