GLOBAL EMERGING MARKETS DECEMBER 2015

FOR PROFESSIONAL CLIENTS ONLY

TALES FROM THE ROAD – BRAZILSovereign rating downgrades, falling currency and rising unemployment and a government rocked by poor approval ratings and political scandal – a great deal has happened since my last research trip to Brazil. However, there are still companies which are well placed to survive against the poor economic backdrop.

The economic challenge For me, the most palpable sign of Brazil’s economic challenges was the traffic – or lack of it. On previous trips, in more prosperous times, schedules were curtailed and arrival at meetings could be an hour late, due to severe traffic congestion in cities like São Paulo. This time, it was nowhere to be seen and it was evidently down to the effect of economic weakness.

From an external perspective, slowing growth in China and emerging markets and the subsequent impact on commodity prices, particularly oil and iron ore, have all had their part to play. They have had a negative effect on exports and investments in both the commodity and related sectors. However, it is the internal causes which are more disappointing. They highlight a lack of political will to address an age-old problem, and one of Brazil’s fundamental challenges – the size of the state.

The strength of commodity markets until 2010 provided a compelling opportunity (and available capital) for the country to reform. Instead of reducing the state’s size and investing in infrastructure and education,

Jeff CassonPortfolio Manager, Global Emerging Markets

the windfall was used to support historical initiatives such as subsidised-lending programmes to certain industrial sectors, tax reductions, and ongoing and financially expensive social programmes. It resulted in strong retail sales and lower unemployment, until the external economic backdrop could no longer mask deep-rooted problems.

Policies to allow significant improvement, such as targeting inflation, have also been relaxed – leading to stagnating growth and high inflation – and the costs of supporting the programmes has increased dramatically, with public sector debt increasing in the past three years.

GLOBAL EMERGING MARKETS DECEMBER 2015

FOR PROFESSIONAL CLIENTS ONLY

Jeff CassonPortfolio Manager, Global Emerging Markets

Brazil’s problems at a glance

n The re-election of President Dilma Rousseff and subsequent rapid deterioration in approval ratings.

n Sovereign rating downgrades by S&P and Fitch.

n Brazil’s currency, the real, has depreciated nearly 40% against the US dollar between January and the start of December this year.

n Interest rates have risen from 8% in 2012, to 14.25%.

n Inflation has deteriorated materially with IPCA (the broad national consumer price index) inflation currently at 10.5%, up from 5.9% at the end of 2012.

n The unemployment rate has increased materially in the past 12 months.

n The ‘Lava Jato’ scandal has escalated, contaminating both corporate and political circles to such an extent that effective functioning of government has to be questioned.

n IMF estimates of GDP declining 3% this year and 1% in 2016 are conservative compared with other data sources.*

Political turmoil The current economic problems have been exacerbated by rapid political deterioration in the last 12 months, making the structural economic reform required seem a distant prospect.

Dilma Rousseff’s presidency has been rocked by a decline in approval ratings for her and the Workers’ Party (PT) over the past year. She faces impeachment proceedings for allegedly breaching fiscal responsibility laws and manipulating government finances to benefit her re-election in 2014. However, the coalition structure of Brazilian politics had already left her in a very weak position, limiting her ability to push through initiatives (at times Congress has worked actively against government proposals).

The government’s legitimacy has been further questioned with the ‘Lava Jato’ (car wash) investigation, into allegations of corruption at state-controlled oil company Petrobras. During the research trip there were several arrests, including the government’s leader in the upper house Delcídio do Amaral (the first sitting senator to be arrested in Brazil’s history) and Andre Esteves, Chairman and CEO of major Brazilian bank BTG Pactual.

The seriousness of Amaral’s arrest in particular cannot be downplayed. His arrest potentially jeopardises fiscal law discussions he would have been leading, sets a very poor political tone for the coming months and could have material ramifications for economic trends.

Political uncertainty remains high and, as the investigations extend their reach, it is difficult to rule out further deterioration in the political – and therefore economic – environment.

Economic and political implications The real’s rapid depreciation highlights the magnitude of the situation but is also a potential virtue. The exchange-rate adjustment is supporting a significant improvement in the trade balance. Brazil is becoming competitive again.

Activity has declined dramatically and the corporate sector is stuck in a rut.There is a massive crisis of confidence among business leaders and consumers.

The political situation is a real concern, potentially limiting the effectiveness of government initiatives, possibly until a new government can be elected in 2018 or earlier.

However, the major positive we as long-term investors can take from ‘Lava Jato’ is the sanctity of the judiciary and the important message that this sends regarding the rule of law.

Rapid depreciation of the real highlights the magnitude of the situation but is also a potential

virtue. The exchange-rate adjustment is supporting a significant improvement in the trade

balance. Brazil is becoming competitive again.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. *International Monetary Fund (IMF), World Economic Outlook, October 2015.

active VIEWPOINT: GLOBAL EMERGING MARKETS

Investment implications

Companies delaying budget planning

Brazil’s economic problems and ramifications for businesses were evident in discussions with companies, particularly when reviewing plans and budgets for 2016. These would normally be finalised by now, but this was not the case (even those who had done so, were now in the process of revising them). Economic and political uncertainty has considerably undermined management confidence. Payment processing company Cielo, for example, is reviewing its 2016 plan following a consistent slowdown during 2015. This is an important indicator, as Cielo’s network processes more than half of financial transactions by volume in Brazil and its operating conditions are very much tied to economic activity.

