Episode 3: Pension reform, politics and the Brazilian economy

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Brazil is in flux, with a new government and pension reform on the agenda. But how healthy is its economy and how can foreign institutional investors access opportunities in this emerging market? This episode will explore the Brazilian economy, its stock market and investment risks and opportunities. We’re joined by Heather Hagerty, a sovereign debt analyst at Fidelity Investments’ fixed income division, Lourdes Casanova, a senior lecturer and director of the Emerging Markets Institute at Cornell University’s Cornell S.C. Johnson School of Business and David Souccar, an executive director and portfolio manager at Vontobel.

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(Run time: 17:18 min, size: 15.8 MB)

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Speakers

Lourdes Casanova

Lourdes Casanova

Senior lecturer and director at the Emerging Markets Institute, Cornell S.C. Johnson College of Business at Cornell University

Lourdes Casanova is a senior lecturer and director at the Emerging Markets Institute, Cornell S.C. Johnson College of Business at Cornell University. She specializes in international business with a focus on emerging markets multinationals. She was awarded one of the 50 most influential Iberoamerican intellectuals in 2014 and 2015 and one of the 30 most influential Iberoamerican women intellectuals by Esglobal in 2017. Casanova is a faculty fellow at the Atkinson Center for a Sustainable Future, a Fulbright Scholar with master’s degree from University of Southern California and holds a PhD from the University of Barcelona. She has taught directed executive programs at INSEAD for senior managers including Telefónica, BBVA and Cemex and the Brazilian Confederation of Industries.

Heather Hagerty

Heather Hagerty

Sovereign debt analyst, Fidelity Investments

Heather Hagerty is a research analyst on the macro research team within the Fixed Income division at Fidelity Investments. In this role, Hagerty is responsible for assessing macro-economic, sovereign, credit, and currency risk for Fidelity’s multi-asset portfolios. Primarily, she is responsible for specific in-depth credit analysis of developed and emerging market sovereigns, quasi-sovereigns, supra nationals, and provincial governments for Fidelity’s asset allocation and fixed income platforms. Prior to assuming her current position in 2010, Hagerty was a sovereign debt analyst in Fidelity’s emerging market debt division. In this capacity, she was responsible for performing fundamental, quantitative, and relative value analysis for emerging market sovereigns and quasi-sovereigns. Additionally, Hagerty architected alpha-generating strategies for the funds through out-of-index sovereign opportunities, corporate debt investments, and yield curve analysis in USD and local curves. She has been in the financial industry since joining Fidelity in 1998. Hagerty earned her bachelor of arts degree, cum laude, in economics from Assumption College and her master of science degree in finance from Brandeis University.

David Souccar

David Souccar

Executive director and portfolio manager, Vontobel

David Souccar joined Vontoberl Asset Management Inc. in April 2007 as a senior research analyst and was promoted to deputy portfolio manager of the firm’s international equity strategy in June 2016. In addition to Souccar’s portfolio management responsibilities he maintains his research responsibilities focusing on the energy, industrials and utilities sectors. Prior to joining Vontobel, from 2005 to 2007, he was a senior investment analyst at Federated Investors. From 1998 to 2005, Souccar worked as a sell-side analyst at Morgan Stanley. He began his financial career in 1996 at McKinsey & Co. where he worked as a consultant until 1998. Souccar received an M.B.A. in finance and management from the NYU Stern School of Business and a B.S. in chemical engineering from Escola de Engenharia Maua.

Text transcript

[Yaelle]: Hello, my name is Yaelle Gang and I’m the editor of Canadian Investment Review.

[Martha]: And I’m Martha Porado, associate editor of Canadian Investment Review and Benefits Canada.

[Yaelle]: Thanks for joining us on Pension Passport, where we’ll connect with investment experts from around the world to zero in on different countries and explore their economies, investment opportunities and risks for pension plans.

