Brazil: political uncertainty - Erste Asset Management

In the current environment of global uncertainties in emerging markets due to idiosyncratic events in Turkey and Argentina, the trade conflict between the USA and China and with regard to the presidential election, late September was probably one of the most exciting times to visit Brazil. To my surprise, I did not see any oversized campaign posters either in Rio de Janeiro or in Sao Paulo. However, the topic was omnipresent in personal conversations. The result of the election seemed uncertain, and the voters came across undecided. The country is divided between the right-wing candidate and former army officer, Jair Bolsonaro (affiliated with Partido Social Liberal, PSL) and the left wing with Fernando Haddad, the substitute candidate filling in for the former president Lula da Silva (who due to a prison sentence for corruption was not allowed to run for office). Fernando Haddad is the former mayor of Sao Paulo and is supported by the left workers party Partido dos Trabalhadores (PT). The weekly magazine “The Economist” has recently referred to the right-wing candidate Bolsonaro as “Latin America’s latest menace”. By contrast and not surprisingly, the markets reacted positively to his the clear first-round victory due to his political agenda and the economic programme by his adviser, Paul Guedes.

Prior to a site visit to the cellulose and paper producer Suzano on the last day of the conference, 21 companies, the Brazilian Development Bank BNDES, and a local political consultant, Arko Advice, had been holding Q&A sessions on current developments, latest company results, and strategic, future plans in the preceding days. Almost all companies we visited had improved their fundamental data again, continued to lower their debt, and boosted their liquidity ratios over the previous two to three years. However, all companies are currently caught up in the maelstrom of global turbulences on the markets. While this trend reverted in the first two weeks of October, the economy is still poised for the second round of an election with unclear economic and political consequences for Brazil and its corporate sector. The general consensus among the companies was to tackle overdue strategic projects and large investments only after the elections amid decreased levels of uncertainties. The dominant corporate sectors in terms of economic output and headcount in Brazil are: 1) energy (we visited Petrobras, Ultrapar, Raizen, Cosan, and Ocyan) with sales of more than EUR 100bn and a headcount of 250,000; 2) food and meat production, with the companies we visited, i.e. JBS, BRF, Mafrig & Minerva, generating sales of about EUR 65bn and operating at a headcount of 400,000. The third sector with companies such as Vale, parts of Votorantim, Cementis, and Suzano produces, processes, and exports commodities. They generate sales of close to EUR 60bn and have a headcount of 150,000.

The one- to one-and-a-half-hour talks with the various companies were meticulously scheduled, very intensive, and incredibly instructive. Without wanting to go into excessive detail, here are some of the impressions of a few selected companies we saw:

The government-owned company Petrobras is one of the world’s biggest oil and gas companies with largely local production of most recently 2.8mn barrels per day. The company is still cutting debt with planned proceeds from asset sales of USD 13.5bn to 15bn generated as free cash flow by the end of the year.
The private hospital consortium Rede D’or has recorded average growth rates of 25% over the past five years. 100% of its income is generated from private health insurance policies, which in turn depend on private household income, the general unemployment rate, and the economic growth rate of Brazil. Some 47mn of more than 200mn Brazilians are potential customers.
The Brazilian Development Bank BNDES will be granting roughly the same volume of loans this year as last year, i.e. close to BRL 70bn (some EUR 15bn). 40% thereof will go towards local infrastructure projects, 20% each to trade and services, with a focus on innovation, sustainability, and clean energy.
Vale, one of the world’s biggest metal and mining companies (global no.1 in iron ore and nickel production), earns a premium above the price of internationally traded iron ore with every single tonne sold, since its product is of outstanding quality. The sales price is derived from different raw material standards and an optimum blend of aluminium oxide Al₂O₃ and silicon dioxide SiO₂.
The biggest Brazilian media group Globo, much like many companies in the sector, has suffered from sustainably brisk international competition (Netflix, Amazon and others) and falling profit margins for numerous years. The company generates two thirds of its sales from advertising and one third from successful in-house productions (which were very popular among the local conference attendants).
The two meat-exporting companies, BRF and JBS, are still navigating the legacy of the tainted-meat scandal of 2017. BRF is currently divesting its production facilities in Europe and will thus discontinue high-value products that have been specifically developed for export markets such as Europe, attain higher standards, but are too expensive for the domestic market.
The government-owned Cemig group wants to re-focus on its core business, i.e. the production, transformation, and distribution of energy through 116 power plants and a grid of 600,000km (i.e. 15x the circumference of Earth), and intends to sell all other investments.
Suzano owns 1.2mn hectares of eucalyptus forests. This is roughly equal to a quarter of the entire forest stand of Austria. Eucalyptus trees follow an economic life cycle (planting to uprooting) of five to seven years, and the company is currently working on a process to produce 100% eucalyptus cellulose for nappies. The company expects higher growth rates and profit margins in this segment than in traditional paper.

The Brazilian economy has only just entered a recovery phase after one of the most difficult recessions of the country, caused by the biggest corruption scandal in the history of Brazil, “Lava Jato” (a corruption scandal worth billions around the government-owned company Petrobras, in English referred to as the “Car Wash Scandal”), an expected budget deficit of 8.9% of GDP (N.B. Italy has just caused a stir with a planned deficit of 2.4% of GDP), and the resulting rapid growth of government debt. That being said, on a corporate level, debt ratios remain low, and fundamental data have improved. If the new government were to initiate the urgently needed fiscal consolidation, privatisations, and a social and pension reform, we would review our current, tactically neutral positioning on the basis of selected companies.

Political epilogue: in the first round of the presidential elections, the two candidates Haddad, and slightly ahead, Bolsanora came out on top, as predicted by Arko Advice at the end of September. This result prolongs the global trend of anti-establishment, frustrated voters and a shift of the political centre to the fringes on either side and thus to populists also in Brazil, although both candidates have to contend with historically high disapproval rates among voters. Bolsonaro is disliked in particular by female voters due to sexist and misogynistic statements, whereas Haddad, as successor to Lula, represents a possible continuation of the existing corrupt system to many Brazilians (“Lava Jato”) and is therefore no alternative for many Brazilians either. Which candidate is favourite to win the second round? Persistent tailwind, the movement against corruption and thus against PT, and the fact that since 1989 the winner of the first round has always been victorious also in the second round (if there was one) suggests a victory for the right-wing populist and more market-friendly candidate Bolsonaro. In addition, Bolsonaro can count on the support from three important power blocs in Congress, the so-called BBB representatives (bull, bullet and bible) for agriculture, military, and the evangelical groups in the country. Even in the event of Bolsonaro’s victory, the planned and, from an economic perspective, urgently needed election promises (and their implementation) such as a general social and pension reform will be difficult to pass in the Chamber of Deputies (30 different parties) and the Federal Senate (21 parties) due to the highly fragmented structure and in view of the required majorities. The closer team with at least five former generals, on the other hand, and their law and order agenda, involving the fight against crime and corruption, could pick up speed quite quickly.