Perspectives April. Quebra-cabeça A Puzzle in Portuguese Brazil s Macroeconomic Challenges and Relative Value Opportunities. Emerging Markets Debt

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1 Perspectives April 2013 Emerging Markets Debt Quebra-cabeça A Puzzle in Portuguese Brazil s Macroeconomic Challenges and Relative Value Opportunities Arvind Rajan Managing Director and International Chief Investment Officer Prudential Fixed Income From 1900 to 1980 Brazil was one of the world s fastest growing economies, 1 but for roughly the past three decades the country has had to overcome a string of crises to arrive at its present state a tantalizing mix of opportunity and challenges. Today, investment opportunities remain, but they are less obvious and far more dynamic. We believe that successful fixed income investing in Brazil requires an in-depth understanding of their economic and policy backdrop, combined with a rigorous bottom-up research process and strong technical knowledge of Brazil s sovereign and corporate debt, as well as currency instruments in order to take advantage of the many relative value opportunities that it presents. Structural Gains One of the more successful chapters in Brazil s recent history was the reduction of external vulnerabilities in the economy. This was accomplished by a reduction in external indebtedness, the adoption of a floating exchange rate regime, and a significant build-up of foreign exchange reserves. Such external resiliency was demonstrated during and after the 2008 crisis, and the Euro-zone crisis which followed. An inflation targeting regime helped anchor the economy, bringing down interest rates, tempering inflation, and fostering growth through renewed confidence. This complemented the improved fiscal resolve to generate primary surpluses to reduce government debt. Policies aimed at liberalizing the financial sector and allowing for the development of the domestic capital markets also helped. By far, the key puzzle piece of success for the political economy was the improved income gain which helped support the development of a large middle class. Brazil has a low unemployment rate that most developed markets can only envy. All of these achievements solidified Brazil s place in the top tier of emerging economies providing stability and a seemingly attractive place to invest. 1 Source: Angus Maddison 1995, Monitoring the World Economy

2 Perspectives April 2013 Page 2 Current Stagnation and Challenges But Brazil s status as a darling of the emerging world is being challenged. Economic successes including the gains from a positive terms-of-trade shock masked the imbalances. In recent years, particularly 2012, growth has lagged and is below potential, underscoring production inefficiencies and competitive and productivity challenges, despite strong domestic demand. In our view, some of the earlier structural gains did not go far enough. Arguably, the public sector is still too large, non-discretionary spending too big a piece of the budget, and crucially, investment is too low. This is most apparent in the deficiency in the country s infrastructure. Also, Brazil s very high taxes create distortions and hurt competitiveness. Likewise, labor rigidities and confusion about the degree to which policymakers are willing to interfere in the economy creates uncertainty. While leadership at the top is very capable and policy management in general held in high regard, there is the perception that things have veered off the path. One need only review decisions regarding the exchange rate level, the role of policy banks, capital controls, and government policy in the mining and energy sectors to see the basis for this skepticism. Future Macroeconomic Challenges and Risks In the very short-term, the challenge is re-anchoring confidence. This can be achieved with very clear and consistent policy signals with regard to monetary policy, the exchange rate, and the fiscal realm. Equally important over the medium to long term, we believe that an increase in investment and savings will be key to sustainable growth. The Brazilian government has a well articulated plan to increase infrastructure investment, and to improve the structural competitive challenges facing the economy. The challenge is to implement it and falling short in this important dimension risks lower potential growth with higher inflation. While exceptionally capable in our view, the credibility of Brazil s central bank has been undermined. It has been criticized for trying to target too many objectives at once inflation, growth, and the exchange rate. That said, recent announcements may help improve this perception and we believe that the market has not duly credited the central bank for cutting rates when they did. Other challenges include the potential creation of an asset bubble, or a framework that does too little too late to avoid a boom/bust cycle. Better Value in Real-Denominated Government Debt These challenges notwithstanding, we believe Brazil s government debt remains safe, and we expect its ratings, currently Baa2/BBB/BBB, to remain investment grade. Nevertheless, with slightly more than a 120 basis point spread over U.S. Treasuries, and limited spread compression potential, Brazil s dollardenominated sovereign 10-year bonds offer mediocre value, especially relative to other highly rated sovereigns with upgrade potential such as Mexico and Indonesia. Longer dated 30-year bonds offer only slightly better value at a spread of approximately 160 basis points. In contrast, local government debt remains compelling. Both sovereign hard currency and local government yields have rallied strongly over the past decade. Yet with nominal yields over 9% and real yields of over 3%, the Real-denominated debt offers considerably better value than the external debt as is illustrated in the chart below. It also offers good relative value compared to developed country government bonds. Brazil s local curve remains one of the steepest in the world and offers the likelihood of long term convergence given Brazil s ongoing commitment to prudent fiscal policy and relatively strong

