Thursday, 13 December 2018

The only way is up

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Brazil is home to legions of investors renowned for their conservatism. It is a country that has traditionally offered interest rates high enough to undermine the appeal of riskier assets that have flourished elsewhere. But now, with its interest rates and notorious inflation seemingly under control, investors are having to look elsewhere for returns. The country’s hedge funds believe they can meet this new demand. Jason Mitchell reports.

Traditionally, Brazilians have been wedded to investing in certificates of deposit, a result of persistently high interest rates. However, on June 10, the Brazilian central bank reduced the overnight lending rate, called Selic, to under the psychologically important 10% level. It now stands at 8.75% – the lowest level in living memory.

“Brazil has had this Disneyland in the past of real rates well above any comparison with the developed world,” said Marcos Duarte, a partner at Polo Capital Management, a Rio de Janeiro-based shop with US$1bn under management, boasting one of the most impressive fund performances in the country. “We are now living in a new era and I think we will gradually see more investors move from CDs to riskier assets.”

At first glance hedge funds might not seem to be an obvious beneficiary of this trend. Certainly, Brazil’s hedge funds saw massive redemptions last year, although now they are starting to attract more inflows again, following the drop in the country’s interest rates to a record low.

In Brazil, the term hedge fund usually encapsulates a giant funds category called multimercados. That is confusing because many of its funds are capital-protected or invest only in bonds. Only a small proportion use leverage and have other characteristics typical of true hedge funds.

According to the Brazilian Investment Banking Association (Anbid), multimercados had total assets of R297bn (US$162.4bn) at the end of July. Gavea, a Rio de Janeiro-based hedge fund manager, estimates that the country’s 50 or so true hedge funds manage only R34bn. Multimercados’ assets are now at their highest level ever. Inflows into hedge funds kicked off again this year, but not at the rate seen in the broader category.

The previous peak of multimercados’ AuM was R268bn in December 2007. True hedge funds reached around R50bn in the same month. Multimercados’ assets bottomed at R247bn last December, whereas true hedge funds’ AuM bottomed at R25bn, also in the same month.

Brazilian investors are not absolute returns driven, and always reference the benchmark CDI rate, Brazil’s interbank lending rate and the Brazilian opportunity cost of money. That rate is at 8.64%, 10 basis points below Selic.

According to Goldman Sachs, market consensus for year-end this year and year-end next year Selic rates are 8.75% and 9.25%, respectively. The central bank is forecasting inflation of 4.37% this year (the IPCA rate), meaning the real CDI rate is at one of its lowest levels ever.

The Central Bank’s monetary policy committee, Copom, will keep the Selic unchanged at 8.75% until the third quarter next year, predicted Goldmans. It also predicted the authorities will raise it twice, by 50 basis points per meeting in the fourth quarter next year, to 9.75% by year-end.

Brave new world

One of Brazil’s biggest problems has always been excessive interest rates, according to analysts. It has undermined the development of the credit markets and hindered Brazilians from exploring riskier asset classes. But now the country could see rates move in a range that is below the historical average range.

This has far-reaching ramifications. Retail investors are likely to increasingly consider alternative investments. Brazilian pension funds, which have traditionally been mandated to seek a yield of 6% in real terms, have historically been able to rely on interest rates to meet their targets. Now they will find this goal increasingly difficult without making forays into hedge funds.

Brazil also has credit markets that are shallow in comparison with the developed world. According to Citi, the country’s credit against GDP is 44%, while in Chile it stands at 68% and in the US at 200%. This has done much to insulate Brazil from the sub-prime crisis and the credit crunch. But there is huge potential for healthy growth in all credit sectors in Brazil, especially in mortgages. Lower interest rates could be the very fillip that these industries require.

Mortgages against GDP in Brazil stand at a miniscule 2% and home loans with tenures longer than eight years are very rare, according to Citi. It is very difficult for lenders to foreclose on properties with delinquent mortgages. The country does not have a well-developed long-term yield curve. As the credit industry grows, the country could also start to see an ABS market spring up – securitisation remains weak in Brazil, as most financial institutions use deposits to finance credit.