[Martha]: In this episode, we’ll take a deep dive into Brazil. On our lineup we’ve got Heather Hagerty, a research analyst on the macro research team within the fixed income division at Fidelity Investments, Lourdes Casanova, a senior lecturer and director of the Emerging Markets Institute at Cornell University’s Cornell S.C. Johnson College of Business and David Souccar who is an executive director and portfolio manager at Vontobel.

[Yaelle]: As the only country on this season of Pension Passport from South America, Brazil’s the eighth largest economy in the world. Brazil saw a huge amount of economic and social progress between 2003 and 2014, with over 29 million people leaving poverty. Despite this growth, in recent years, the economy has been quite depressed.

[Martha]: That’s right. In 2015 and 2016, Brazil went through one of the worst recessions in the country’s existence. And politically Brazil has seen a lot of change as well. With a newly elected leader Jair Bolsonaro, ending a 13-year rule of the leftist Workers’ Party and coming in with pro-market policies. But the start of 2019 from an economic perspective has been rough, with GDP contracting in Q1 for the first time since the recession.

[Yaelle]: Pension reform has been another major political issue for Brazil. To tell us more about that and the other macro-economic issues investors need to know about, we’re joined by Heather Hagerty from Fidelity. Thanks for joining us Heather, where are you calling in from today?

[Heather]: Thank you for having me. I’m calling in from Merrimack, New Hampshire in the United States.

[Martha]: So tell us what’s currently going on with Brazil’s pension reform and why those changes are so important to the country from a macro-perspective?

[Heather]: It is a very exciting time in Brazil right now because after more than two years of public discussion, Brazil has a historic opportunity to pass pension reform. This is so important because Brazil’s pension system is one of the most generous in the world and it is also fiscally unsustainable. Brazil is one of only a small number of countries that allow its people to retire based on the number of years that they contribute to the system and one of the only countries in the world with no minimum retirement age. In fact, most people in Brazil retire around the age of 55.

This has caused immense pressure on the federal and state budgets, with pension spending absorbing over a third of the tax revenues. And this is only expected to continue to rise as a share of government payouts. Now some Brazilians are retiring even longer than they contributed into the system. The system is also socially unjust with over half of this pension spending being taken up by the wealthiest fifth of the population and less than three per cent by those that are worse off.

The poor is also baring the cost of severe underfunding in other areas of public spending to offset this pension cost. Public utilities investment are being severely underfunded, which raises economic, financial and political risks. Without action this pressure is only going to increase as Brazil’s facing one of the fastest demographic transitions in the world. The country is aging quickly, fertility rates are falling and life expectancies are increasing. Last year, Brazil spent 13 per cent of its GDP on pensions, but only eight per cent of its population is over the age of 65. Let’s compare these numbers to Japan, where over 26 per cent of its population is over the age of 65, but they spend about one per cent of GDP less than Brazil.

The Brazilian government understands its grave fiscal situation. At an event in New York City this spring a Brazilian government official spoke on the urgent need for reform with the message that demography itself is a time bomb against any pay as you go system.

[Yaelle]: Thanks so much Heather. And when Brazil actually makes changes to the system, what do you think this means for the country’s growth potential?

[Heather]: I think it could have a very large impact. By extending the work life of Brazilians by as much as 10 years, this is going to have a large and material impact on economic productivity. There are some estimates that by implementing a minimum retirement age of 65 for men and 62 for women it could add as much as four million people to its workforce. This large increase in the workforce would be a positive supply shock to its labour market, which would increase growth for some time without wage pressure. The reason why we think this is, is because reform is also going to increase labour demand, increase the need for jobs, all coming from greater business confidence and a lower cost of capital.

The Central Bank has signalled that the passage of pension reform could warrant a lower interest rate in Brazil. Last year, the IMF estimated potential growth at 1.8 per cent and this year Brazil is likely to grow at less than one per cent. All in, we think that reform could increase GDP to grow on average by as much as three to three and a half per cent annually over the next five years.

