Brazil: fiscal samba

In the latest episode of the Emerging Market Equities podcast, Nick Robinson sits down with Ivan Kleimann. Discussing what the new Trump presidency could mean for Brazil, tariffs, reforms and more.

Transcript

Nick: Hello everybody. This is Nick Robinson from abrdn and you're listening to the Emerging Markets Equity Podcast, the show that explores the factors that underpin our thinking on emerging markets. We ask our expert guests the big questions, from key individuals to evolving trends, all with the goal to identify and profit from opportunities in the region. So there's been a huge amount going across emerging markets in the last couple of years, thinking about just what's been going on in the major economies. We've had the continued ups and downs in China with the many false dawns of an economic recovery there as the economy still struggles to recover post-Covid. India has been a great performer, and there was even a brief period recently where it looks set to overtake China in terms of the benchmark weighting, and perhaps it will do one day. Then we've also had this huge tech CapEx boom, and the benefits for that is brought to Taiwan and the whole AI value chain. And we've got many podcasts in the back catalog for those subjects in case you're interested. So whilst all this has been going on in the major EM economies, it's been quite easy to overlook a region that's quite dear to my heart, which is Latin America. So the next two podcasts, we are going to deep dive into the region to catch up with what's been going on there. First, today we're going to focus on Brazil, and then next month we'll take a step out to look at the region as a whole. Specifically what's been going on in the economy, markets, politics and some of the key issues for the future of the region. So joining me today to talk about Brazil specifically is my colleague Ivan Kleimann, Ivan is on the emerging markets equity team based in Brazil. He's been with the firm for nearly a decade, now, managing our Latam funds and also covering a broad range of companies in the consumer and tech sectors. So he's ideally placed to give us the on the ground insights into what's going on in the country at the moment. So Ivan welcome to the podcast. It's great to have you on. 

Ivan: Yeah, thanks for having me, Nick. 

Nick: Well, brilliant. Well, let's get cracking. I mean, we're to timestamp this podcast. We're recording this just a few days after the outcome of the US election with, a pretty clear victory, for Donald Trump. So with that in mind, previous president of Brazil, Bolsonaro was described as Trump of the tropics, and they famously got along quite well. Lula shares a lot of the populist characteristics of Trump, but governing much more from the left. So yeah, any initial expectations on what we might see from the new Trump government from the perspective of Brazil?

Ivan: Yeah, it's a good point to get things started. So, you know, if Trump means higher growth and therefore higher rates, in the US for longer, this can definitely delay even further the timing of when, you know, the Brazilian central bank starts, cutting rates. We did see, you know, the local curve steepening even further. Both US elections. But I would say, you know, the more positive side of things, I would tend to take it as a sort of wake up call, for Brazil, I think, you know, even though we are seeing a very strong US economy, accelerating GDP growth, very tight labor market, etc. Voters, I guess, did ask for a change. And I think, you know, we are seeing some evidence of this shift towards a more pro-market approach happening elsewhere in Latin America. You know, there's the example of Chile, Argentina, but Brazil, for now, you know, under this administration remains with a more standard, let's say, leftist populist agenda focused on social policies. So, yeah, let's see how it goes. But I think the Trump win can be, you know, the start of a change for Brazil in that regard. 

Nick: And to, and to follow up on that, you see, you know, one of the, one of the things that Trump has talked about a lot in his campaign was trade tariffs. And, you know, particularly trade tariffs on China. But I think he's also talking about trade tariffs on a blanket basis for all imports. I mean, I know the US is no longer Brazil's largest trading partner, but do you think that poses a potential risk or too early really to tell?

Ivan: Yeah I think might be a bit too early to tell. But I think, you know, Brazil in that regard is less exposed, compared to other markets on the tariff discussion. I think it would be I guess a more indirect, impact. But, you know, Brazil is primarily exporting to, you know, all the economies and reducing the reliance on exports to the US. So I think, you know, if there is an impact, it will be certainly, less harmful that, you know, it was in the in previous cycles I would say. 

Nick: Okay, great. Well, let's move on to the, the domestic economy in Brazil. And I suppose in terms of the government and Lula's leftist government and the fiscal discipline that's had. Yeah, I remember in his first term, he was helped out on the fiscal side from a commodity boom. And which he isn't really enjoying this time round. But despite that, yeah, we've seen a credit upgrade of the company's debt by, Moody's, which suggests that that actually finances are in better shape these days. Well, what do you see what’s going on there? 

Ivan: Yeah. So let me start with the recent Moody's upgrade, which happened in October. And, you know, basically left Brazil only one notch away from getting back to investment grade after a long while. Obviously, you know, this has taken many by surprise. So, you know, I think the glass half full is that, you know, the rating agency referred to all the structural reforms, which have been implemented in the country since 2016. You know, we can name the Social Security reform, labor reform, the spending cap. And I think, you know, perhaps one of the most important of all is the central bank independence, right. We also did see the primary deficit improvement, from 2023 to this year. And now we are flirting with the idea that, you know, the government can actually meet, this year's target versus, you know, we were almost certain at the start of the year that they were going to miss it. So that's the glass half full that, you know, I think Moody's alludes to it. But the other side of the story is more around the sustainability of the current fiscal framework. You know, with Moody's, I guess, more focusing on how things stand at the moment and not necessarily or guess less so the trajectory of the debt profile. What I mean by that is that, you know, even with the record high revenue figures that we've seen since, you know, some of this year and GDP growing, you know, above potential, we are still seeing, you know, gross debt as a percentage of GDP increasing, right and not stabilising. So where does that leave us at this stage. I think, you know, we continue to see this record high, revenue figures. But there's been more than offset by the rise in expenditures, right. But I can elaborate more on that, you know, at a later stage. 