Lower wage rises

Union membership is widespread in Brazil and there has been a definite impact on the negotiation of wage agreements. Historically, increases would be a minimum of inflation plus a couple of percentage points. A similar amount in pricing would result in margin pressure. Of the companies I met, around 50% were trying to negotiate below-inflation wage adjustments for 2016.

Central bank policy

From the Central Bank’s perspective, this control on wage agreements could be welcome news. The bank is concerned about the inflationary environment and wants to take some pressure out of the system. While it voted recently to maintain interest rates at 14.25%, in a surprising development two board members voted for an increase of 50 basis points. The bank is primed to act if market inflation expectations do not trend lower in the near term.

The biggest risk Brazil faces at this point is inflation expectations becoming unshackled with the negative feedback loop associated with rising prices and a weaker currency. If Minister of Finance Joaquim Levy is able to bring any fiscal reforms to the table (with pensions the most likely) and political consensus can be reached, this would be taken positively by market participants.

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Reacting to crisis

I met two firms currently at the centre of major recent crises to see how they were affected, and assess any wider impact on companies in Brazil.

Petrobras

The Brazilian semi-public multinational at the centre of the Lava Jato investigation, highlighted the many challenges it faces from an operational perspective, as a result of its poor debt position. The company’s management plans to make divestments to cover cash requirements, which I believe could prove challenging but not impossible in the current environment. Governance structures remain a concern and as I was leaving Brazil, chairman Murilo Ferreira, who took a leave of absence in September, confirmed he was permanently standing down from the Petrobras board. The key question now is who will replace him and, more importantly, will the government be able to name an individual who commands the market’s respect?

Vale

We met mining company Vale, which has made significant progress restructuring costs to cope with the collapse in iron prices. However, the main issue facing the company – and the wider mining sector in Brazil – is the ramifications of the Samarco dam collapse. The accident unleashed 60 million cubic metres of mud and mine waste, demolishing a nearby village, killing at least 13 people and causing devastation to the local environment.

Vale is joint owner of the iron-ore pellet operation with BHP. The cause of the tailing-dam collapse is still under investigation and the financial implications of the accident are very difficult to quantify. I think it prudent to assume that environmental legislation and construction-compliance costs will increase for the mining sector in Brazil. This will affect cash flow, returns and corporate value.

Brazil’s economic problems and ramifications

for businesses were evident in discussions with

companies, particularly when reviewing plans and budgets for

2016. These would normally be finalised by now, but this was

not the case (even those who had done so, were

now in the process of revising them).

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable.

Opportunities for acquisitions

The economic backdrop is also creating opportunities for companies to acquire assets, which would not normally be available. J&F Investments, the holding company of meat processing company JBS, acquired Alpargatas (the manufacturer of Brazil’s iconic Havaianas flip-flops) for US$718 million (2.7 billion real) from private conglomerate Camargo Corrêa. Camargo has been selling assets to pay a number of fines related to the Petrobras/Lava Jato investigation.

Bucking the trend

Amid the political and economic turmoil, during the research trip operating rights for a number of hydropower projects were auctioned. China’s Three Gorges Corporation was the largest winner, bidding US$3.6 billion for a number of projects in a total auction size of US$4.5 billion.

Despite a negative economic backdrop I met a number of companies who have continued to deliver through this economic scenario. Their focus was very much on ensuring consistent minimum returns. Retail drugstore chain Raia Drogasil, for example, is carefully considering the return profile of new stores, while another retailer Lojas Americanas, is concerned with maintaining a balance between growth and profitability.

Transition to mobile technology

The transformational impact seen by companies in developed markets moving to mobile technology, has been no different in Brazil. Financial name Itaú has moved the majority of banking transactions within its network online, which has proved positive for costs and productivity. A period of accelerated investment in technology should allow the bank to offset some of the inflationary pressure in wage costs but, more importantly, improve efficiency.

Reduced scale at physical branches, as a result of creating digital branches, has resulted in increased revenue per client and improved efficiency. Digital branches use computers, ATM facilities and centralised telephony support (reducing one-to-one interaction with customers). There are no physical cash-handling facilities, removing the requirement for additional security measures and associated costs.

ConclusionsWhile there is a great deal of economic and political noise, Brazil’s positive demographic profile remains. However, investment is needed for the country to prosper. This will create opportunities for local and international companies to benefit in the medium term. Our portfolio continues to have exposure to Brazil, in businesses that are, we believe, well positioned in the long run.

In the short term, Brazil will continue to face headwinds from an economic and political perspective. While the real’s depreciation has started the required adjustment process, significant political reform and economic progress is required in order for consumer and business confidence to improve. This should hopefully set Brazil on a path to achieving its potential.

Despite a negative economic backdrop I met a

number of companies who have continued to

deliver through this economic scenario.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable.

active VIEWPOINT: GLOBAL EMERGING MARKETS

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