How Reforms Can Bolster Emerging Markets: Brazil Edition

A slate of business-friendly reforms against an improving economic backdrop have helped Brazilian stocks surpass their Emerging Markets (EM) peers this year. With further beneficial measures on the docket and pervasive skepticism about their chances of passage, we think more positive surprise may await. In our view, Brazil’s experience underscores how economic reforms can lift stocks, particularly in the many EM countries where they are badly needed.

After emerging from a two-year recession in Q1 2017, Brazil seemingly struggled to find its mojo amid lingering political scandals and tepid GDP growth. 2019 has been kinder, though: GDP growth accelerated in Q2 and Q3 (0.5% and 0.6% q/q, respectively).^[i] While backward-looking, the data suggest Brazil’s economy may be on firmer economic footing.

The biggest surprise out of Brazil this year, however, has been the government’s economic reform progress. Right-wing legislator Jair Bolsonaro took office on January 1 promising major changes many considered long shots. Brazil’s Congress contains over 30 parties, and his (now-former) Social Liberal Party holds just 53 of 513 seats in the lower house and 2 of 81 seats in the upper.^[ii] Navigating a fractured legislature generally requires diplomacy. Bolsonaro’s reputation for bombast and often testy relationship with Congress had many pundits thinking diplomacy wouldn’t materialize.

But in October, lawmakers approved changes to Brazil’s bloated pension system. Prior governments had tried and failed to overhaul it for three decades, fearing blowback from beneficiaries reluctant to give up generous benefits. Meanwhile, the system’s fiscal burden mushroomed, eventually soaking up 45% of the federal budget while remaining substantially underfunded.^[iii] While the reform won’t fix Brazil’s finances overnight, it should stanch the bleeding. By raising the retirement age and dialing back benefits, the government projects it will save nearly $200 billion over 10 years. Passage also signaled the administration is willing and able to follow through on difficult reforms—and, equally crucially, that Brazil’s Congress can muster agreement on controversial legislation.

Beyond pensions, the administration—under the guidance of Economy Minister Paulo Guedes—has implemented several other business-friendly changes. These include tariff cuts, signing a (not yet ratified) trade deal with the EU, privatizing state-owned assets and firms (including utility giant Eletrobras), and easing restrictions on starting and running a business.

Markets have seemingly applauded said changes. Year to date, the MSCI Brazil Index has risen 18.6%, compared to 12.5% for EM stocks overall.^[iv] (Developed market stocks trump both at 24.1%.)^[v] Brazil’s advantage over EM comes despite a -4.4% November dip—likely a case of investors selling the news of pension reform’s passage after buying in the run-up.^[vi] In our view, Brazil’s outsized 2019 gains show a pro-reform political environment can be a bullish force for stocks in less economically competitive nations, which are more prevalent in Emerging and Frontier Markets. Many EMs have significant barriers to trade, investment and doing business generally. Since markets are accustomed to these negatives, they often rise despite them. But when an EM bucks the pattern and looks set to press on with meaningful reforms, markets often respond positively. A similar process played out in recent years in Indonesia, Mexico and India following the election of reformist candidates.

While many seemingly understand reforms are the swing factor for Brazilian stocks, sentiment is still guarded. Many fret pension reform has exhausted Bolsonaro’s political capital and don’t expect much more progress. Yet the administration has several more policies in its sights, including trimming government expenditures and improving their efficiency, simplifying the tax code, reducing the federal workforce, cutting more tariffs and privatizing more state-owned firms and assets. This is an ambitious agenda, and we aren’t saying all of it will come to fruition. But we think they have a better shot than many currently expect, upping positive surprise potential.

More economic growth would likely sustain the administration’s political capital and give Congress breathing room to pass measures that wouldn’t fly when the economy was weak and voters craved stimulus. On this front, Brazil’s economic backdrop looks promising. Inflation is low, averaging just 3.7% year to date compared to 8.9% in 2015 – 2016.^[vii] That gives the central bank flexibility. They don’t need to tap the brakes while credit growth to non-financial corporations and households is accelerating, most recently notching 6.6% y/y in October.^[viii] Abundant capital should support domestic demand. Meanwhile, the ongoing global expansion likely means steady demand for Brazil’s exports—important in a trade-heavy country. All this suggests to us investors are underrating the probability of continued growth facilitating more beneficial reforms—potentially setting up further gains for Brazilian stocks.

Ultimately, we think most individual investors are better off focusing on opportunities in the global developed world right now, with perhaps a few dabbles in mega-cap EM Technology stocks, which Brazil lacks. However, Brazil’s recent outperformance relative to other EMs illustrates how market-oriented reform can drive stocks in the developing world.