The allocation of capital in the global economy is imbalanced.  85% of the world’s population live in emerging markets, which represents about 50% of world GDP (using purchasing power parity). Many investors are massively underweight emerging markets, in large part due to misperception of risk in developed home countries as well as prejudice about the risks in the emerging world.

Once convinced of the strategic importance of increasing allocations to emerging markets, the next question is: Where are the main opportunities?  One is actively managed, Brazilian local currency bonds. 

Why Brazil?

Brazil has one of the largest accessible local sovereign bond markets in emerging markets, with outstanding government debt near $1tn, mostly domestically held (about 12% is held by foreign investors). As well as deep and well regulated liquid currency and swap markets allowing large amounts to be invested and hedged, the country is under represented in the main EM Benchmarks. A good example is the GBI-EM Global Diversified, a local currency government bond benchmark, which has a market-cap of $843bn in bonds and a capped 10% allocation in Brazil.

With the country’s historically still high but declining interest rates Brazilian local bonds have outperformed emerging market peers both on an absolute and relative to risk basis over the last 10 years.

The case for possible continued outperformance includes the observation that the Brazil Central Bank is currently in the middle of an easing cycle that is explicitly intent on  reducing the base interest rate (Selic) to single digit levels from 10.50% today (as evidenced from the minutes of January 2012’s COPOM meeting). Indeed interest rates can be expected to go through a normalisation process over time where they should drop towards other emerging market economies’ levels, as inflation comes more fully under control.  Inflation is currently trending downwards from 7.50% in September 2011 to 6.44% today and is expected to close the year at 5.30%.

The country’s vulnerability to external crisis has dramatically reduced over the past 10 years as it moved from a debtor nation to one with robust foreign reserves. In 2002 Brazil suffered a confidence crisis due to uncertainties associated with a left wing party, led by Mr. Luiz Inacio Lula da Silva, leading the presidential elections after Argentina defaulted on its own external debt. By then, the Net Debt/GDP ratio was at 60% and the External Debt/Reserves ratio was at 557%. With prolonged fiscal discipline the government has not only reduced the debt levels but also accumulated external reserves. In August 2011, net Debt/GDP was at 38.2% as compared to an External Debt/Reserve ratio of 86.10% - in other words Brazil is today a net external creditor.

More importantly, the main political actors in the country today share the view on how to handle the economy. The economy’s macro framework has been maintained for nearly 20 years based on: (1) fiscal austerity; (2) inflation targets and; (3) floating exchange rate. Implemented during Fernando Henrique Cardoso administration (1995-2002) it was maintained by Lula (2003-2010) and recently by Dilma Rousseff (since 2011).

Getting Real

Foreign investors are buying local debt bonds in order to benefit from both high yields and from currency appreciation. Lack of infrastructure has weighed on exporters’ competitiveness, but Brazil’s commodity terms of trade, FDI and companies raising capital abroad are expected to continue pushing the Real higher over the next decade. In any event it is still over 10% weaker than July 2011 levels.

Brazil’s balance of payments shows consistent deficits on its current account, as appropriate for a relatively capital scarce economy with high growth prospects. In 2011 the deficit reached 2.12% of GDP. Conversely, the capital and financial account have been showing a steady surplus as foreign direct investment finances the deficit on current account. Foreign investors have been attracted by a steady growing consumer market, natural resources and, recently, some infrastructure projects, much more of which is needed.  Brazil welcomes foreign investors as insufficient levels of domestic saving and high interest rates constrain incentives for local players to invest in long term projects, until such point that interest rates can be brought down to substantially lower levels without  stoking inflation. A further consequence of high interest rates is that the volume of middle to long-term external debt has increased substantially since 2010 as creditworthy local companies have looked for cheaper funding from the external market.

A major factor that will affect the Balance of Payments in the future is oil exports. Brazil’s proven oil reserves have tripled. With oil prices at $95, the net exports of oil might reach levels close to $100bn per annum. That’s a relevant number for a country that had an average trade surplus of $28bn over the last five years.

Active Management

Passive management is arguably riskier in Brazil as for many markets, with the first job of active management being the reduction of risk.  Ashmore Brasil is a demonstration of this.  The Ashmore Brasil Fund Limited (ABFL) allows foreign investors to access directly the domestic fixed income market. It has the ability to deal on Brazilian local securities, external public debt securities and derivatives in order to construct a local bond portfolio. It actively manages currency (from the foreign investor’s point of view) and interest rate risks.  Performance speaks for itself, with an annualised return of 9.46% since inception, consistently outperforming its benchmark.