Nick: Sure, and when I suppose thinking about kind of a fiscal framework and reforms that are going on in the economy, one of the issues with Brazil, to my mind, is the amount of reforms that are going on in terms of education and infrastructure and the impediment that those have issues have in terms of long term growth at the moment. And certainly when you compare that, the likes of China, which is producing huge numbers of graduates coming out of universities and the infrastructure for anyone who's been to China is kind of incredible. Yeah, are there any signs that, you know, some of those kind of longer term reforms, are occurring at the moment or the government is looking to try and put more investment into those kind of areas.

Ivan: Yeah. So it's a good point, Nick. And I think, you know, I'm afraid, it goes back to politics. So, you know, unfortunately there isn't much to say on this front as Lula's focus remains on boosting consumption via policies, you know, which have been more focused on, the shorter term end of this spectrum, I would say. That said, on the more long term reform agenda, you know, one of the examples that we discussed, in the market a few months, ago, was the intention to backtrack on some of the reforms that were, you know, pushed through by the previous administration, such as, you know, allowing private participation in the sanitation sector. You know, obviously that's a thing that we see with positive eyes, and, you know, happy, to share that, you know, the intention to backtrack on that did not go through. So as I said, you know, focus on regulation coming from the federal level has been on increasing social welfare. So topics such as setting minimum wage to increase above inflation or, you know, even eliminate income taxes from what we consider locally, you know, the middle class, you know, you mentioned, you know, education and health care, one of the proposals is to set a floor on these expenditures based on the current tax collection levels, which, you know, as I mentioned before, are running above a normalised level. You know, this all compromises the fiscal, and I guess there's limited appetite at this stage to tackle the long term reforms that you alluded to. So, yeah, I think that would be the summary. 

Nick: Yeah. That's interesting. I suppose, you know, thinking about kind of fiscal reforms and changes to taxation without, you know, seeing this very strong rally in the US at the moment on the back of corporate taxation levels, likely to be lower under a Trump government. So is there anything like that in the pipeline in Brazil? I mean, I yeah, I guess not all reforms are positive for markets. And yeah, there may be some reforms out there which which could be negative given a more left leaning government. 

Ivan: Yeah. So I think there are a few that, you know, it's worth mentioning here. So you know, to so for the higher spending intentions and make the fiscal deficit fall within the expectations, you know, there has been a rise in focused on increasing tax collection, right. So there are good initiatives here I would say, you know, such as efforts to reduce fraud, the receipt of, you know, some social transfer payments. But overall, the finance minister, Haddad, has another agenda that is not really positive for corporates. And, you know, that includes tax breaks and state tax subventions, being revoked. Or, you know, another example is an instrument that companies use as tax shield interest on capital, being basically eliminated, right. So several of the companies that we engage with suggest that, you know, this matter, will be taken to court. And, you know, corporates are preparing their legal cases. But the actual short term impact that, you know, can be more limited on the back of that. But it does cloud the visibility ahead for corporates, right. Especially some that have, you know, more than 20% of their profits coming from this tax rate, for instance. So yeah, you know, increasing tax collection, and being tougher on corporates, I think, you know, it's one of the areas that we are constantly monitoring and it's, you know, front and centre of the finance minister agenda is at this stage.

Nick: I suppose you touched on earlier, but thinking about, you know, Brazil and where they are in terms of the interest rate cycle. Interesting that Brazil really, buck the trend globally in terms of starting to raise rates again recently. And it's quite striking in a way, how going into a period where the US is stimulating aggressively, China's kind of loading more stimulus into the economy. I mean, even in the UK, we've had a new government that's just come out with quite a stimulative budget in terms of spending. You think there's a risk out there that maybe this hiking cycle in Brazil now is a bit more persistent, given some of this kind of macro things going on in the rest of the world.

Ivan: Yeah. So it all, you know, it always goes back to the fiscal in a way, doesn't it. So, you know, with Brazil sort of overgrowing or let's say growing on steroids at the moment with all the fiscal stimulus that we are talking about, you know, inflation expectations are running above central bank's targets for this year, next year and 2026. So, you know, on the back of the the central bank had not only to stop cutting rates but start to hiking cycle. And obviously, you know, if rates take longer to come down in the US given Trump and we see a stronger US dollar affecting the Brazilian Real and therefore, you know, local inflation, the timing of the easing cycle, I think could be postponed once again. Having said that, Brazil has already one of, you know, one of the highest real rates across markets. So if we get more comfort on the domestic fiscal front, you know, regardless of the US cycle, I think there could be room, for the central bank to bring forward this easing cycle and I guess move closer to the rest of the globe, which, you know, is starting to to cut rates. That would certainly be a relief, to markets.

