Managers see silver lining in Brazil's woes

Brazil's troubles over corruption, political instability and volatile markets are creating something of a perfect storm for some money managers.

The country has been under pressure for a long time. The real dropped to a record low in September, falling to 4.1 per U.S. dollar. The MSCI Brazil index returned -41.13% in 2015, vs. -14.58% for the MSCI Emerging Markets index. But so far this year, returns look better: the Brazil index returned 15.42% to March 15, vs. -0.25% for the EMI.

On the debt side, the BofA Merrill Lynch Brazil Government index has gained 5.08% in the first two months of this year, compared with a 2.1% gain for the same period in 2015.

Political scandals have included a former president called in for questioning and the resignation of a party minister. All eyes now are on the future of President Dilma Rou-sseff's administration, sources said.

Adding to its woes, the country is in recession. The International Monetary Fund projects 2016 growth of -3.5%, after an estimated -3.8% growth in 2015. In 2014, Brazil grew 0.1%, according to the IMF.

But there are signs the tide might be turning for Brazil, both on economic and political grounds — and money managers are taking notice.

“Brazil has its headwinds to overcome, but a bunch of factors from market volatility to the government's inability to get very much done has lowered valuations to really attractive levels,” said Brett Diment, head of emerging market debt at Aberdeen Asset Management in London. “There's a lot of bad news already priced into Brazil.”

But improvements in Brazil's current account — with a decline of 43% in the deficit to $58.9 billion in 2015 compared with 2014, along with the fact that foreign direct investment now covers 127% of that deficit — plus “progress on corruption provides glimpses of light,” Mr. Diment said.

The economic outlook also is becoming more positive. “The economy is showing signs of bottoming out with inflation past the peak, the currency much-depreciated and growth also now contracting at a slower pace,” said Jan Dehn, London-based head of research at Ashmore Investment Management Ltd. And the case for local currency fixed income “is strong given very high yields and likelihood of rate cuts” in the second half of this year.

The more positive economic outlook was sparked by growth in industrial production, of 0.4% in January, when the markets had been expecting a decline of 0.4%, said investor research issued by Ashmore on March 7. The pace of decline of the country's gross domestic product was slower than expected at -1.4% for the three months ended Dec. 31. Expected GDP for that quarter was -1.6%.

A number of money managers said they have built up positions in Brazil on the debt side. “The yield curve, while still high, has shifted down substantially — investors see less risk in the bonds than they did a few months ago,” said Melissa Brown, senior director of applied research at Axioma Inc., New York.

Schroders PLC's Emerging Markets Debt Absolute Return fund, which has $3.2 billion in assets under management, “has accumulated this year a sizable exposure to this market with the view that political uncertainties have become discounted to a large degree, inflationary pressures are showing signs of abating and the required external adjustments are well advanced,” said Abdallah Guezour, head of emerging markets debt absolute return, in London. “Brazilian assets are starting to recover strongly as a result of these positive developments.”

Mr. Guezour said Brazil assets showed resilience “in the face of escalating negative news headlines” when, last summer, panic selling of assets took 10-year local government bond yields to levels in excess of 17%. “This impulsive move had the hallmarks of a spike top in yields, which was subsequently followed by a period of consolidation, during which this market has shown resilience.” He said this was “a clear indication that the very high yields on offer are now providing an important cushion against the domestic and exogenous shocks that Brazil is still facing.”

The fund's holding in local government debt (currency unhedged) is 9.5% of its net asset value. U.S. dollar government debt represents 1.6% of the NAV of the fund, and Petrobras U.S. dollar bonds are 1% of the value of the fund.

There are selective opportunities out there, “pockets of value” to be found, said Yerlan Syzdykov, London-based head of emerging markets bonds and high yield at Pioneer Investments. “We don't think the currency is the best place to be invested in the medium term,” but the money manager is long-Brazil, albeit in a “specific and defensive” way. “We are overweight in Brazil, and we added to our exposure recently on (the) hard currency side,” added Mr. Syzdykov.

Aberdeen Asset Management at the start of the year moved to overweight the real, “which together with being overweight the bonds has benefited our portfolios,” Aberdeen's Mr. Diment said. “There is no question Brazil still has some big challenges to overcome, but as long-term investors we're willing to stick with it as the country still offers a lot of potential.”

Aberdeen has been overweight Brazil interest rates — and had been neutral the currency — “for a while as we felt the bonds were oversold and the yield available adequately balanced out the significant downside risks, in terms of the country's global and fiscal outlook,” Mr. Diment said. Aberdeen has a 9.5% exposure to Brazil, vs. its JPM EMBI Global Diversified benchmark, at 4%.

Other managers have long had allocations to the market. Abbas Ameli-Renani, London-based global emerging markets strategist at Amundi Asset Management, said Brazil already is one of the firm's biggest overweights, “a position that has performed well (recently) with the increased likelihood of President Rousseff's impeachment and the prospect of judicial action against former President Lula (Luiz Inacio Lula da Silva). We continue to think Brazil hard currency assets are cheap relative to fundamental valuation metrics,” and high foreign-exchange reserves render a sovereign default “extremely unlikely.”

Having said that, Mr. Ameli-Renani added, a recent rally in Brazilian assets means Amundi is “slightly more cautious about valuations now.”

And for some, the developing political situation has meant leaving what was a profitable allocation.

Executives running Pictet Asset Management's £205 million ($292 million) multiasset portfolio recently sold a just less than 5% position in a Brazilian inflation-linked bond. It had taken the position at the end of October, once the Brazilian real had fallen about 40% vs. the U.S. dollar.

“Although we agreed with most that Brazil faces deep political uncertainty, the risk premia available in the bond market was extremely high on a deeply depressed Brazilian real valuation,” said Percival Stanion, London-based head of multiasset strategies at the firm.

“While our view was that the path for a solution was far from certain, better expectations for an upcoming solution were a strong enough catalyst for the risk premia to fall in both the bonds and the currency. This indeed has been the case as the movement to remove Dilma (Rousseff) has allowed expectations for change in Brazil to be reflected in the rebound of asset prices.”

Mr. Stanion said in the last week, executives' assessment of risk premia “suggests that now much further performance does indeed rely on the impeachment of Dilma, not merely the change in expectation. Dilma's decision to bring back Lula into her cabinet, puts the ex-president out of immediate fire of anything but supreme court prosecution, and at the same time adds an influential political figure firmly to her camp. The path to a solution is less clear, and the potential for expectations to deteriorate once again has risen.” n