Interview with Frederico Tralli, BNP Asset Management

September 3, 2017

How does the corruption scandal surrounding Brazil’s president, Michel Temer, impact his reform agenda?

Frederico Tralli: It is the main topic in Brazil right now. It is also an important issue for our fund because we are slightly overweight in Brazil at the moment from our previous neutral position. The reason that we’re overweight at the moment is that the various crises created some attractive stock picking opportunities.

The current crisis looks like it could impede the social security reform, which is an important measure for Brazil to address its fiscal imbalance. In political terms Temer is running out of time as by October most congressmen will be focusing on next year’s elections. Because this is a constitutional amendment it needs to be passed by three-fifths of congress so it will be really challenging to get it done in the window remaining. Especially as during that time President Temer will be focusing on his own political survival.

In a sense it has already had an impact. The market now believes that it is less likely that this reform will be passed, which has a knock-on effect on monetary policy and the economic cycle. Indeed consensus estimates for 2017 GDP growth have been downgraded to 0% from 0.7%, while the 2018 estimate is 1.8% down from 2.5%.  However, it is not all bad news. There are smaller reforms that will be easier to get through congress and they will still happen. Indeed some already have. For example the labour reform was concluded last week and that was vital because it will reduce employment costs for Brazilian companies and create more flexibility in the labour market. There have also been lots of improvements in the business environment. The regulation of various sectors has improved and red tape has been cut, which will improve the ease of doing business in Brazil.

Why are you positive on Brazil and how are you playing it?

FT: Inflation is under control and continues to fall, which will boost economic growth. Indeed we think that growth next year could be 2% because the falling inflation will allow interest rates to be cut to 9% from the present level of 10.25%. That’s a huge interest rate cut that will leverage growth across the economy. Everyone stands to benefit because Brazil’s consumers are leveraged, the companies have high indebtedness and the government is also trying to cut the fiscal deficit – so lower rates are good for everyone. The impact of lower rates on Brazilian household consumption would create 1.5% of GDP growth because the consumer market is such an important part of the Brazilian economy. Also the Brazilian market is cheap at the moment on a price to earnings basis. As the economy improves and credit picks up earnings will grow further and eventually valuations will have to match.

We are overweight in utilities. Not because they are defensive, although that is an additional bonus, but because they looked well placed to benefit from several factors. Improving regulation is good for the utility sector, while the more solid players have been able to pick up bargains as construction companies linked to the ‘carwash’ corruption have divested great assets at good prices. You also have the state selling assets for fiscal reasons. The ongoing privatisation process means there will be a steady stream of attractive assets for the utility companies to buy. There is also a lot of demand among international investors for Brazilian utilities as they provide higher returns in a setting of low interest rates globally.

There is also a lot of demand among international investors for Brazilian utilities…

The financial sector is cyclical so it depends on the economy and as we’ve seen, the recovery is going to be gradual. However, the market marked down banks in Brazil because of an assumption they would suffer from high delinquency in consumer credit, defaults on the corporate side and exposure to the recession in general. Actually the banks have managed the situation better than expected. Really banking in Brazil is an oligopoly with four banks controlling 75% of the market, so they have been able to ride out the situation. They increased bad debt provisions in their balance sheets, achieved a return on equity of 20%, have shown good asset management and achieved solid returns in a consolidated industry. They’re now not as cheap as they were, but we still see some upside.

We also like think that Brazilian real estate looks attractive. We like the smaller names that don’t have leveraged balance sheets. The sector suffered a lot in the downturn but now it has good long-term opportunities. As investors we look for companies with pricing power in their markets. Some of the bigger Brazilian consumer brands have done that very well and managed to protect their margins during the recession by cutting costs. So now that we’re coming out of the recession they will probably do even better. However, it is also a popular theme with global investors and valuations are not very attractive.

Mexico’s energy reform is a huge investment story; how are you playing it?

FT: There is a lot of excitement around the energy reform in Mexico. It clearly has huge implications because oil is a pillar of the Mexican economy. Pemex has had difficulties with falling reserves, lower production and fiscal constraints that hampered its ability to invest and boost productivity. That has an impact on the government because oil is a very important source of revenue. It’s estimated that by 2018 the decline in Mexico’s oil production will be reversed, which will give a boost to the whole economy.

The first oil and gas auction in 2015 was considered a failure because just 20% of the blocks were awarded. However, as the reform progressed we saw results improve. In early July a consortium led by Talos Energy announced a huge shallow water discovery so it’s clear that the energy reform is getting results. Of course it all depends on the price. If oil is at $30 dollars for a long time then the reform is not going to go well. If it goes up to $60 then lots of companies are going to benefit.

In terms of playing the reform there are no listed direct pure plays in Mexican E&P. A broader Mexican energy stock is Ienova, which we hold. It develops and constructs gas infrastructure, such as storage facilities, and electricity generation plants, so it benefits from different elements of the reform. For example, it recently won a contract to build a refined gasoline import terminal in Veracruz, which is only possible because of the reform.

Which Latin American economies do you like outside of Brazil and Mexico?

FT: It’s a difficult question. Currently we have no clear country allocation but rely on our stock picking to select opportunities. Although we are underweight Colombia because of the macroeconomic challenges that country is facing. There is also a lack of investment options and valuations are high. Peru on the other hand looks very attractive. It has sound macroeconomic fundamentals, higher potential GDP growth, a favourable demographic which should expand the middle class and a big programme to build infrastructure. Peru has the ability to combine monetary and fiscal easing, which isn’t something you can say about many Latin American economies at the moment. The economy has suffered from some temporary shocks, such as the fallout from a corruption scandal and recent floods, but may recover in the second half of 2017. In particular we think the banking sector despite its current rich valuation.

Latin America has returned to economic growth; is it the start of a new cycle?

FT: Latin America is very appealing for long-term investors. It has growth potential that could be leveraged as most economies in the region have room to lower interest rates. Commodity prices are looking more balanced now, which helps Latin America. Indeed macroeconomic situations have improved across the board, with many countries in the region now benefiting from lower current account deficits. Global conditions are clearly helping, with Europe’s return to growth providing a more diverse base of demand for Latin America’s exports. The region’s policymakers need to take advantage of the current benign situation to fix remaining imbalances.

We saw a huge consumer boom from 2005 to 2010 that stalled recently…

One challenge is that valuations in the region’s stockmarkets are quite high. Brazil is still fair but not that cheap and Peru has some room to move upwards but Chile, Colombia and Mexico are at premiums. However, inward foreign flows could help boost valuations even more. So far this year we’ve seen $73billion going to emerging markets so there is clearly a lot of appetite.

The consumer sector, which is very fragmented, could be attractive. We saw a huge consumer boom from 2005 to 2010 that stalled recently. However, that could start again next year. Countries like Mexico, Colombia and Peru still have young and growing populations – indeed the region’s demographic bonus is set to continue to 2025. The finance sector also looks attractive, partly for structural reasons as more Latin Americans begin to use financial products, but also because the penetration of related services, such as insurance, is still very low at just 3.5% of GDP. Finally infrastructure is an attractive investment theme across the region. Brazil, Peru, Colombia and Mexico all have significant and much-needed programmes in place to boost their infrastructure, which should create good long-term returns for investors