Believe in Brazil

Allegations abound that Brazil’s president, Michael Temer, has been caught on tape encouraging the payment of “hush money” to Eduardo Cunha. The former congressman is currently serving a 15 year jail sentence for his role in the Petrobas scandal. Prospects for much needed fiscal reforms have been thrown into a cloud of uncertainty. The BRL and Brazilian rates sold off sharply while Brazilian equities plummeted. Predicting the legal implications of Brazil’s latest political scandal may be impossible. Investors have been given yet another reason to wash their hands of the once great star of the EM complex. They see a country roiled by corruption, anemic growth, unsustainable public debt, and a rigid labor market. Yet below surface level, there are reasons to be optimistic of the nation’s future. Corrupt politicians being brought to justice is a testament to the strength of rule of law. Inflation is finally below the central bank’s target of 4.5% and wage growth is picking up. Brazil should finally exit one of its deepest ever recessions in 2017. Despite significant hurdles, the underlying drivers for the great optimism of the 1990s & 2000s remain – investors willing to weather the storm may be rewarded.

The end of the commodity super cycle brought 6 years of economic deceleration. Per a recent IMF study, Brazil would need to accomplish a fiscal contraction of 6% just to maintain its already high level of Public Debt to GDP. Without reforms of its labor laws, and an overhaul of the pension system the economy will continue to wobble. Less than half of Brazilian students leave school literate, and the country remains poor. Red tape and inefficiencies plague the economy. Per The Economist, it takes the average mid-sized Brazilian firm 10x as long to file their tax return compared to the global average. Brazil averages 119 days to start a business versus the OECD average of 12. It takes an average of 4.0 years to resolve insolvency cases versus the OECD average of 1.7. Protests erupted before the 2014 World Cup complaining about the decrepit public transportation system. “Custo Brasil” has plagued the nation for decades – with large domestic appliances often costing as much as 50% more than most other countries! “Peter Pan” companies (those who refuse to grow up) stay under a certain size intentionally to avoid additional regulation that comes with expansion.  The International Chamber of Commerce rated Brazil as one of the world’s most protectionist economies.

So why given this bleak reality combined with a fresh political scandal should investors believe in Brazil? The risks Brazil faces are well documented and in focus – but in the rest of this post I will remind readers about what makes Brazil so unique, and its ceiling so high.

Potential Unrealized

Despite its faults, Brazil remains one of the most diversified emerging market economies. The country is abundant in iron ore, deep sea oil, agriculture, and is home to a formidable financial sector. A large percentage of Brazil's population is young and working age, with relatively few dependents at the upper end of the age scale. The Brazilian military is the second most formidable in the western hemisphere after America. The country lacks the intense and fractious religious and sectarian conflicts that plague much of the Middle East, Africa, and Southeast Asia. Most importantly, in the past Brazilians have shown themselves to be a driven and entrepreneurial people – especially when the government DOESN’T help.  

The Brazil That Works

Perhaps the best anecdote is the agricultural industry. In the 1970s “gaucho” pioneers were priced out of expensive fertile southern farmlands. So they headed to the barren north which lacked in infrastructure, education, electricity, water supply and basically anything else resembling a successful society. They had capital and a hunger for prosperity. Around the same time, the military regime sent over 1,000 young scientists abroad to study modern farming techniques. These “gauchos” provided the risk and capital while the scientists provided the know-how to make the agricultural boom happen. Utilizing techniques like deep tilling and injecting huge quantities of lime and fertilizer into the soil, the northeast of Brazil transformed from an arid and nutrient deprived land into fertile grounds for fast growing crops. Northeast Brazil’s location in the tropics made this no easy task. The lack of cold winters allow pests and disease to fester. Transforming the soil is incredibly capital intensive, often costing as much as the farm itself!  Given the region's sudden success, prosperous new towns sprang up out of nowhere. In 1990 Brazil reduced tariffs and did away with import and export controls. Per The Economist, since 1990 the area under cultivation has increased 38%, and production has increased 3x! Total factor productivity has been growing by 4.6% annually! Brazil is now among the top 3 in almost all of the 15 most widely traded crops globally. What other agricultural economy has achieved such prominence with less government protection than its manufacturing industry? In contrast to their counterparts in Europe and America, Brazilian farmers are now steadfast supporters of free trade, actively pushing for a new trade deal with Europe.

Brazil’s consumer products industry experienced tremendous growth in the past few decades. Innovative firms have taken advantage of both Brazil’s own growing middle class as well as abroad. Natura – a domestic cosmetics firm with global ambitions operates on a model similar to America’s “Avon ladies.” The model is based on enhanced and personalized customer service adapted to Brazilian economic conditions. Fewer direct employees provide cover from burdensome labor laws. Low capital intensity allowed the business to survive during periods of hyperinflation and terrible road conditions. Natura’s focus on the middle market displayed foresight given the rapidly expanding middle class. Consumer products companies like Natura should be positively positioned for the future. Market research - finding that although global consumers know little about Brazil, they generally associate Brazilians with “style”, “beauty”, and “biodiversity.”

