Rarely is an economic contraction a cause for celebration, but some market observers were undeniably jubilant earlier this year when real gross domestic product growth figures showed that Brazil’s economy shrunk far less in the first three months of the year than many economists had expected — 0.3 percent quarter over quarter, compared to consensus forecasts of 0.8 percent.
This news prompted the International Monetary Fund to declare that the recession, which began early last year, was likely to be less severe than originally thought, and that Latin America’s largest economy might return to positive growth as soon as next year.
Carlos Constantini, director of research at Itaú BBA in São Paulo, agrees. “We currently forecast a 3.5 percent contraction this year, with growth of 1 percent in 2017,” he says. “We have noticed a significant rebound in business and consumer confidence indexes already taking place.”
Analysts at BTG Pactual are even more upbeat. “We believe the combination of lower interest rates, higher levels of business and consumer confidence, record low industry capacity utilization and a horde of more than 11 million unemployed people creates the conditions for an economic recovery that may surprise to the upside,” says Carlos Eduardo Sequeira, Rio de Janeiro-based head of equity research. “We wouldn’t be surprised to see Brazil’s GDP growing more than 1 percent in 2017.”
Investors have been waiting a long time to hear those words, and they are eager to know how best to position their portfolios for the turnaround. No firm has provided more helpful guidance, they say, than Itaú, which rises one rung to claim the top spot on the All-Brazil Research Team, Institutional Investor’s exclusive annual ranking of the nation’s leading sell-side analysts, for the first time since 2011. It captures 18 positions, one more than in 2015.
BTG Pactual, which had led the team for the past four years, slips to second place after losing one position, leaving it with 17. Credit Suisse spends a fifth straight year at No. 3 even though its total falls from 15 to 12. Bank of America Merrill Lynch, with 11 spots — one fewer than in 2015 — nonetheless extends its tenure in fourth place to a fourth year. Two firms share the fifth tier, with nine positions each: J.P. Morgan, whose rank is unchanged from last year despite the loss of one spot, and Santander, which advances one level after picking up three positions. Thirteen firms are represented on this year’s team, including two that did not appear in 2015: Citi and UBS.
The Leaders link in the navigation table at right provides access to the full list, while the Best Analysts of the Year identifies the winners in each of the survey’s 19 sectors. (Please note: Information about researchers in second and third places, plus runners-up, is available to subscribers only.)
Optimism about Brazil is apparent in its stock market’s performance. The benchmark Ibovespa index surged more than 32 percent year to date through July, to 57,308, and has been one of the world’s best performers in 2016.
“We believe Brazilian equities have done a major catch-up, and current valuations are already demanding in certain sectors — particularly for those focusing on the short term,” Constantini observes.
Nonetheless, the rally may continue, he adds, because of three factors. One, earnings are relatively compressed following years of disappointing GDP growth, which leaves room for operating leverage and recovery in coming years. “Since Brazil is a highly cyclical market, some investors perceive the right time to buy is when earnings are low and valuations are high,” Constantini notes. “At this point, analysts have just started to revise earnings upward, but this trend may grow in the next 12 months if our macro scenario is right, and stock markets usually pay up-front for that.”
Two, given global market conditions, with excess liquidity and a search for yield, emerging markets will most likely continue to attract investments to both equities and fixed income, and Brazil is a very attractive destination, he adds.
Finally, the government of acting President Michel Temer — who took over in May following Dilma Rousseff’s suspension as she awaits the conclusion of an impeachment trial — has been making the right decisions in terms of macro policies, such as a cap on fiscal spending, which helps rebuilding investors’ confidence.
Maurício Fernandes, head of Latin America equity research at Bank of America Merrill Lynch in São Paulo, also projects a sustained turnaround. “We forecast the Ibovespa to close the year at 62,000,” says Fernandes, who also ranks third in Technology, Media & Telecommunications. “Valuations remain attractive at an estimated 12 times 2017 price-to-earnings and, more importantly, we could see a significant margin recovery in the coming years, sustaining double-digit earnings growth.”
But Morgan Stanley’s Guilherme Paiva, who celebrates his sixth straight year at No. 1 in Equity Strategy, is skeptical. “Yes, the fundamental story is very interesting, but when we look at what equities have already priced in, the getting will get tougher,” the New York–based strategist says. “Our current model portfolio is geared toward domestic cyclical stocks leveraged to two themes, acceleration in domestic growth and a reduction in interest rates. Therefore, we like selected companies in the shopping malls, financials, transportation and electric utility sectors.”
That view is echoed by BTG Pactual’s Sequeira, who earns a runner-up spot in Technology, Media & Telecommunications. “We recommend being exposed to sectors that are positioned to capture a potential reduction in interest rates and prospects of improved economic activity,” he says. “These would include shopping mall operators, real estate developers, banks, retailers and car rental companies.”
Analysts at BofA Merrill expect three themes — financials, interest rate sensitivity and operational leverage — to boost outperformance in key sectors, Fernandes says. “Brazilian banks remain attractive, in our view, trading at 1.4 times price-to-book value, which is 25 percent below historical averages,” he maintains. “We expect the central bank to start cutting rates at the end of this year, easing pressures on corporate balance sheets. Also, real rates in Brazil remain above 6 percent, and any compression would be positive for bond proxies, such as concessions and malls.”
The bottoming of the economy should also be positive for companies with significant operational leverage, Fernandes adds, such as capital goods producers, hardline retailers and steelmakers.
“We moved Brazilian equities to overweight in March, and we expect the country to continue to outperform Latin America and global emerging markets,” declares Pedro Martins Jr., who oversees Latin American equity research at J.P. Morgan in São Paulo. “We are starting to see positive revisions to earnings expectations across the region, and we see the following driving forces sustaining double-digit earnings growth for Brazil in 2016 and 2017: operating leverage, stronger net financial results and higher commodities prices compared to last year.”
The new regime is playing a positive role, he adds. “President Temer has not disappointed in his willingness and ability to deliver on a market-friendly agenda,” Martins contends. “The gradual advance of the Temer government should encourage investors to look toward medium-term valuation metrics such as price-to-book value. This metric could be interpreted as the ‘installed capacity’ for normalized earnings in the next few years.”
Against this backdrop, J.P. Morgan is urging investors to overweight basic materials stocks, owing to stabilizing commodities prices and stronger domestic activity; energy names, on the positive outlook for sugar and ethanol and rising oil estimates; and financial services firms, thanks to attractive valuations and an inverse correlation to future interest rates, he explains.
Consumer staples are best avoided, Martins adds, as unemployment is unlikely to peak until the fourth quarter of this year or the first quarter of 2017, and valuations are demanding.
The 2016 All-Brazil Research Team reflects the opinions of 714 buy-side analysts and portfolio managers at 375 institutions that oversee an estimated $252 billion in Brazilian equities and $136 billion in Brazilian debt.
