As long-mostly investors, we tend to be (a) optimistic about the future and (b) early at times. Full disclosure: we started to get really excited about EM last Fall which is why we decided to go live with the LARE Index and license it out to the first US-listed product offering access to the LatAm real estate asset class. Our 20+ years’ experience taught us that when EM valuations approach extremely oversold conditions, the first movers tend to be bond and real estate investors. That is exactly what we saw in the Fall: EM sovereign bonds rallied and FX correlations diverged. The USD negative correlation trade crossed an inflection point.
The late January swoon presented investors with a glaringly obvious entry point. Brazil REITs, for example, were trading at close to half of tangible book value. Brazil assets overall were trading at single digit P/E and the proverbial taxi driver was busy shorting everything EM. But old ideas die hard. After a massive rally in the 2nd quarter, we found ourselves, again, facing deep skepticism from even sophisticated institutional investors about Brazil’s prospects. The same crowd that doubted the oversold conditions a year ago simply swapped one wrong view for another, just because.
What we want to point out here is that despite an exceptional rally and continuation of the same rally into the Fall this year, Brazil remains quite attractive from a valuation standpoint. We estimate that about 60% of the Brazil rally YTD is attributable to FX, which suggests there is room to run.
Brazil becomes even more compelling when compared against the S&P500. By almost every metric, Brazil is attractive and offers a decent cushion should either macroeconomic or political conditions deteriorate. We believe Brazil is about halfway through the normalization process, however, this time is different for a couple reasons:
First, the current phase will be much longer than previous cycles. Given global slow growth and unknowns related to the post-commodity cycle, we just don’t know how Brazil will fare in its transition to a consumer-driven economy. Right now, it looks like the Temer government is steering policy successfully. That said, investors in broad equities need to accept the notion that alpha will become more elusive as Brazil volatility is unlikely to fall much and overall returns will come down. For this reason, we really like real estate which inherently is low volatility and low correlation. Real estate also pays the investor to wait. Note: historically high Brazil yields are gone for the time but not for real estate which offers unleveraged yields of around 10%.
Second, while we know what Brazil growth looks like when you strip out China demand for commodities, we really don’t know what a consumer-driven long term growth rate will be? Will it look more like Mexico or better or worse? We don’t know.
Third, we know the central bank is very close to cutting rates and we also know they can cut rates a lot (we think 200bps to 300bps over the next 12 to 18 months). What we don’t know is the pace of cuts nor how the central bank would react if above average inflation remains sticky? Will they adopt the Yellen view of letting it run hotter for longer or will historical experience with hyperinflation cause the central bank to act hawkish should CPI remain high? We don’t know.
What we do know is developed markets assets are not cheap. Everywhere we look we see yields converging across the private-public spectrum, so while growth may still be a projection in Brazil, at least there is valuation on both an absolute and relative basis. You may not like it but it’s a clear reason to have at least some exposure.