My travels took my KKR colleague Jaime Villa and myself from New York to Brazil, where we participated in a number of meetings, including discussions with business leaders, macroeconomic analysts and government watchers. As colleagues at our São Paulo office can attest, there is a lot going on in Brazil right now on the macro front.
• We believe Brazil’s economy is caught in somewhat of a perfect storm, including pressures from the Petrobras corruption scandal, an epic drought (70 percent of energy in Brazil is hydroelectric) and a major fiscal adjustment since Joaquim Levy, the country’s new finance minister, took office at the start of the year.
• We have lowered our 2015 GDP growth forecast to –1.5 percent, versus our prior estimate of –0.75 percent and a consensus projection of –0.65 percent. Credit conditions are tightening amid higher rates, and confidence, among both businesses and individual consumers, remains under pressure.
• Consistent with this choppy macro outlook, we estimate that the country’s total risk premium has dramatically increased, to 10.4 percent from 6.5 percent in 2012. As such, Brazil now joins countries such as Nigeria and Russia at the high end of the perceived risk premium — and it is nearing Argentina.
• We feel compelled to raise our inflation forecast for 2015 to 7.3 percent, compared with our previous estimate of 6.5 percent and versus a consensus of 7.6 percent. We thought previously that the adjustment in regulated prices and subsidies would be gradual and that Brazil would not allow inflation to break the 6.5 percent upper band of the inflation target for a sustained period. We no longer think this is the case.
• Despite significant nominal depreciation, Brazil’s real effective exchange rate still needs to come down if the economy is going to rebalance toward exports and investment, versus the prior cycle of government-induced consumption.
• The last time we saw macro sentiment this bad in an emerging-markets economy was in India before the prime minister and the head central banker were replaced. We do not see President Dilma Rousseff being impeached, but we do think that Levy could emerge as the most influential figure in Brazil’s potential economic recovery story.
• We believe an upside case for 2016 and beyond can emerge under three conditions. First, Rousseff continues to support Levy and allows him to enact fiscal austerity without intervention. Second, as a result of tighter monetary and fiscal policy, inflation slips back toward more manageable levels. Third, CEOs get their confidence back and spend, particularly on much-needed investment.
Against the current macro backdrop, one has to be selective on the investment front, including on the private equity side. We left São Paulo thinking there are interesting opportunities for investors to consider. For example, after the most recent central bank increase of its overnight rate to 12.75 percent in early March, short-dated bonds offering real yields of 5.5 percent now appear quite attractive, compared with investment opportunities elsewhere in the world.
In addition, we also heard a lot about distressed sales of subsidiaries and receivables from companies either being swept up in the events surrounding the Petrobras investigation or overleveraged to spending that has not occurred. On the other hand, certain services companies could face additional tax hikes, whereas many companies that benefited from excessive credit and government outlays to middle-class consumers are likely to face stiff headwinds from tighter credit and a deteriorating labor market.
Finally, we believe that companies that can drive growth through expense control, consolidation and export sales should be rerated upward. Some 30 percent of the companies listed on the BM&F Bovespa actually appreciated by 20 percent or more in 2014.
Overall, from an asset allocation perspective, Brazil reflects the emerging-markets carnage we now see more broadly following the plateauing of China’s growth binge. The key for Brazil will be to refocus toward investment and savings and away from leveraged consumption. This transition will not be easy, but considering how risk premiums are up and valuations are down, now is probably not a bad time to be sniffing around, particularly for investors who can invest higher up in the capital structure — and still get some equity upside.
Henry McVey is the head of global macro and asset allocation at KKR in New York.
Read more of McVey’s views on Brazil.
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