3 Rate (Mid Conventional %) Perspectives April 2013 Page 3 inflation-fighting credentials. As inflation converges toward that in the developed world, we believe there is a high probability of a long term reduction in rates of several hundred basis points. USD Brazil Sovereign Curve BRL Brazil Local Curve USD Brazil Sovereign Curve US Treasury Curve M 6M 2Y 4Y 7Y 10Y 15Y 20Y 25Y 30Y Source: Bloomberg. As of 3/18/13. Currency A Real Riddle Until early 2012, the Brazilian Real enjoyed a strengthening trend, driven by a confluence of factors strong capital accounts from foreign direct investment and portfolio flows, high nominal and real yields, rising external reserves, and the benefits of being a commodity exporter during a commodity super cycle. However, since February 2012, the Brazilian Real has transitioned from a free-floating to a managed float currency. The government, dismayed by poor growth and an uncompetitive export sector, decided to engineer a weaker Real. Together with the 500 basis point rate cutting cycle that began in late 2011, this intervention policy decimated currency returns in 2012, making the Brazilian Real one of the worst performing currencies in 2012 with a 9% depreciation in nominal terms. Emboldened by a $350 billion war chest of reserves, central bank intervention became more aggressive and more frequent, with the intent to depreciate the currency and deter speculative inflows into Brazil. Currency volatility became a function of central bank policy and action rather than free market forces. In 2012, from February to May, the Real traded from 1.7 to 2.1, even as growth, confidence, and capital flows deteriorated and inflation expectations rose. In late 2012, the Brazilian authorities, sensing the need to tame inflation and restore foreign direct investment, declared themselves comfortable with the level of the currency. From December 2012 to February of this year the Brazilian Central Bank allowed the currency to appreciate from nearly 2.14 to below 2. Going forward, we believe trading the Real is likely to remain tricky. A short hiking cycle is priced in for 2013, but rate hikes are likely to be slower and shallower than what the curve prices in, reducing appreciation pressures. Inflation too will likely taper off gradually. Equally important, the currency regime will continue to be managed-float and it will be important for investors to heed any central bank communication concerning the level and trend of the exchange rate and the pattern of intervention. At this point the Brazilian Central Bank has demonstrated that it has both the credibility and the tools to control

4 Perspectives April 2013 Page 4 the foreign exchange market, and past important levels of perceived intervention targets will need careful monitoring. Corporates Calling for Careful Bottom-up Analysis If choosing government bonds and currency is tricky, the Brazilian corporate bond asset class can be a real challenge. On the one hand, the major emerging market countries include a number of world class companies and Brazil is no exception. However, in today s world of easy money, lenders must be wary of the fundamentals and do their credit homework, and here again, Brazil is no exception. While many Brazilian corporations are high quality credits and offer significant spread pick-ups over comparable developed country corporations, there are also situations where over-exuberant investors are demanding too low a spread premium. To illustrate a relative value example, we contrast the basic credit data on two Brazilian corporate issuers in the following table. It is our view that Odebrecht offers better risk/reward than Oi. Odebrecht is an investment grade construction company, which being internationally diversified, offers exposure to construction in Latin America (albeit focused in Brazil), low leverage, strong positive free cash flow, a backlog of projects including hydro, ports and roads as well as those related to the 2014 World Cup and 2016 Olympics, a history of strong management and significant pick-up over the sovereign. Oi, by contrast, is a relatively highly leveraged wireless operator facing pressure on margins from strong competition, high capex needs, with a wireline business that is in secular decline, and negative free cash flow hence not as good a value despite trading at a somewhat higher credit spread. We expect their relative spreads to widen as the market prices in these fundamentals. We believe this comparison demonstrates the need for careful bottom-up credit selection, rather than a broadbrush approach to emerging market corporate credit. Corporates in Contrast: Odebrecht vs. Oi Company Odebrecht Oi Industry Construction Telecommunications Rating Baa3/BBB-/BBB- Baa3/BBB-/BBB- Bond Spread +237 bps +308 bps Net Leverage 0.8x 2.9x LTM Revenue BRL 27.4B BRL 28.1B Net Debt BRL 2.3B BRL 25.1B Free Cash Flow Strongly positive Negative Characteristics 13th largest in world 35-40% Brazil +18 countries Strong backlog of projects 2014 World Cup/2016 Olympics Increased infrastructure spending 4th in wireless market share Wireline business in secular decline High capex needs Large dividend Competitive wireless industry Source: Prudential Fixed Income. As of 3/19/13. Shown for illustrative purposes only and does not constitute a recommendation by Prudential Fixed Income to buy, sell or hold any security.

5 Perspectives April 2013 Page 5 Fitting The Pieces Together In Depth Research Is Crucial Brazil illustrates a dilemma for investors common to the fixed income assets of many emerging countries today. The takeaway here, applicable to all emerging countries, is that intelligent investing calls for a nuanced approach that is both macro driven and country and asset specific. On the one hand, the fundamentals of emerging economies may be superior to those of the developed world in terms of growth, debt sustainability, and credit trajectories. Prospects appear strong for emerging market bonds as an asset class. On the other hand, emerging market bonds cannot replicate the past decade of stellar returns, and in aggregate offer only steady mid-single digit performance, being more a safe haven than a risk-reward play. In this context, the need to choose the right local curves, currencies, and credits within and across countries is now more important than ever to maximize returns. We believe there are two key ways to take advantage of such relative value opportunities. The first is a traditional long-only approach selecting a broadly defined blended benchmark of hard-currency sovereign and local bonds, and allowing a manager to freely add value by shifting between currency, local yield and hard currency sovereign and corporate spread risks to find the best alpha opportunities. An alternative, available to those willing to take a pure relative value approach, is a long-short strategy that seeks to maximize exposure to specific mispricings in rates, currency and spread markets without an explicit emerging market benchmark. The latter approach could potentially target a high single digit absolute return over LIBOR utilizing all possible instruments and hedging out those risks that do not offer good returns. Either approach has the potential to allow investors to find opportunity in what appears to be a puzzle in Portuguese.

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