Macro Research

Brazil: Upgrading the market on stronger upside potential and improved outlook

We see further upside for Brazilian equities even after the strong performance in 1Q22.

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  • Published on 07 May 2022

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  • The global commodity price outlook has improved and we expect prices to remain supported moving ahead. This is a big plus for Brazilian equities given the boost to macro recovery and corporate earnings.
  • Earnings estimates have been revised significantly higher with headroom for further upgrades. Earnings are expected to hit an all-time high in FY22, setting up a strong fundamental narrative for a further rally.
  • With greater clarity in recent months, we believe political risks have subsided and the election outcome is less of a headwind for equities. Valuations are also compelling, trading at more than 40% discount to the historical average. 
  • Overall, Brazilian equities are a high-risk high-reward play. We project an upside potential of 75% (by end-2024) but acknowledged the risks present. With a rosier equity outlook and stronger upside potential, we upgrade Brazilian equities from 3.0 Stars to 3.5 Stars “Attractive”.

Brazilian equities, on aggregate, were one of the best performing equity markets globally in the year-to-date (Chart 1). Riding on the surge in commodity prices, the Bovespa index rose around 35% in 1Q (SGD terms), catapulted by a blistering 18% appreciation of the Brazilian real relative to the Singapore dollar in the same period. Despite the strong showing in the year-to-date, we believe the conditions are ripe for the rally to continue.  In this article, we outline the reasons why we are upgrading Brazilian equities and the factors driving further equity upside.

Chart 1: After a lackluster 2021, Brazilian equities started the year with a bang



Stronger global commodities price outlook supportive for equities


Commodity prices and their outlook are arguably one of the most dominant drivers for Brazilian equities. Since our previous update on Brazil in November 2021, the global commodities price outlook has largely improved and one of the biggest (and most recent) catalyst is the Russia-Ukraine war. The conflict was a significant negative supply shock to the commodity complex as both countries are large commodity producers. To put things into context, Russia alone accounts for an estimated 11% of the global supply of oil and around 4-6% for the global supply of base and ferrous metals (steel, iron ore, copper, nickel, and aluminium).

Due to variability in the length of the war, potential for more export sanctions on Russia, and further Russia retaliation, there is difficulty in assessing the extent of the negative supply shock. Therefore, we believe markets will take time to digest the impact (to supply) even after an initial de-escalation, leading to an extended period of supply tightness. This should buffer against demand concerns arising from China, given the escalating Covid-19 situation. 

Looking ahead, we continue to expect ongoing supply-demand imbalance, and underpinned by our expectation of a global commodities supercycle, we expect commodity prices to remain supported. The stronger commodity price outlook is a big plus for Brazilian equities as the impact is two-fold, via the economic and (a more direct) equity channel. 


i. Macro growth and commodity prices: The combination of higher commodity prices and supply shock will likely be net positive for Brazil’s growth. We expect the biggest driver to come from trade – from both export quantity and value (Chart 2). Macro data are already showing a rise in demand for Brazilian goods at higher prices, with exports hitting record high in March. The additional growth impulse from trade is a much needed buffer against the ongoing drag from elevated inflation and potentially higher interest rates.

ii. Corporate earnings and commodity prices: Higher commodity prices should uplift Brazil’s corporate earnings. As shown in Chart 3, there is an intimate long-term relationship between earnings and commodity prices. This can be explained by both the primary impact (weight of Energy and Materials combined is around 36% of Bovespa) and secondary impact (net positive for economic growth). The net impact on equities goes beyond fundamentals. Elevated commodity prices tend to improve market sentiment and consequently inflows for commodity exporters such as Brazil.

Chart 2: Stronger commodity prices often drive Brazil’s export value



Chart 3: Stronger commodity prices also boost Brazil’s EPS growth


 

Robust earnings revision and improvement in earnings outlook


The stronger commodity price outlook has sparked a series of positive earnings revision for Brazilian equities. Earnings estimates (as gauged by the Bovespa index) have been revised higher by 19% in the year-to-date. While the earnings upgrade are likely to be front-loaded, we see room for further positive revision if commodity prices remain elevated, Brazilian equities see strong earnings results (reinforcing another round of upgrades), and/or Brazil’s macro growth improves.

Brazilian equities are projected to generate an EPS growth of 6% YoY in FY22 before marginally falling by -4% YoY in FY23. While an EPS growth rate of 6% may at first look underwhelming relative to other EMs, we have to consider 2021’s dramatic EPS growth of 454% YoY. Should the positive EPS growth materialise, earnings are expected to hit an all-time high in FY22, setting up a strong fundamental narrative for a further rally.

This is achievable in our view as FY22 EPS growth is firmly supported by i) the improved commodity price outlook, ii) support from key sectors such as financials and energy, boasting strong double-digit growth, and iii) broad-based earnings strength, where a majority of the sectors are expected to generate positive growth in 2022 and 2023 (Table 1).  The headroom for further positive EPS revision also mean that there could be upside for earnings growth.

While the EPS growth projection for FY23 is negative, it is largely in line with a higher base from 2022’s EPS integer. The base for comparison will toughen in next year with the expectation of a 6% YoY growth and an all-time high EPS in FY22. That said, we do expect some moderation in EPS, especially from the cyclical sectors in FY23, after two full year of earnings recovery, and this should weigh on topline EPS growth. 