[Martha]: Given that picture you painted, what do you think the implications of those reforms are for foreign institutional investors looking at the country?

[Heather]: Brazil could be the success story of the decade as reforms unlock Brazil’s enormous potential. For foreign investors, a permanent increase in potential growth, improved public spending and lower interest rates should result in both lower risk and equity premiums and raise Brazil’s credit standing.

[Yaelle]: So pension reform aside, are there any other macro issues at play that investors should keep on their radar?

[Heather]: Absolutely. Pension reform is a necessary, yet insufficient condition for Brazil to achieve its full potential. Pension reform is only the first of a five-step agenda that also seeks to sell government assets and use those proceeds to pay down public debt, a new tax system that seeks to dismantle its byzantine structure by collapsing multiple taxes into one single federal tax, fourth to reduce public bureaucracy and lastly to open up its economy. In short, Brazil’s government has an impressive agenda which could substantially improve the country’s short, medium and long-term economic prospects – raising the standards of living for all Brazilians.

[Yaelle]: Great, thank you so much for sharing your expertise with us Heather. Before moving on to our next guest Martha, I have a pop quiz for you.

[Martha]: You know I love being in the hot seat.

[Yaelle]: Brazil shares a border with every country in South America except for two. Name those two countries.

[Martha]: Ok. Well I know Chile is definitely one of them, my sister was just visiting there.

[Yaelle]: Correct.

[Martha]: And, oh, goodness. I’m going to go with Argentina?

[Yaelle]: Close. But it is actually Ecuador.

[Martha]: Okay, okay. Alright. Well at least I got one of them this time [laughs].

[Yaelle]: Well, let’s get back to the experts.

[Martha]: Okay. Now we’re joined by Lourdes Casanova, senior lecturer and director of the Emerging Markets Institute at Cornell S.C. Johnson College of Business at Cornell University, who [is] going to better help us understand what’s driving Brazil’s economy. Welcome Lourdes, where are you calling from this morning?

[Lourdes]: I’m calling from Barcelona in Spain, where I am speaking in an event tomorrow.

[Yaelle]: Great. To get us started, what types of sectors are currently dominating the Brazilian economy right now?

[Lourdes]: Natural resources are very important in Brazil as well as banking. Brazil has a very thriving banking sector, both state-owned and private. And regarding natural resources, we have to remember oil, iron ore and other minerals are very important in the Brazilian economy – agriculture as well. So we have also companies that in the meat industry.

[Martha]: Can you describe what the stock market in Brazil is like and how it might differ from systems in other economics?

[Lourdes]: Emerging markets’ stock markets are not always that diversified. Very often the stock market is very dependent on a few number of companies that are the ones that are more liquid, the ones that have more debt and that’s one thing.

Second thing, is that Western business press do not cover emerging markets that well. So if you are [inaudible] investor in New York or in another place, the Western Press or the TV stations will be covering in depth all the stocks – all the companies. So even without realizing you know more about the companies that are closer to you.

If you are an investor from let’s say U.S. or Canada or Europe and you want to invest in emerging markets, make sure that you have experts in those markets – experts that follow the press in that country and that are aware of what is happening because the stock markets very often move with the electoral cycle. What we are not necessarily used to with the Western world. The change of a president or prime minister does not influence as much the stock market, while in emerging markets, yes.

And then also these markets go up and down. So be aware of that. Be aware that the stock markets can gain 40 per cent in a given year, and lose the same amount the following year because, as I mentioned, political changes, second different in natural resources prices and third because sometimes because you have had so many profits, you may want to cash those profits so then those investors that cash those profits because they need to balance their portfolio may move the markets – so even sometimes for factors that are foreign to that local market you may move the market in a rapid way and in a profound way. So be aware of that and be aware that you have to be able to enter the market at the appropriate moment and be able to get out as well at the appropriate moment. Also because less liquidity as well.

