Market traveler

Can a reshaped, business-friendly Brazilian government produce an era of economic stability in the region?

We traveled to Brazil to gain insights from elected officials, business leaders, and institutional investors.

Here’s why we believe in Brazil, based on encouraging economic policies aimed at fiscal soundness and growth.

Believing in BrazilBefore arriving in Brazil (and after the seven inoculations I had to get before traveling), I thought hard about what to expect from my first trip to a Latin American country. Would I see poverty next to wealth? Would people be accepting of foreign visitors? What if I got lost in São Paolo? As it turns out, what I remember most is how warm and friendly people were.

We flew to Brazil in late 2018, a time of change in the region. For decades, Brazil suffered under widespread political corruption. However, just prior to our trip, Brazil held a supercycle election that reshaped its government—including the presidential office, large portions of the senate and congress, and various state-level seats.

Could this bring about a new era of stability for Brazil’s economy and society? As emerging market investors, we needed to hear directly from the sources. So we timed our trip to coincide with the JP Morgan Brazil Opportunities Conference in São Paulo, whose speakers included Brazil’s newly elected cabinet officials, members of Congress, and a range of locals who lived, worked, and invested in the region—all of whom we had the opportunity to speak with. We also met with leadership from more than a dozen companies in a private sector that is hopeful for a business-friendly climate.

In this piece, Sergio and I will recount what we learned, what Brazil has endured and must overcome, and how Brazilians’ sense of optimism has shaped our views on the country’s future.

—Alison Shimada

Impressions of a new Brazilian government

When I sat down for lunch at the conference, it was never like sitting down to a table of strangers but rather meeting new friends. The diversity of opinion and heritage in Brazil is quite amazing, yet the personal identity of being Brazilian is also strong.

Alison ShimadaSenior Portfolio Manager, Head of SF Global Emerging Markets Equity Team

May 2019

Sergio TorresPortfolio Analyst, SF Global Emerging Markets Equity Team

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Over sushi dinner, I had a lively conversation with industry peers contrasting life in the U.S. and in Brazil. One thing everyone at the table noticed: Brazilians are coalescing around hope. Locals we spoke with were highly optimistic about future policy developments the new government could launch.

Is the new cabinet capable of executing on ambitious reform plans after years of dismal leadership? I found it enlightening to hear new cabinet members questioned up close about their motivations for joining the government; goals for what they’d achieve in office; and plans for working with Brazil’s new president, Jair Bolsonaro.

Also impressive: the officials’ candor. They admitted what was going wrong and the extent to which they’d need to work to produce real change. Overall, I could feel that people were hopeful for a positive transformation in government based upon better integrity and hard work.

—Alison Shimada

How pension reform could affect the Brazilian government’s gross debt

40

50

60

70

80

90

100

110

With pension reformWithout pension reformActual

2013 2014 2015 2016 2017 2018 2019E 2020E 2021E 2022E 2023E

Gro

ss d

ebt a

s a

perc

enta

ge o

f GD

P (%

)

Source: Ministry of the Economy (Brazil). “The Arithmetic of Solvency: Pensions and Fiscal (Im) Balance,” March 2019

“A reason to believe

A major goal of our trip was identifying new investment opportunities among Brazilian companies that hadn’t met our criteria in recent years but could under better management and an improved backdrop.

I’ve been able to envision this scenario since 2016—when Brazil’s former president was impeached and a more principled, business-friendly administration took over. However, perceptions based on Brazil’s past struggles have been harder to shake for others.

On a prior visit, the one question local investors asked me most frequently was “Why do foreign investors not see Brazil the way we do, in a positive light?” My reply was that perception would change when Brazil had solved the issue of pension reform.

At the time of this writing, the Bolsonaro administration had submitted an ambitious pension reform bill. The Brazilian population is gradually coming to terms with the idea that such a measure is necessary—mainly to bring government finances back on track. Currently, the consensus view is that Brazil’s government will vote on—and pass—the bill during 2019. We’ll be watching. Should that happen, the government’s economic team would then introduce more reforms aimed at increasing Brazil’s economic competitiveness and building a more sustainable path for growth.

— Sergio Torres

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Impressions of Brazilian corporate leadership

In a very diverse country with a young population, leadership at the top is of utmost importance. When things go well at the top, the rest of the organization works effectively. Three conference panels in particular featuring Brazilian business leaders gave me insights into how the private sector is handling an economy in transition:

1. Consumer insights: A Brazilian beverage company CEO discussed the challenges of reaching local consumers. For example, Brazilians are shifting from buying beer at bars and restaurants to purchasing it from retail stores for parties hosted at home. The company is trying to segment its brands to capture more of this market. However, the current consumer environment in Brazil isn’t that robust. Still, hearing from beverage company leaders about consumers trading up to more expensive brands when they have more money reminds me that consumption is always aspirational.