“We forecast that the natural nominal Selic rate will be around 10% to 11% in the future,” said Marcelo Kfoury, chief economist at Citi in Brazil. “Ten years ago the natural rate would have been at 16%. Lower natural rates will encourage retail investors, including high-net-worth individuals and the mass affluent, to consider alternative investments more and more.”

Learning curve

Investors will increasingly invest in Caderneta de Poupanca (savings accounts), currently yielding an attractive 6% in real terms, said Kfoury. These are regulated by the government in that all financial institutions must pay the same interest rate on all deposits. They will then move towards investing in stocks, real estate, commercial paper and debentures, he predicted, before finally turning their attention to hedge funds, private equity and equity funds.

Luiz Figueiredo, chairman of Maua Investimentos, a Sao Paulo-based hedge fund manager with total AuM of US$293m, believes there will be big flows into hedge funds: “Interest rates coming down will be very good news for hedge funds,” he said. “We are starting to see the normalisation of the investing environment; Brazil is gradually becoming a developed country. Within two years, I believe the nation’s true hedge funds industry will be three times bigger.”

The country's hedge funds industry has started to breathe a bit easier following the battering it took last year. “The aggressive hedge funds in Brazil lost around two-thirds of their assets during 2008 because investors are not absolute return driven,” said Analicia Gil, a spokeswoman at Maua.

Polo Capital has put in a highly impressive performance this year: its flagship fund Polo Fia, with R500m in assets, is up 60% on the year and was up 10% last year. Its average annual return has been 40% since its 2003 inception.

"This year has been a great year for the fund," said Dara Chapman, a partner at the shop. "The financial crisis of last year opened up a significant number of opportunities. Share prices at that time no longer reflected fundamentals, but more investor flows. Foreign investors left Brazil and share prices suffered. The homebuilders sector was one of the hardest hit."

Polo said it saw value in this sector in particular and concentrated its risk by investing it. Lower interest rates and the government's plan to build low income housing have been a fillip to its base case scenario. Brazil’s stock market is up by 54% year to date and could be set for a slight correction. Currently, PE ratios are in the order of 19 to 20, based on earnings this year.

Some major groups are expected to list on the Bovespa within the next few weeks, including the Spanish bank, Santander, and the IT company, Tivit. The airline, Gol, and the homebuilders, Rossi and Brookfield, are also expected to do follow-ons. That the IPO market is warming up following a long hiatus since 2007, when it had one of the highest numbers of IPOs for any country in the world – 64 companies raised R56bn – indicates a return to more normal conditions.

“Commodities have recovered significantly this year,” said Marcelo Stallone, a partner at Gavea. “That is good news for Brazil. It’s important for the country’s major exporters. China also seems to be withstanding the financial tsunami reasonably well and when China does well so does Brazil.” Brazil is regarded as a proxy for China due to the difficulty investors have accessing the latter directly, she explained.

There had been a total of R12bn of flows from foreign institutional investors into Brazil by the end of August 2009, according to Stallone. The Brazilian economy is also showing signs of growing more rapidly than expectations: at the start of September, the country's statistical office, the IBGE, reported that in the second quarter, real GDP growth expanded 1.9% quarter-on-quarter, seasonally adjusted, from 0.8% in the first quarter – markedly better than Goldman Sachs' forecast of 1.4%, for example. On a year-on-year basis, real GDP contracted 1.2%. The rebound in activity was driven by the industrial sector, which expanded 2.1% quarter-on-quarter, followed by an expansion of 1.2% in services.

It all points to the prospect of a major rebound in Brazil, supported by a new era of comparatively low interest rates. If this promise delivers, it will have major implications for the way Brazilians – and foreigners – invest. In the longer term the beneficiaries are likely to be riskier asset classes, particularly true hedge funds.

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