Brazil's high powered economy

Key Points:
External headwinds most culpable in 2011 for poor equity returns, 2012 (thus far) has seen returns of 18.8%
Positive policy support should see the Brazilian economy stage a strong comeback in 2012
Growing consumer strength poised to benefit 2 key sectors - Consumer Sectors, Financials Sector
Demographic and Structural changes present investors with opportunities to benefit from Brazil's continuing transformation
Brazil currently offers potential upside of 27%, maintain 4.5 Star "Very Attractive" rating
After a horrid year in 2011 where it lost -24.7% as a combination of rate hikes to combat inflation and a weak global economic outlook took hold, the Brazilian stock market has come roaring back in 2012 with returns of 18.4%.

EXTERNAL HEADWINDS MOST CULPABLE IN 2011
Ever since the re-ignition of the European debt crisis in the middle of 2011, Brazil’s economy has faced significant headwinds.
The uncertainty took its toll on the local economy with economic activity deteriorating as both capacity utilisation and industrial production began to fall, leaving 3Q 2011 GDP coming in slightly negative at - 0.1% on a quarter-on-quarter basis.
Internally, Brazil had been fighting its nemesis that is inflation in 1H 2011, hiking its key Selic interest rate to 12.50% as it sought to cool an overheating economy which also suffered from rising commodity prices. In addition, lending curbs were introduced in an effort to reduce credit available and reduce Brazil’s demand-pull inflation.
As for the Bovespa, the materials, industrials and utilities sectors were amongst the hardest hit as a result of the above while the Financials benefitted from the initial rate hikes before succumbing to pressure emanating from troubled Europe as well as rate cuts in 2H 2011.

With the closure of 2011, 2012 has spelt much better news for the Latin American nation.

Currently, the Brazilian government has undertaken several measures ranging from the slashing of its key Selic rate to cutting taxes on various goods in an attempt to boost growth since 2H 2011. With the government prioritising growth over inflation control, we take a closer look at 2 key sectors which are poised to deliver.

CONSUMER SECTOR - FROM STRENGTH TO STRENGTH
Brazil’s domestic consumption story, based on demographic and positive structural changes is something that’s not new to investors. However, what investors might not know is that the story has continued gaining in strength. Retail sales in Brazil have been climbing higher and higher, growing by close to 7% for the second consecutive month on a year-on-year basis in November and December, on the back of rising real wages and historically low unemployment (thanks to job creation), with retail sales growing by 7% for the second consecutive month on a year-on-year basis as seen in Charts 1 and 2 below.

CHART 1: RISING RETAIL SALES & REAL INCOME















CHART 2: MORE JOBS, LESS UNEMPLOYMENT


The strengthening of incomes and the creation of more jobs has also seen family expenditure become more resilient as compared to the past.
During the financial crisis of 2008-2009, although family expenditure did not contract, this key component of Brazil’s’ economy saw its growth rate fall significantly from 7.7% to 2.7% on a year-on-year basis from September 2008 to December 2008 in spite of the seasonal effect normally seen in December (holiday sales).
In the most recent episode of the European debt crisis, family consumption held up significantly better and demonstrated its new-found resiliency with a less painful fall from a 5.6% growth rate in June 2011 to a 2.8% rate in September 2011 (Chart 3).

CHART 3: CONSUMPTION'S INCREASING RESILIENCE


Taking a closer look at the retail space, the decision by the government to cut taxes for household goods has seen the purchases of furniture and appliances continue to hold its pace of growth steady with data showing a healthy year-on-year gain of 15.3% in December 2011. Supermarket retail sales have like-wise kept up its pace of growth, registering a growth rate of 4.6% in the same period. However, retail sales for apparel & footwear have slowed as a result of a minor slip in consumer confidence as the weak external environment saw consumers reduce their discretionary spending.

Given the increased stature of the Brazilian consumer, both the Consumer Discretionary and Consumer Staples are expected to benefit from the resilience of Brazil’s consumption story and its growing strength.

FINANCIAL SECTOR - LONG TERM BENEFICIARY
The financial sector in Brazil has long been on the up and up. Credit loan growth in the country has been growing steadily over the course of the decade as a conflux of factors allowed such phenomenal growth.

The very same demographic and structural changes in Brazil that has seen the consumer sector do well have also positively impacted the Financials sector.
With increasing affluence, credit cards and loans to service mortgages (which in part is also due to urbanisation, a structural change), the Brazilian financials have a benefitted from the consumer boom.
Consumer credit has almost doubled over the past since December 2007, while default rates still remain in an acceptable range of 7-7.5%, a far cry from the 8.5% seen during the peak of the financial crisis in 1H 2009 (Chart 4).

CHART 4: CONSUMER CREDIT BOOM


Looking at the larger picture of total private sector loans outstanding, currently, the total amount of these loans only reach approximately USD 1.2 trillion, with a booming economy in the backdrop and as the Middle Class in Brazil grows, incomes increase and urbanisation takes place rapidly, the financials are a sector which is poised for further rapid expansion.

The decision by the Brazilian central bank to cut interest rates is a double-edged sword for financials as although it will cut the rate with which they lend at, the rate at which they borrow to fund their operations will be reduced as well. Historically, the average banking spread for Brazil has averaged 27% with the latest figure as of end December 2011 registering a reading of 26.9%, almost spot on with the long-term average (Chart 5).

CHART 5: AVERAGE BANKING SPREAD


While margins are important for banks, we believe that an increase in the growth of demand for credit in Brazil as a result of lower borrowing rates will more than sufficiently make up for any shortfall in profits as a result of a potential narrower lending spread.

CONCLUSION

Any country moving from an “Emerging Market” status to “Developed Market” status provides investors with several opportunities to capitalise on demographic and other structural changes; in Brazil’s case, the ever-growing consumer spending power and the need for financial services will see the Consumer Staples, Discretionary and the Financial Services sectors prosper.

At current levels, the Bovespa is trading at a price-to-earnings ratio of 9.0X based on 2013’s earnings, representing a potential upside of 27% (as of 7 March 2012) by then when compared to its fair value of 11.5X. We have a 4.5 Star “Very Attractive” rating on Brazil, and a 5 Star rating on the larger Global Emerging Markets.