[Yaelle]: And in your view, what are the biggest challenges or risks when it comes to Brazil’s economy that pension plans allocating capital to the country should be thinking about?

[Lourdes]: Yeah, so Brazil’s economy is very sensitive to these two factors I mentioned before- one natural resources prices. So oil, iron ore, minerals in general, these prices go up or down and the economy will improve or will sink. So now we are in a period in which natural resources prices are down, except for a little bit of volatility as of the last weeks and then so the stock market may be down.

Also we have had recent elections so again the stock market may change and there is still political turmoil inside so that may affect the stock markets quite a bit. So you need to follow that very closely. You need, as I said before, experts in the market. Experts not only in the economics and business side, but also in the political side because the enormous influence that politics has in the performance of the stock market.

[Martha]: Amazing. Thank you so much Lourdes for your insights today.

[Yaelle]: Next, to take us further into the specifics of what institutional investors like pension plans need to know when analyzing Brazil, we’re joined by David Souccar, an executive director and portfolio manager at Vontobel. Welcome David, where are you calling in from today?

[David]: Thank you so much for inviting me. I’m calling from New York today.

[Yaelle]: When it comes to corporate transparency, is there a lot of corporate transparency in Brazil?

[David]: So relative to other emerging markets, corporate transparency is on par with other countries. But when you compare corporate transparency to developed markets, Brazil has a long way to go. The transparency has improved a lot in the last 20 years, since I started looking to equities in Brazil. The disclosure is better and there is actually better protection for minority shareholders. Having said that, controlling shareholders still have a disproportional influence over the strategy of their business and the composition of the board. This is a process that is going to take a while to improve. But I think we are going the right destination. And one of the key factors that is going to influence on this process is the participation of domestic retail investors in equities because I think this is going to increase the awareness of the regulators for the needs to improve minority shareholder protection and corporate transparency.

[Yaelle]: And you spoke about retail investors, but what about international investors, like Canadian pension plans?

[David]: Sure. All institutional investors, including Canadian pension plans will benefit from more active participation of local retail investors. It’s difficult to motivate local regulators to improve corporate governance, corporate transparency, when the majority of investors in Brazilian equities today are institutional investors. Once retail investors start to get skin in the game, and I expect this to happen in the next five years, the discussion gets more political importance. And then you start moving regulation either to protect small investors and everybody benefits from that. Retail investors and institutional investors.

[Martha]: So what sectors dominate in Brazil and how is that reflected in its equity markets?

[David]: So the main index of the Brazilian equities, Ibovespa, is not a good reflection of the real economy. The index is very much dominated by commodities and state-owned enterprises. The real economy is made of consumer staples, financials, health care companies, etc. and there are great companies listed on the market that are on par with world-class corporations that investors can get exposure to that.

[Yaelle]: So given the picture you’ve painted of the business landscape, what guidance would you give pension funds looking to invest in Brazil?

[David]: So we are quite optimistic for the opportunities in Brazil. It’s one of our top destinations in terms of investments in our emerging market fund, together with China and India. Now I think institutional investors need to understand that Brazil is a volatile market and it’s hard for generalists to stay on top of it. So, when we get exposure to Brazil, it’s important to make Brazil a slice of the portfolio and manage risk by diversification of Brazil versus other countries in the world.

[Yaelle]: Wonderful, thank you so much for joining us David and sharing your insights.

[Martha]: Before we go, here’s a quick spotlight on a Canadian pension fund invested in Brazil. In June 2018, the CPPIB announced a $175 million Canadian equity target for a 20 per cent interest in the Goodman Brazil Logistics partnership to invest in prime logistics and industrial assets in Sao Paulo and Rio de Janeiro.

[Yaelle]: Interesting, well that’s all for today. Thank you for exploring Brazil with us here on Pension Passport. You can listen to the next episode by going to www.investmentreview.com/podcasts.

[Martha]: That’s all from us. See you next time. Or as they say in Brazil- Tchau, Até a próxima.

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