Consumer spending has been the main driver of Brazil’s GDP growth (percentage of GDP growth by component)

2014 2015 2016 2017 2018

GDP growth 0.5 -3.6 -3.3 1.1 1.2

Consumer spending 1.5 -2.2 -2.6 1.0 1.4

Government spending 0.1 -0.3 0 -0.2 0

Gross fixed investment -1.0 -3.0 -2.3 -0.4 0.8

External balance 0.2 3.0 1.5 0.1 -1.0

Stock building -0.3 -1.0 0.1 0.7 0

Sources: McKinsey & Company, Brazil Digital Report, April 2019 (citing data from the Brazilian Institute of Geography and Statistics)

2. Logistics insights: In a panel titled “Rethinking Infrastructure,” local business leaders discussed the bottlenecks in Brazil’s efforts to build better transportation networks for cargo and people. It turns out, in Rio de Janeiro, the government only allows truckers to unload their goods within a few hours of the day. This is great for avoiding noise and excess traffic but not so much for getting goods to customers on time and at lower costs. The business leaders suggested loosening these regulations in Rio and other major cities as well as moving the entire country from overdependence on roads to shipping and rail.

What Brazil is coming back from

If you’re an investor who prefers countries with some degree of predictability in economic policy and political regimes, the past six years in Brazil have likely been particularly disconcerting for you.

As the largest economy in Latin America, Brazil and its development potential are not new themes for dedicated emerging market investors like ourselves. The premises in favor of investing in Brazil that were valid 25 years ago are still valid today. Unfortunately, one can say the same thing about the region’s history of politics, social challenges, risks, and distortions.

Stating the obvious, returns in Brazilian equities as a whole have not been commensurate to their risk—mostly because the risks have been larger than what met the eye. For years, the government was hiding fiscal deficits and corruption. Too many public and private companies in Brazil bore the impact with too little legal consequences for the bad actors and large impact on market values.

This, combined with the 2016 presidential impeachment and revelations of far-reaching corruption, led us to raise our bar on governance requirements for any companies we invest in or are considering. Not just in Brazil but across our investment universe.

So here we were in late 2018, traveling to the country of our largest active position and contributor to date. Our thesis was simple. Despite decades of lost opportunity, Brazilian companies could revalue materially under a conventional economic system that offers predictability and, eventually, continuity.

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Impressions of Brazilian corporate leadership (continued)

3. Telecom insights: During a session on telecom industry challenges, we were surprised to learn Brazil is quite far along in its plans to roll out 5G networks. The private and public sectors—as well as local research institutions—have been laying the groundwork to advance 5G since 2017. The region’s telecom regulator is on track to auction frequencies to top local mobile carriers next year. However, major unknowns remain with regard to ownership: Who bears which costs for 5G implementation, and what model of private/public coordination will help Brazil accomplish the upgrade?

—Alison Shimada

However, Brazil’s internet speed is significantly slower(Mbps: Megabits per second)

Brazil Global average U.S.

13 Mbps 31 Mbps 46 Mbps

Sources: McKinsey & Company, Brazil Digital Report, April 2019 (citing data from Brazil’s Center of Studies on Information and Communication Technologies; Google’s Consumer Barometer; CISCO; and Speedtest by Ookla)

9.1 hours Brazil

6.3 hours U.S.

Brazilians spend more time using internet-based services than their U.S. counterparts

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“ This time it will be different

— Sergio Torres

In informal talks with Brazilian institutional investors, I perceived a level of optimism that I hadn’t seen outside of the realm of soccer. It’s like that sensation when thousands of jersey-clad fans sit at the edge of their seats as the striker approaches the goal. Mirroring a heightened sense of purpose from incoming administration officials, local investors wore an aura of conviction best summed up as “This time it will be different.” In my view, there is no reason it shouldn’t be.

In my last visit to Brazil, it was clear hope was already rising. During the 2016–2018 tenure of interim president Michel Temer—who took over after the prior president was impeached—management from every Brazilian company I spoke with remarked on two things:

l Ho w different it was to work with a government that welcomed the private sector’s efforts

l Ho w competent government ministers seemed to be in how they understood Brazilian businesses and were willing and able to support them, no strings attached

I was always of the view that, during those two years, we had all peeked into what Brazil could look and function like under a business-friendly environment. The view was beautiful and inviting then, and from my perspective, it remains so to date.

Final thoughts: Do we believe in Brazil?

The insight we gained into Brazil’s new government gave us confidence that conditions can indeed change for the better. Our engagement with corporate leadership helped us understand the day-to-day challenges of operating a business in Brazil. It also showed us what the opportunities are for regional companies that can:

l Problem solve in a systematic way

l Use technology to overcome bottlenecks

l Employ people who can execute on a large and long-term scale

Lastly, our conversations with Brazil helped us get to know the warmth, honesty, and vivacity of the region’s people.

Do we believe in Brazil? Let’s put it this way: On our trip, we met with leaders of 14 local companies across a range of industries. After everything we’ve learned on the ground, we maintained an active position in the country. With the proper attitude and a business-friendly government, we believe a lot can and will change going forward. If the optimism of Brazil’s people and leaders is any indication, a great nation that has endured a lot may be on the path to success.

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The views expressed and any forward-looking statements are as of May 1, 2019, and are those of Alison Shimada; Sergio Torres; and/or Wells Fargo Funds Management, LLC. Discussions of individual securities, or the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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