Brazil: Look to this 2022 top performer to repeat its stellar performance

• A supportive commodities outlook in 2023 should not only be positive for Brazilian economic growth but also for Brazilian equities and earnings.
• Monetary policy could be a fresh tailwind for equities in 2023 as we look at potential rate cuts later this year.
• While several election-related risks have emerged over the past months, we believe these risks remain manageable for now and recommend a “wait-and-see” approach.
• Valuations remain extremely cheap, despite our relatively conservative earnings estimates.
• We see an upside potential for Brazilian equities of +49% by FY24, and retain our Star Rating for Brazil at 3.5 Stars “Attractive”.

Brazil was the king of equity markets in 2022 – it even managed to end 2022 in the green despite what was mostly a bloodbath across asset markets (Chart 1). This strong performance was carried by a global commodities rally in 2022, supporting index heavyweights like Vale (+25%) and Petrobras (over +40%) (Chart 2), who led the performance for the broader benchmark.

Looking into 2023, we remain positive on Brazilian equities and see an upside potential of +49% by FY24, making it one of the more attractive markets to invest in this year. In this article, we will highlight several reasons that underpin our positivity, and our decision to retain our Star Rating for Brazil at 3.5 Stars “Attractive”.

Chart 1: Brazil managed to end 2022 in the green unlike its global, DM, and EM peers

Chart 2: Bovespa performance was driven by Vale and Petrobras

Supportive commodity outlook to buttress Brazilian equities

As highlighted in our previous update on Brazil, the region’s equities are heavily influenced by commodity prices. There are two reasons for the strong link between commodities and Brazilian equities.

First, higher commodity prices help to support domestic growth, especially through trade revenues as commodities are key components of Brazil’s export (Chart 3). A supportive growth backdrop is often positive for Brazilian equity performance. Second, due to the outsized allocations of the Materials and Energy sectors in the Bovespa Index (Chart 4), higher commodity prices also help to uplift revenue for these two heavyweights, thereby enhancing aggregate earnings for the index (Chart 5).

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

We remain cautiously optimistic on commodities prices moving ahead, focusing on iron ore and oil given their importance within the Bovespa Index. On the supply-side, structural underinvestment over the years is expected to persist as producers maintain capital discipline (especially as we head into a global recession), thereby supporting commodity prices. The demand-side outlook is more mixed, but we see a likelihood of some positive surprises given our expectation that the incoming recession will not be too severe, while the ongoing China reopening could also serve as a near-term buffer for commodities demand. Therefore on balance, supply-demand dynamics lead us to believe these commodities prices will remain supported this year.

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Chart 3: Brazil’s main exports fall within the commodities space

Chart 4: Materials and Energy are two of the three largest sectors in the Bovespa Index

Chart 5: Bovespa earnings estimates have moved in tandem with commodity prices

Monetary policy could be a fresh tailwind for equities in 2023

The BCB started its rate-hike cycle much earlier compared to most central banks. This has already helped to quell inflation significantly from its peak (12.1%) to current levels (5.8% as of Dec 2022) (Chart 6). As inflation moderates, we believe the BCB could gradually turn less hawkish over the year. We see higher odds of potential rate cuts in the latter half of 2023, and the start of a rate-cut cycle can ultimately be supportive of investor sentiment, economic growth and equity markets.

We believe inflation has likely peaked and see little risk of re-accelerating, especially given the high-base effect in play. Nonetheless, we acknowledge that inflation will likely remain elevated above the 3.5% target, anchored by our positive view on commodities – the top two IPCA basket constituents are tied to food/energy prices (Chart 7). We think this should be encouraging enough for BCB to cut rates in 2023, though we expect the first rate cut only in 2H23, and the pace of rate cuts could be more gradual compared to previous cycles.

Two observations from the previous rate-cut cycle in 2016 support our belief. First, Brazil’s first rate cut in 2016 came 9 months after the inflation peak (Jan 2016) – this time, inflation has already peaked in Apr 2022 (Chart 6). Second, real policy rates are at historical highs (7.9% in Jan 2023 compared to the 7.5% peak in Mar 2017) (Chart 8), suggesting that the BCB may already be at its peak hawkishness. Both observations suggest that BCB rate cuts are likely on the cards for 2023.

Chart 6: Inflation in Brazil has come down significantly from its peak

Chart 7: Brazil's IPCA inflation basket is heavily influenced by food and energy prices

Chart 8: Real policy rates in Brazil have exceeded recent peaks

Earnings estimates to remain conservative in light of the incoming recession

We expect earnings to decline by about -24% this year (Chart 9). Consensus EPS estimates are suggesting a similar but smaller decline of about -11%, though we expect these estimates to catch up as the recession becomes increasingly apparent. Nonetheless, we remind investors to keep this number in perspective, and explain below why it does not necessarily represent a very bearish view of Brazilian earnings.

1. Organic earnings declines from recessionary headwinds are not uncommon, especially for cyclical markets like Brazil. Brazilian equity earnings declined -48% in 2008 (GFC) and even turned negative in 2015 (when commodity prices crashed). In comparison, our forecast of -24% is significantly less pessimistic given our view of a mild recession and supportive commodities outlook.
2. High-base effects arising from the sharp earnings growth (+242%) in 2021 meant that some moderation in earnings is to be expected. Earnings would still be almost 3 times of end-2020 levels even if we assume this -24% earnings decline in FY23.