Nick: Yeah. Just thinking about some of the other macro factors and external factors on Brazil. We've just yeah, go for a period now where we're seeing a bit more optimism about the the Chinese market, given some of the stimulus that's coming through there. Do you think Brazil is still a country which is quite reliant on that relationship with China and specifically China's demand for for commodities?

Ivan: Yeah. So I wouldn't say necessarily relying on China, but it's definitely a good kicker, right. So for instance, commodities, heavy in the Brazilian benchmark and a proxy for China growth based materials and energy, which, by the way, is basically a third of the local benchmark would definitely benefit from, China, recovery story. And Brazil is a high beta market, right. So that's the discussion around falling U.S. rates. But if China comes back and this implies in a stronger global growth outlook, it's definitely positive for commodities. And you know, Brazil being a high beta market, I think, you know, Brazil would be, well positioned to perform well on that environment. 

Nick: Yeah. I mean, certainly from a broader emerging market perspective, I think we're all hoping that China does come back at some stage. I mean, it's interesting you said that commodities are about a third of the Brazil benchmark. I think when I was based in Brazil, which was about 8 or 9 years ago now. Yeah, we're at about 50% of a benchmark back then. So it's been quite interesting to see how the market is, has gradually broadened out. And actually be, you know, interesting to hear what you think the more innovative opportunities in Brazil at the moment in terms of the markets. I mean, yeah, you make a contrast, say China, for instance, where there's an awful lot of new economy and tech companies. It's there much going on in the Brazilian market from that perspective in terms of new innovative companies that we can invest in?

Ivan: Yeah. So I think, some very good examples that we can talk about today Nick .So, you know, just to, to get started, I think, you know, with the fiscal gridlock theme that we just discussed, I think it makes domestic names more challenging, despite all the macro data that shows a very strong consumer, or at least, you know, a consumer that is in much better shape versus previous years. So, you know, that's domestic names that are challenged, but also companies with high leverage, which are naturally being more impacted. But the revision of interest rates speculations going forward, I know there has been a constant pressure on earnings growth. Having said that, there are, you know, well created companies that are either say, defensive by nature or, you know, continue to benefit from structural tailwinds. You know, one of them, let's say, you know, the aging of population, which, you know, we capture, via the drugstore operator, Raia Drogasil or even banks, right that would benefit from higher rates for longer. But there are all the stories that, you know, we tag here internally as idiosyncratic. And here, you know, I would mention, you know, Mercado Livre, which is the e-commerce platform with, with that, you know, fintech arm, there's Nubank, the digital bank, they started in Brazil and now is expanding quite aggressively. You know, the markets and even, you know, the waste management company, Orizon. So, you know, all these three companies that I mentioned, obviously they operate in very different segments of the market, but all of them have their sort of self help angle. And, you know, that could translate into the potential to continue to perform well, regardless of the market, right. So that's I guess, how this innovative companies come in quite handy, in Brazil, right beyond the, I would say the exporters, right, which obviously benefit from a weaker BRL or even value, right. Which, which obviously is geared towards a China recovery story as that would be supportive for, oil demand. 

Nick: Yeah. That's good to hear about those companies. I mean it's definitely a real contrast to a lot of the legacy companies that have been listed in Brazil for several decades. Seeing the new companies come into the market and you have better standards of governance and less links into the government is always nice to hear from a kind of bottom up stock picking perspective. You know, perhaps it would be good to just, I guess, summarise really an outline for a case for Brazil at the moment going forward and and why you think, you know, we should be continue to be looking at the market. 

Ivan: I think it's a good way to to wrap up the discussion because, you know, I find it interesting that it is somewhat easy to get carried away and see the glass half empty, given the fiscal discussion that we had. But we need to remember the following, right. Brazil is a high beta market, as I mentioned, and you know, with falling US rates and, you know, US elections getting behind us. Brazil is well positioned to perform well in that environment. Commodities are also, as I mentioned before, having the Brazilian benchmark. And that's a proxy for China recovery if that comes through. Valuations are extremely supportive. It doesn't really matter how you slice and dice it. And you know, real rates are the highest across emerging markets, right. So I think in other words there's very good downside protection. Why we wait for this, you know, bounce back from the markets. And last but not least, I would just mention, you know, the outcome of the US election, which is something that we talked about in the beginning of today's podcast. You know, can serve as, I would say a warning sign for the current administration. Then, you know, with the 2025 budget discussions taking place at the moment, I think it leaves us, you know, in a good spot for the government to to come publicly and announce some more rational, expanding forecasts for next year. So, yeah, let's let's keep an eye on that. 

Nick: All right. Great Ivan. Well, that's, a nice optimistic point to wrap things up. So, Thanks very much Ivan for joining today. 

Ivan: Yeah. My pleasure. 

Nick: Great. And thanks to everyone who's taking the time to listen in. If you enjoyed today then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for the next episode and tune in.