Let’s compare these two anecdotes with the Brazilian car industry. In an attempt to protect its domestic car industry – car imports were completely banned from 1974-1990. In that time Brazil went from a non-existent car industry to producing over 3mm vehicles a year. Foreign automakers were subject to high tariffs to shield the domestic competitors. But in the 2000s when the BRL surged over 50% tariffs could not save Brazilian carmakers from foreign competition. Foreign car sales increased from 5% in 2005 to 22% in 2011 all the while domestic carmakers never improved their process or product due to lack of competition. Can you name a Brazilian car?

The comparison between the agricultural and consumer products versus the auto industry in Brazil is important. Left to their own devices Brazilians have shown themselves capable of innovation and prosperity despite extreme overregulation. When the government seeks to coddle an industry like automobiles it will inevitably struggle in the long run, not to mention the cost to tax payers.

Populism Trending Down

Latin America is a rare example of a region today that is trending away from protectionism as opposed to toward it. While populism surges to the forefront of political debate in Europe and America, those regions have not experienced a populist surge since the 1930s, making its pitfalls a distant memory. Brazilians have learned first-hand what the long term consequences of Dilma Rouseff and Lula da Silva get them. Take one look at cable news to see the horrendous condition Venezuela is in after decades of Hugo Chavez and Nicolas Maduro. According to Christopher Sabatini, a professor of International Relations at Columbia University, “We’re basically passing each other on the highway” in reference to Latin America opening up as other geographies experiment with protectionism and nativism. Latin America is in the process of dismantling trade barriers. The Central American Trade Platform should be in place in 2017, which will sync migrations, customs, and tax systems. Large scale infrastructure projects like the $50bn Nicaraguan Canal, and the $60bn Chinese-backed Trans-Amazonian railway are bringing much needed fiscal spending to a region that only averaged a meager 2.7% of GDP on infrastructure from 2004-2014. Imagine what the Brazilian farmers could do with suitable roads and ports to transport crops! Latin America raised $90Bn from the bond markets in the first nine months of 2016 – global investors are clearly still willing to provide credit. In Columbia – peace between the FARC guerillas and the government will finally pave the way for a $70Bn 20 year infrastructure plan. Even Argentina has returned to the financial markets and is embarking on rebuilding its crippled economic institutions. Perhaps the ever elusive free trade deal between the EU-Mercosur is in the cards during the next few years? Even if this doesn’t come to fruition, rumors abound that Mercosur may relax restrictions on its members completing bilateral trade deals (Brazil may look toward Japan, Canada, India, and Britain). Undoubtedly the trajectory for liberal economic policies is pointing up in Latin America while pointing down for much of the rest of the world.

Reforms on the Horizon

During the past year, the government has embarked on serious and deep reforms to restore the nation’s economic health. Landmark legislation limiting future increases in budget spending to zero in real terms will stabilize the upward trending Debt/GDP ratio. Serious pension reform will improve long-term financing and regain the confidence of global creditors. Plans to pass additional reforms on education, labor, and tax laws before the 2018 elections will unleash the talent of the Brazilian people and may remedy “custo brasil”. Combining a new streamlined economic system with Brazil’s natural entrepreneurial spirit, generous natural resources, and diversified economy will lead to prosperity in the years ahead. The central bank finally has inflation under control and interest rate cuts will stimulate demand. Brazil should register positive GDP growth in 2017 before these reforms have even taken effect. Even if Mr. Temer is removed from office and fails to deliver, his successor still can.

Believe in Brazil

Brazil’s turmoil is a cleansing fire – its people will not stand for corruption or squandered potential any longer. The new middle class demands decent jobs, clean governance, functioning public transportation, acceptable infrastructure and a promising future for their children. Despite a significant cartel problem, there are no signs of sectarian strife or religious conflict that seem to doom progress in other parts of the world. Thuggish drug lords can be dealt with. Protests have remained peaceful and the government has not reacted with violence. Can you imagine years of such protests lasting peacefully in the Middle East? The Supreme Court is keeping the corrupt political class in check and is determined to reach the ugly bottom of the scandal. The strength and resilience of rule of law in Brazil is unique and crucial. A justice system bringing a corrupt government to heel in Putin’s Russia or Erdogen’s Turkey is unimaginable.  Brazil’s youth have endured a brutal recession and moral failure of government during their formative years - it should harden them in the decades to come. Hopefully, the 2018 national elections usher in a new political class – one charged with restoring the promise of Brazilian glory. The road ahead will be turbulent no doubt, but what doesn’t kill you makes you stronger – and Brazil will survive.