Table 1: Earnings estimates for 2022 – 2024

Source: Bloomberg Finance L.P., iFAST Estimates, iFAST compilations.  Data as of Apr 22. 

Political risks have subsided


Political risk was part of the core basis for our downgrade of Brazilian equities back in November 2021, considering the upcoming election in October 2022. The importance of the election is that Brazil has one of the worst fiscal balance across emerging markets, which by itself is a vulnerability to the nation’s growth outlook. However, with greater clarity over recent months, we believe political risks have subsided.

We expect the election outcome to be less of a headwind for equities. First, we expect economic reforms after the election regardless of the winning candidate. With softening economic growth and fiscal sustainability issues before Covid-19, the pandemic worsened the nation’s growth and fiscal outlook. Policymakers have publicly acknowledged this and, in our opinion, Brazil will likely be in repair mode post-Covid as the presidential administration’s focus should be on establishing a sustainable recovery and long-term growth. On the ground, evidence seems to reinforce this view. Bolsonaro has re-affirmed his intentions to continue with pro-growth policies if he gets re-elected, while Lula has also hinted at post-election tax reforms more recently during the campaign.

Second, we expect lower equity volatility heading into the election. With a fairly consistent lead for Lula over Bolsonaro in opinion polls since 2021, there is a lower possibility of a close-contest and thus, less wild re-pricing of election outcomes as markets are able to price ahead with greater certainty. In the event of a close-contest, we think the outcome where reforms are likely (as outlined above) may calm equity markets. Under this scenario, there will no doubt be volatility in Brazil’s equity market, but as compared to our previous update, where clarity in policy outlook is scarce, we believe volatility will be tamer this time round.

Valuations at a steep discount


Brazil’s (gauged by the Bovespa index) forward PE ratio, with 2022 earnings estimate, is currently trading at 6.9x, which is significantly below the historical average of 12.2X, or -2.3 standard deviation below the average.  Valuations are down by more than 40% relative to the historical average (Chart 4), making it one of the cheapest equity market under our coverage. 

Despite the recent rally, the large positive year-to-date earnings revision of 19% has kept the PE ratio at a more muted level, preserving the room for valuation expansion. If our expectation of positive earnings growth and revision materialises this year, valuations may remain palatable and justify a further re-rating. At current depressed valuation levels, Brazilian equities also offer a broad margin of safety from valuation compression triggered by the risk factors outlined below.

Chart 4: Valuations went from cheaper to cheap after the recent rally 


 

A mixture of global, macro, and political risk in the way


Brazilian equities are not without risk. While multiple upside drivers exist, Brazilian equities are exposed to a confluence of global, macro, and political risks. A potential global growth slowdown poses a key risk to Brazilian equities. While consensus is generally expecting a gradual slowdown in global growth, we are watching the rate of change (how fast the slowdown will be) and how it impacts the commodity complex. We believe markets will be able to digest a gradual softening in growth momentum but a significant slowdown will be challenging for a market like Brazil, which is highly sensitive to global growth. Furthermore, a significant slowdown can be detrimental to the commodity price outlook, which is a major driver for the Brazilian economy and equity markets.

With strong near-term inflation pressure from elevated commodity and other input prices, the Central Bank of Brazil has hiked rates by an estimated 100bps in May, pushing the Selic rate from 11.75% to 12.75% (Chart 5). A Selic rate beyond 12.75% will be considered restrictive for Brazil’s growth, as guided by the central bank. This means an unyielding high level of inflation is a macro risk in 2H22. Not only will it embolden policymakers to raise rates into restrictive territory, but may also offset the growth impulse from an improvement in trade.

Political risks may have abated, as we argued above, but it remains present and the election is a source of volatility. In the run-up to October’s election, we are expecting an uptick in volatility especially when there is fiscal noise.

Chart 5: Inflation data is the steepest since late 2002



Upgrading Brazilian equities, a high-risk high-reward play


Applying our designated fair P/E ratio of 12.5X on EPS projections for the next two years, we project a target price of 194,000 for the Bovespa Index by end-2024. This implies a 75% upside potential over the next two years, should earnings and valuation expansion materialise. We see Brazilian equities as a high-risk high-reward play as the attractive potential upside comes with a confluence of risk factors. 

Overall, the outlook for Brazilian equities have improved and we now see a stronger upside potential. Therefore, we upgrade Brazilian equities from 3.0 Stars to 3.5 Stars “Attractive”. Investors who wish to seek exposure to the Brazilian market can consider the iShares MSCI Brazil ETF. Investors who seek a diversified approach can consider our recommended fund for Latin American equities, Schroder ISF Latin American A Acc SGD, where Brazilian equities comprise more than 60% of the fund. 

Chart 6: Earnings forecast and price performance of Bovespa Index



Table 2: EPS and upside projection for Bovespa Index

Brazil (Bovespa Index)

FY2021

FY2022

FY2023

FY2024

PE ratio (X)

6.8

6.9

7.2

7.1

Projected earnings growth (YoY %)

454%

6.5%

-3.8%

0.5%

Projected Earnings Per Share (EPS)

15121

16100

15490

15560

Target fair price (Based on 12.5X Fair PE ratio)

-

-

-

194,000

Potential upside (%)

-

-

-

75.0%

Source: Bloomberg Finance L.P., iFAST estimates. Data as of Apr 2022. 


The Research Team is part of iFAST Financial Pte Ltd.

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