Head of Equity Strategy, Saxo Bank Group
Summary: Investor optimism is high in the wake of right-wing politician Jair Bolsonaro's Brazilian election win, but Brazilian shares are not exactly cheap, and the country still faces severe structural issues.
Bolsonaro's right-wing stances, complete with counsel from University of Chicago-trained financial advisor Paolo Guedes, could be seen as making him a natural ally to the pro-business US president. The long-term disconnect between politics and equity markets, however, is often huge and investors should be careful about turning too optimistic on Brazil. The country’s unemployment rate has spiked over the past four years following the collapse in commodity prices, stronger USD and higher interest rates.
Brazil is still one of those countries that played its hand very badly during the commodities super-cycle. But even more importantly, the equity market is not cheap enough to warrant risk-taking by foreign investors.
But how important is that for future returns?
That’s attractive on the surface but these numbers are in BRL so the attractiveness is only valid for domestic investors. For foreign investors, the opportunity looks less attractive. The current average inflation rate is around 4.5% and if it stays at that level over the coming years, then the expected nominal return in BRL is around 7.5%.
Unfortunately, foreign investors cannot capture this expected return. For a European investor there are two options. You could invest in Brazilian equities and assume the currency risk in EURBRL or, alternatively, invest in Brazilian equities and hedge the currency risk.
The current Brazilian one-year interest rate is around 7% and the one-year euro area rate on a GDP-weighted basis is 0.6%. When a European investor hedges the currency risk, the attractive local return disappears.
For more on Bolsonaro and Brazil, see Saxo Bank Head of Forex Strategy John Hardy's take on the Brazilian real.