Following that, we expect earnings to rebound by +6% YoY in FY24. At the moment, we remain conservative in our forecast when compared to previous historical rebounds as we remain cautious about China’s reopening trajectory as well as the possibility of extended fiscal uncertainties in Brazil (see below).

Chart 9: We forecast a mild EPS contraction in FY23, followed by a small rebound in FY24

Key risk: Political and fiscal uncertainties

A major key risk for Brazilian equities is the political and fiscal repercussions over the recent election of President Lula, in what was also the closest-fought election in Brazil’s history.

One concern for investors is political instability following the recent riot and storming of Congress. However, politically-motivated protests and riots are not entirely uncommon in Brazil - what is worth watching in our view is the potential for economic spillovers from such protests. One instance was the 2018 trucker riot which saw truck drivers blocking traffic across Brazil, crippling the nation’s agricultural sector and driving food prices higher. The riot was estimated (by USDA) to have caused USD1.75b in losses for the agricultural sector. Unlike that 2018 riot, the recent storming of Congress has had little implications on the real economy thus far. We advise investors to avoid any knee-jerk selling as this situation is still ongoing.

Brazil’s fiscal sustainability is another major concern for investors, especially with debt levels near record highs (using net-debt-to-GDP) and the government budget in the red despite the recent commodities boom (Chart 10). This has been fuelled by Lula pledging to increase fiscal spending during his election campaign. However, we think the party may be forced to adopt a more centrist position this time (compared to Lula’s previous Presidential stint) given that they only barely won the election by a razor-thin margin, and even lost ground to Bolsonaro's allies in Congressional elections. Newly-appointed Finance Minister Haddad has also committed to proposing a new fiscal anchor by Apr 2023. Therefore, while we remain mindful of long-term fiscal considerations, we do not see a sudden and steep deterioration of Brazil’s finances - this is also similar to what markets are pricing in (Chart 11).

To summarise, we prefer a “wait-and-see” approach regarding Brazil’s political and fiscal uncertainties. Markets themselves appear not to be viewing these issues too negatively with volatility in Brazilian equities and the Brazilian real already normalising (Chart 12). In other words, we will certainly be watchful of the political and fiscal uncertainties following Lula’s election, but also avoid being overly optimistic or pessimistic unless we get substantial developments in either direction.

Chart 10: Brazil’s budget remains in the negative, while net debt is at record levels

Chart 11: CDS spreads indicate that markets do not see an immediate deterioration of Brazil’s finances

Chart 12: Volatility in Brazilian equities and the Brazilian real has already subsided after climbing in the post-election period

Valuations remain extremely cheap despite strong 2022 performance

With the aforementioned risks in mind, we have decided to lower our target fair P/E ratio for Brazilian equities from 12.5X to 11.5X. That said, Brazilian equities continue to look very attractively valued, trading at a forward P/E ratio of about 8.2X, a massive 38% discount from its 15-year historical average. As a comparison, such levels were breached only in late 2008 at the peak of the GFC where, in contrast, we are currently expecting a milder recession (Chart 13). On a relative basis, Brazilian equities are also very attractively valued relative to EM and LatAm peers including Mexico, all of which show that Brazilian forward P/E ratios are trading at historically large discounts to that of peers (Chart 14).

Put another way, valuations for Brazilian equities are so cheap that it would require a drastic earnings collapse just for them to return to our fair P/E of 11.5X. We constructed three scenarios (Table 1) that differ based on the severity of the incoming global recession with different earnings forecasts for each scenario. Even in our bear case for earnings (with an EPS decline of -40%), we find that the upside remains positive.

Chart 13: Brazilian equity valuations are cheap relative to history

Chart 14: Brazilian equities are trading at larger-than-average discounts to peers

Table 1: Three simplified scenarios for Brazilian equities – Bear / Base / Bull cases for earnings outlook

Brazilian equities still among our top picks for 2023

To summarise, we believe Brazilian equities will continue to be buttressed by a supportive commodity outlook, alongside an additional tailwind of looser monetary policy in 2023. Our expectation of a mild recession also means that earnings are unlikely to take a major hit in FY23 and FY24. Nonetheless, we acknowledge lingering political and fiscal uncertainties, which have led us to downgrade our fair P/E to 11.5X.

Using a fair P/E ratio of 11.5X, we project a target price of around BRL 170,000 for the Bovespa Index by FY24, giving a potential upside of +49% topped by an annual dividend yield of around 6% - 7% (Chart 15, Table 2). As such, we maintain our Star Rating of 3.5 Stars “Attractive” for Brazilian equities, and investors should consider our recommended iShares MSCI Brazil ETF (NYSE:EWZ), which is one of the largest and most liquid Brazilian equity ETFs, for a passive approach to medium and large-cap Brazilian equities (Table 3).

Chart 15: Bovespa Index Price and TTM EPS

Table 2: Brazilian Equity Market Projections 2023 – 2024

Table 3: Key details of EWZ ETF

Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a NIL position in the abovementioned securities.