BRAZIL’S PRESIDENTIAL SHIFT: INVESTMENT OPPORTUNITIES AND RISKS IN LULA DA SILVA’S ECONOMIC LANDSCAPE INFLATION RATES, TRENDS, AND INVESTMENT IMPACT Inflation in Brazil has seen fluctuations recently, with internal and external factors like drought and wildfires driving food and energy prices higher. Due to rising inflation, the central bank has taken a proactive approach, tightening its monetary policy by hiking interest rates. Rising inflation increases fear and uncertainty among investors, mainly because it erodes real returns and purchase power. For those reasons investors might lean towards inflation-protected bonds. SELIC RATE AND IMPLICATIONS FOR BONDS AND STOCKS Reversing prior reductions in interest rate Brazil’s central bank raised it by 25 b.p. in September 2024 and set a path of potential new hikes until 2025. The Selic is forecast to reach 11.50% early next year. This signals a cautious stance by policymakers, aiming to tame inflation while balancing economic growth. For bond investors, higher Selic rates generally mean lower bond prices, but they also offer higher yields, making fixed-income investments attractive. For stock markets, rising interest rates can suppress equity valuations by increasing the cost of capital and weighing on corporate profits. As interest rates rise, investors often shift from riskier equities to safer bonds, which could slow stock market activity. POLITICAL, FISCAL, AND EXTERNAL FACTORS Politically, Brazil's fiscal policies have become a major concern under President Luiz Inácio Lula da Silva. His administration has proposed weakening budget surplus targets, sparking fears of fiscal slippage. A reduction in fiscal discipline could lead to higher public borrowing, which already stands at 75.5% of GDP. This, in turn, raises concerns about long-term inflation and interest rates, potentially undermining investor confidence in Brazilian assets. External factors, such as climate related events and global energy prices, are also driving inflation, limiting the government's ability to control domestic price levels. While growth forecasts have improved, with GDP growth expected to hit 3.2% in 2024, inflation and fiscal uncertainty remain significant risks. This mix of fiscal expansion, inflationary pressures, and interest rate hikes creates a challenging environment for investors, particularly in the stock market. BOND MARKET Brazilian bond market is largely driven by sovereign bonds, which are issued by the government to finance public debt. Compared to corporate bonds, these government bonds are considered relatively safe, as they are backed by the Brazilian government. The market is characterized by three main types of bonds. Fixed-rate bonds (Tesouro Prefixado) offer a pre-set interest rate that has been known from the outset. While these bonds offer predictability, their returns can be eroded by rising inflation, reducing the purchasing power of the interest earned. Floating-rate bonds (Tesouro Selic) are tied to the Selic rate. As it fluctuates, so do the returns on these bonds, making them ideal in a rising interest rate environment. Investors benefit from these bonds when interest rates are expected to increase, as the returns adjust upwards with the rate. 1 Lastly, IPCA+ bonds (Tesouro IPCA+) are inflation-linked bonds tied to the IPCA, Brazil's Consumer Price Index. These bonds provide a fixed interest rate along with an inflation adjustment. This structure ensures protection against inflation, preserving the real value of the investment. These fiscal challenges are having a direct impact on Brazil’s bond market. Investors are increasingly demanding higher yields to compensate for the perceived risk. STOCK MARKET These macroeconomic characteristics have consequences on the Brazilian stock market especially regarding the Ibovespa. The index is the flagship Brazilian index composed by the biggest market capitalizations such as Vale, Itaú and Petrobras. We can observe that the Ibovespa is made up of 3 main sectors that correspond to more than 60 % of the index: financial services, basic materials and oil/gas. Regarding the performance of the Ibovespa, the index reached its highest level (137,344.00) in August 2024, but keep in mind that the nominal return can be biased by inflation. For this reason, to get a more accurate picture of the Ibovespa evolution, we must deflate using the main Brazilian inflation index (IPCA). Economatica study: “Ibovespa, heading towards an all-time high. Will it?” 12/18/2023 Over the past 15 years, the Brazilian stock market has exhibited a negative risk premium (ex-post), indicating that stock returns have not adequately compensated investors for the additional risk compared to safer investments like bonds. For regular investors, this creates an unfavorable scenario, as it subjects them to high volatility without the expectation of higher returns. Indeed, as a reminder, the equity risk premium compares the expected returns of the stocks to those of the free-risk assets such as treasury bonds. This poor risk-reward ratio makes the Brazilian stock market a risky choice, especially for those who cannot absorb significant losses or tolerate prolonged downturns. Even if several elements could be the origin of this phenomenon, we can mention that the investor’s expected return is low and/or the observed excess returns were less than expected. Also, Brazil has good inflation-related and risk-free bonds that can perform better during high inflation periods. 