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Managers play it safe in Brazil

Investors wait on sidelines as new leader takes over


Not so long ago, a left-wing firebrand named Luiz Inacio Lula da Silva sent Brazil's stock markets plunging with each gesture of support he won from Brazilian voters.

But by the time the former union boss won the country's presidential election in a landslide vote on Sunday, foreign and domestic investors alike had decided that the candidate popularly known as Lula is not as bad as they first thought.

Brazil's Bovespa stock index has tumbled 57 per cent this year in U.S. dollar terms, but gained 11 per cent last week before the election in which Mr. da Silva had become the overwhelming favourite.

"Now it will start getting interesting," says Wes Mills, vice-president of international equities at Scotia Cassels Investment Counsel Ltd. as he looks forward to the president-elect's first moves.

Investors worldwide -- including many Canadian fund managers -- now seem willing to give the president-elect a chance to prove he will be as fiscally responsible as he promised in his campaign.

Still, many of them worry that the former shoeshine boy and trade unionist will abandon the market-friendly policies of his predecessor and deepen the financial morass in South America's largest economy.

Yesterday, Mr. da Silva said he will name an "eminently technical" transition team, but did not immediately announce its makeup.

Mr. Mills, who manages the Scotia Latin American Growth Fund, says that so far, Mr. da Silva and his team seem willing to tell the Wall Street crowd what it wants to hear.

"They're trying to keep foreign lenders happy and interested."

Mr. Mills continues to hold an "underweight" position in Brazil.

The positive signals that Mr. da Silva is sending to Brazil's international bankers have prompted Mr. Mills to reduce his holdings in the country's domestic banks, such as Unibanco, which may not find the new environment so favourable.

He has also taken profits in the country's largest exporter, iron ore giant Companhia Vale do Rio Doce, or CVRD, because that stock is one of the few that has seen a strong runup.

Meanwhile, he has added to positions in telecommunications, because better economic prospects could lead that sector to perform well.

Luis Carillo, a portfolio manager with J.P. Morgan Investment Management Inc., wants to see Mr. da Silva build viable coalitions and keep inflation targets at about 7 per cent.

Mr. Carillo, a co-manager of the BMO Latin American fund, says market sentiment is improving toward Lula.

"He deserves the benefit of the doubt, but we need to see consistency from a good team."

Mr. Carillo still favours companies such as CVRD, jet maker Embraer SA and BAT Industries PLC affiliate Souza Cruz ON, which earn U.S. dollars through exports.

He is staying away from utilities and other companies which could be privatized under a left-leaning regime, and reducing holdings in domestic banks because they "are making too much money" and might be forced to hand more of it over to the government.

Jane Lesslie, vice-president for emerging markets bonds at RBC Dominion Securities Inc., also sees signs that investors are becoming more sanguine.

She notes that Brazil's bond market has rallied in response to two weeks of positive comments from members of Mr. da Silva's team.

The spread between the yield on Brazil's U.S. dollar bond index and the U.S. Treasury 10-year note -- which essentially measures the risk premium investors are assigning to Brazilian debt -- has narrowed considerably, Ms. Lesslie adds.

Investors are clearly signalling "we will give you the benefit of the doubt" by bidding up bond prices, the portfolio manager says.

A 39-per-cent depreciation of Brazil's currency, the real, against the U.S. dollar this year -- along with high interest rates -- have increased the country's public debt burden, since much of its of its debt is U.S. dollar denominated.

Earlier this year, the country negotiated a $30.4-billion rescue package from the International Monetary Fund.

Under its agreement with the IMF, Brazil must achieve a government budget surplus equal to at least 3.75 per cent of gross domestic product during 2003.

This so-called primary surplus, which excludes debt payments, is critical for stabilizing Brazil's debt burden, which has swelled to 60 per cent of GDP.

The portfolio manager is encouraged to see that Mr. da Silva is sending positive signs that Brazil will meet -- and even exceed -- its surplus target.

At the same time, Ms. Lesslie will be watching for interest rates to come down and for Mr. da Silva to give the country' central bank more operating independence.

Another concern still lingering in investors' minds is whether Brazil's state governors will seek to renegotiate the debt agreements that have cleaned up the country's balance sheet in the past.

Ms. Lesslie says some of the state leaders are "characters still stuck in the 1970s" who may urge Mr. da Silva to increase spending by blowing out the debt again. Mr. da Silva owes his election victory to many of those constituents.

"A lot of those states delivered for Lula. There is going to be horse trading," she says.

Investors will also be watching, Ms. Lesslie says, to see what Mr. da Silva proposes spending on social security, wages and pensions.

She notes that the current government has used a 5.5-per-cent increase in the minimum wage for budgeting purposes, while Mr. da Silva has talked of a 20-per-cent jump.

The problem, she says, is that many other government spending programs -- most notably social security and pension funding -- are indexed to the minimum wage.

"Markets are looking for a cut in spending here -- not an increase."

Ms. Lesslie says some investors have been stepping back into Brazil recently, but she fears that some of the action may be the result of hedge funds covering their short positions.

At this point, she says, psychology is driving the markets in Brazil, and Mr. da Silva will have to make some bold gestures.

"You're at a psychological juncture now where you need to bring about a positive confidence shock."

Nandu Narayanan, chief investment officer of New York-based Trident Investment Management LLC, believes conditions will remain difficult in Brazil for some time.

"I think it's a bit too early to get excited or depressed."

Mr. Narayanan, who manages the CI Emerging Markets fund, calls his position on Brazil "very underweight".

He notes that Mr. da Silva will be inheriting problems that would be challenging for any president, regardless of background.

But Mr. Narayanan sees an advantage in Mr. da Silva's populist and left-leaning past. Any leader will face hard tradeoffs between fiscal spending and debt, but cuts to social packages would be more palatable coming from Mr. da Silva than from a right-wing candidate.

"People will realize that there's no alternative."

He adds that Mr. da Silva will form coalitions with other parties, which in turn will force compromises that water down any aggressive action on fiscal policy.

"I think things are still pretty fluid."

Mr. Narayanan wants to see Brazil bring down real interest rates aggressively. He is also waiting for Mr. da Silva's cabinet to set policies and name a new central banker.

"Unless we know the rules under which we're going to be operating, we're just rolling the dice."

© 2007 The Globe and Mail. All rights reserved.

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