Reading the headlines following the Brazil central bank’s well telegraphed 25bps cut yesterday might leave one with the impression the event is a sell-the-news opportunity – “less dovish” is what Dow Jones elected to emphasize in their reporting this morning. The fact is this: conservative estimates foresee at least 250bps of rate cuts into 2017. That is a massive tailwind for investors, and the irony of it all kind of oozes off the page just as much every reluctant, almost daily, analyst upgrade does. Luckily, we don’t have to look back very far to remind ourselves how wrong everybody has been on Brazil, Latin America and emerging markets overall.
We won’t rehash what was said about Brazil’s prospects for a turnaround as recently as this Summer and simply remind folks that Brazil (and Latin America overall) is on a very constructive long term path marked by sustainable consumer-driven growth, further integration of financial markets, expanded free trade and a decline in fiscally-backward policies that emphasize populism over pragmatism. With that said, we’d like to reiterate what we’ve been saying over the past year: The combination of cheap assets, the path of lower interest rates and the central bank’s rising credibility is a unique opportunity in the global context to invest in growth.
We had the occasion early last Summer to discuss Brazil’s prospects on CNBC Europe and the question asked was “Brazil is cheap, but is it investable?”. Admittedly, the combination of bright lights and live TV made it hard to thoughtfully answer the question so here is what I should have said: Cheapness is inextricably linked to investability. It isn’t the only reason but it is a central factor and to deny that leads to missed opportunities. Perhaps the interviewer was getting at the different, but related, issue of timing. Certainly timing is a key factor as much as cheapness. As it was, the correct timing for starting to build exposure in the South America region was the 1st quarter of 2016. That much is irrefutable. But what about the next twelve months?
We believe that the easy money has been made and generating alpha is going to become harder for the simple reason that more than half of returns in Brazil this year were currency related. We also don’t see volatility dropping substantially and that company fundamentals are going to take center stage. Our analysis suggests that low volatility and current income (dividend yield) are two of the best determinants of future equity returns in the region. In other words, minimizing drawdowns and getting paid more now, generates more alpha, on average, than simply “owning the Index”. Unfortunately, most investors, including institutions, have been conditioned to buy EMs either through overly broad strategies or country-focused approaches that basically own five or six stocks.
As an example, the Brazil Index is highly concentrated in five names. These top holdings of course are widely traded, very liquid and could be individually owned by any global fund, but there is a downside to that approach: volatility. The Brazil Index, while up tremendously this year, is also one of the most volatile equity trackers in the world. As we’ve said before, high volatility is great when the trend is your friend, but when it goes against you, look out below.
As the chart above illustrates, the Brazil Index had a max daily drawdown this year of 6.2% versus the S&P500 max drawdown of 3.74%. In fact, of all Latin America Indices that serve as reference for listed ETF products, only three had smaller drawdowns (Chile, Peru & Mexico FX Hedged). Virtually every other LatAm tracker experienced drawdowns of at least 4.5% and much greater.
The other factor we prioritize is income. Many investors bought Brazil and LatAm this year for the appreciation potential and they’ve done well, but our view remains that focusing on dividend yield and low volatility are going to be the primary differentiators over the next period. Frankly, wealthy Latin America insiders are much more aligned with shareholders on this point versus US insiders who reap most of their wealth through performance-based RSUs. And on that front, there is really only one asset class that stands out: Latin America Real Estate.
LatAm real estate not only displays lower volatility versus the broad MSCI Emerging Markets (comparable max drawdown versus S&P500) but also displays a dividend yield that is about 3x greater than any other Latin America equity strategy. Year to date, the LAREPR Index has paid out over a 5% yield and projects a 5.5% to 6% forward yield, net of local withholding taxes. LAREPR is also one of the least correlated strategies versus the S&P500, currently running less than 50% correlated, and since it is a regional product, will benefit from what many experts believe will be a rebound in the Mexican peso.