2 Chart from www.maisretorno.com Compared to others great indexes, Ibovespa is more exposed to volatility because of its exposure to emerging markets and political instability. The commodity prices fluctuations have also a big influence on the Brazilian stock market since some commodity companies are significant (Petrobras, Vale, etc.). Furthermore, Ibovespa is less diversified in terms of companies and sector than S&P500 for example. Unlike the main developed zones indexes, Ibovespa is more domestically oriented that reduces its exposure to global issues. INVESTMENT STRATEGY The strategy described in the following section was developed to cater to what we will refer as a regular investor, defined as anyone meeting the following criteria: • • • • 1. Not a company. 2. Total net worth of up to 50,000 euros. 3. Doesn’t have easy access to leverage. 4. Doesn’t have easy access to structured operations (options and futures market). The cash investment strategy involves a regular investor allocating up to 30% of their total net worth to purchase Brazilian sovereign bonds indexed to inflation (IPCA+), known as NTN-Bs, maturing in August 2026. This approach allows the investor to secure a guaranteed gross real return of approximately 6.55% p.a. over a period of approximately two years. The roughly two-year period is strategic, as it ensures one of the lowest tax rates on returns under the progressive tax table (17.5%), while also providing the investor the opportunity to reinvest at potentially higher rates. This expectation is driven by the forecasted growth in public spending by the current government, which is likely to increase both inflation and bond yields. Additionally, the relatively short duration reduces exposure to default risk. However, this strategy does carry some risks that must be considered: 1. Liquidity Risk: There is likely to be a steady increase in the rates offered by NTN-Bs, which would consequently decrease their unit price. As such, withdrawing funds before the bond's maturity date is generally not advisable. 2. Default Risk: Brazil is an emerging market with a history of public debt defaults. Currently, this risk is relatively low, given the presence of a strong and independent central bank. 3 3. Reinvestment Risk: Although unlikely given the political-economic context, there is always the risk that upon maturity, there may not be an equally favorable bond available for reinvestment. Fig. 02: IPCA+6% x IBOV 5y (IPEA). Table. 02: IPCA+6% x IBOV 5y (IPEA). Considering these factors, we believe that the above-mentioned strategy is an excellent way for regular European investors to diversify their assets into emerging markets, achieving real returns higher than domestic investments in fixed income, with a risk level ranging from low to moderate. REFERENCES B3. (n.d.). Ibovespa composition index portfolio. Retrieved from https://www.b3.com.br/en_us/market-data-and-indices/indices/broadindices/indice-ibovespa-ibovespa-composition-index-portfolio.htm Economatica. (2022, February 7). Ibovespa: Será que é um bom benchmark?. Insight Economatica. Retrieved from https://insight.economatica.com/ibovespa-sera-que-e-um-bom-benchmark/ MarketScreener. (n.d.). Brazil Ibovespa: Index performance & data. Retrieved from https://www.marketscreener.com/quote/index/BRAZIL-IBOVESPA7656/ Economatica. (2023, June 5). Ibovespa rumo à máxima histórica. Insight Economatica. Retrieved from https://insight.economatica.com/ibovesparumo-a-maxima-historica/ Mais Retorno. (n.d.). Comparador de ativos. Retrieved from https://maisretorno.com/app/comparador-ativos?p=1230768000000++1726876800000&a=BOVA11%3Ab3%2Ccdi%3Aidx&onboarding_step= Tesouro Direto. (n.d.). Tipos de títulos do Tesouro Direto. Retrieved from https://www.tesourodireto.com.br/titulos/tipos-de-tesouro.htm Wheatley, J. (2023, September 15). Brazil’s treasury bonds: How they’ve become a safe haven for investors. Financial Times. Retrieved from https://www.ft.com/content/2538f75c-535e-44a8-8c81-3c8feef08473 Harris, B. (2023, September 15). Brazil: Economic outlook for 2024. Financial Times. Retrieved from https://www.ft.com/content/14e6a4d4-8be7-46cfbb51-8445b0e85dc1 Reuters. (2023, September 13). Brazil sees GDP accelerating in 2024 to 3.2% growth. Reuters. Retrieved from https://www.reuters.com/world/americas/brazil-sees-gdp-accelerating-2024-32-growth-2024-09-13/ Reuters. (2023, September 13). Brazil central bank may hike rates by 25 basis points in September. Reuters. Retrieved from https://www.reuters.com/markets/rates-bonds/brazil-central-bank-hike-rates-by-25-basis-points-sept-18-2024-09-13/ Reuters. (2023, September 11). Brazil economy to grow at least 3% this year, finance minister says. Reuters. Retrieved from https://www.reuters.com/world/americas/brazil-economy-grow-least-3-this-year-finance-minister-says-2024-09-11/ Reuters. (2023, September 9). Brazil economists see rate hike amid stronger growth, ending 11-week stability. Reuters. Retrieved from https://www.reuters.com/markets/rates-bonds/brazil-economists-see-rate-hike-amid-stronger-growth-ending-11-week-stability-2024-09-09/ 4
