Pursuing Lasting Progress in Emerging Markets

Field Notes: São Paulo and Rio de Janeiro

Second Quarter 2013

On my recent visit to Rio de Janeiro, a taxi driver patiently answered my questions about the city. In response to my inquiries about the occupants of some particularly eye-catching office towers in the Centro zone of the city, he said, “On your right is Petrobras [Brazilian multinational energy corporation], on your left is BNDES [Brazilian Development Bank] and straight ahead is Banco do Brasil. This intersection is what we call the Brazilian Bermuda Triangle: it is where our money goes to disappear.” This joke was an interesting precursor to the mass protests and demonstrations that were to unfold across the country just weeks later.

The overall vibe on the street was markedly more somber, and the underlying tone of my meetings with management teams was decidedly more cautious, compared to my experience in Brazil just nine months ago. Despite a whole host of problems bubbling in Brazil right now, I remain optimistic about the future of the country and believe that current equity valuations are compelling. What follows are a few insights from my visits to the immensely large cities of Saõ Paulo and Rio de Janeiro:

Discontent with the Rousseff administration. Almost every one of the CFOs and senior managers with whom I met expressed concern over the increasing amount of market intervention by the current administration. With President Rousseff already having intervened in the banking, insurance, electricity, petroleum and materials sectors, many of the senior executives with whom I met were trying to anticipate where the administration would strike next and determine how to position themselves defensively if at all possible.
Oh, the traffic! Saõ Paulo’s roads frequently resemble parking lots. Residents are stuck in bus queues everywhere you look, and private helicopters are a constant sight in the sky. Saõ Paulo is home to more than 260 helipads; by way of comparison, Manhattan has just a handful. The country’s rapid economic growth over the past decades has lifted more than thirty million Brazilians into the middle class and resulted in many more cars on the streets. Problematically, public spending on roads, public transportation and ports has not kept pace. A recent report on global competitiveness by the World Economic Forum ranked Brazil's ports 135th out of 144 countries (with shipping companies sometimes required to fill out dozens of forms from as many as twenty different institutions); and ranked roads 123rd.2 The following statistic is particularly eye opening: Brazil has approximately 213,000 kilometers of paved roads, which compares to 4,374,000 kilometers of paved roads in the U.S., a nation of comparable geographic size and population.3 During one of the many hours I spent in Saõ Paulo traffic, I saw a lineup that was at least ten miles long for trucks destined for the nearby port. Leaving my hotel as much as two hours before my 9AM morning meetings in order to combat the choking Saõ Paulo traffic and then enduring the same level of traffic in the evenings - and sometimes even midday - has made me keenly sympathetic to the protesters’ transportation complaints.
Custo Brasil. The “Custo Brasil” refers to the increased operational cost of doing business in Brazil due to a host of factors beyond the increased government intervention and lack of infrastructure spending discussed above. High banking spreads, excessive bureaucracy, low educational levels, and pervasive corruption are just of few of the factors that make the cost of doing business in Brazil unnecessarily high. Other policies that contribute to the Custo include “local content” rules. The administration requires that 60% of the input costs for certain products and services be traceable to local sources. The rules span industries such as auto parts, oil exploration, electricity generation, and infrastructure projects. The elevated cost of doing business in Brazil has many root causes, most of which need to be addressed if Brazil is to realize its full potential.
World Cup woes. The week after my visit, a local judge ordered a friendly football match between England and Brazil at the newly renovated Maracanã stadium in Rio to be postponed at the last minute due to safety concerns related to construction rubble remaining outside the stadium. The game was ultimately allowed to occur, but the surrounding drama raised serious questions about the nation’s readiness for the 2014 World Cup and 2016 Olympics. The protesters’ grievance that the World Cup stadiums have been unnecessarily expensive is directly tied to the Custo Brasil and, in my view, these protestors have every right to be angry.
Business environment uncertainty. In June, the spread on the benchmark 10 year dollar-denominated bond for Brazil surpassed the spread on the benchmark 10 year dollar-denominated bond for Russia for the first time in three years. This bondholder preference for Russian risk over Brazilian risk offers evidence that the market is highly concerned about the state of the Brazilian economy. Today, these two benchmark bonds trade at roughly even valuations, both at + 2.5% spread (higher yield to maturity) over the 10 year U.S. Treasury benchmark.4 The relative relationship of these two bonds is something we will watch closely over the coming weeks and months.
Inflation woes. The release of April inflation statistics was a significant concern for almost all of the CFOs and senior managers with whom I met. This April data showed the inflation rates on non-price controlled items breaching the 8% level for the second quarter in a row, as seen in the chart below. The managers’ main concern, which I share, is that Brazil’s inflation will likely surpass the desired target of 4.5% for the year.
Source: Bloomberg
Past performance does not guarantee future results.
Note: Regulated prices in Brazil – which include electricity, water, gas, gasoline, and pharmaceuticals and account for 24% of the aggregate Extended National Consumer Price Index (IPCA) – are increasing at a rate of 1.54%. Unregulated prices – which include food and beverage, housing, clothing, education, healthcare and communications and account for 76% of the aggregate IPCA – are increasing at a rate of 8.11%. The aggregate inflation number breached 6.5% in May for the second time this year.5 The government’s push to hold down inflation is probably unsustainable. The government’s attempts to contain inflation via suppression of regulated prices may well feed higher inflation in unregulated categories; the net effect is that the government’s efforts are likely to backfire, as aggregate inflation remains stubbornly high.

Over the course of six days, I visited ~20 companies in Saõ Paulo and Rio, and not one of these meetings ended without some level of concern being voiced about the current administration. As such, the wave of mass protests that began in Saõ Paulo a few weeks later, on June 17, in opposition to bus fare increases and soon radiated throughout the rest of the country were not a complete surprise to me. The country’s high taxes, poor infrastructure, inadequate education, expensive healthcare, and pervasive corruption are problems that the government would do well to address. Having said all that, I remain optimistic that Brazil will come back from this dangerous cliff if the current administration can make good on three promises: 1) take meaningful steps to reduce corruption, 2) increase education spending in earnest, and 3) successfully execute on a host of much needed major infrastructure projects in conjunction with the private sector. Right now, media coverage of Brazil is quite pessimistic, and stock valuations clearly reflect this. Nevertheless, I am optimistic that the country can and will emerge from this dark corner stronger and more cohesive than before. Furthermore, current valuations in certain sectors of the Brazilian economy are attractive.

Kate Jaquet

São Paulo

Heliport in downtown Saõ Paulo on a midrise hotel. Gridlock below, heliport above.
Miles of trucks in queue to access main port route
Overcast and gridlocked day in Saõ Paulo
Snarled power lines in Saõ Paulo

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

Kate Jaquet is a Registered Representative of ALPS Distributors, Inc.

  1. Global Competitiveness Report 2012-2013, World Economic Forum
  2. Global Competitiveness Report 2012-2013, World Economic Forum
  3. Departamento Nacional de Infraestructura de Transportes de Brasil and the CIA World Factbook, as of 30 April 2013
  4. Bloomberg, as of 26 June 2013
  5. Bloomberg, as of 26 June 2013