Brazil’s GDP growth looks poised to worsen in 2023 amid steadily weakening economic data points and a worrying decline in consumer/business confidence. Meanwhile, the government’s latest revenue-focused fiscal framework, despite addressing fiscal uncertainty and public debt/GDP, will have negative long-term implications for corporate earnings. And while inflation has eased this year, the government’s fiscal stance has unanchored inflation expectations, keeping the BCB (i.e., ‘Banco Central do Brasil’ or Brazil’s central bank) in hawkish territory. At ~6x earnings and ~1.4x book, the Franklin FTSE Brazil ETF (NYSEARCA:FLBR) portfolio screens attractively relative to other emerging market ETFs, but given the backdrop of fiscal uncertainty, higher tax burdens, and more monetary tightening, the risk/reward isn’t compelling.
Fund Overview – Low-Cost Brazilian Investment Vehicle Levered to the Cycles
The NYSE-listed Franklin FTSE Brazil ETF seeks to track, before fees and expenses, the performance of the FTSE Brazil Capped Index, a market cap-weighted index comprising Brazilian large and mid-cap equities. The ETF held $266m of net assets at the time of writing and charged a 0.19% expense ratio, making it a cost-effective option for US investors looking to access Brazilian equities.
In contrast with when I last covered FLBR, the fund’s sector allocation has shifted away from the materials sector (formerly the top holding at ~24%) to financials at 23.9% (up from ~22% prior). Materials remain a meaningful allocation at 21.0%, along with energy at 17.4% (up from ~16% prior). From a sector perspective, FLBR remains highly concentrated – the top-five sectors account for a combined 82.2% of the total portfolio.
The single-stock allocation also remains top-heavy, though the fund’s holding in metals and mining company Vale SA (VALE) has been reduced to 15.1% (down from ~18% prior). The allocation to state-owned petroleum multinational Petrobras’ (PBR) preferred stock has increased to 8.2% (up from ~7% prior), along with financial services company Itau Unibanco (ITUB) at 6.6% (up from ~6% prior). Petrobras common stock and B3 SA (OTCPK:BOLSY) complete the top five at 6.1% and 3.9%, respectively. In total, the top-five holdings make up ~40% of the overall portfolio.
On a YTD basis, the ETF has returned 6.8%, declining in value since its January peak. Relative to the fund’s inception in 2017, FLBR has also lost -1.2% in value on an annualized basis. Thus far, the fund has distributed $2.07/share for 2022 out of income (implied ~11% yield), though the cyclicality of the distribution (comprising semi-annual income payouts and annual capital gains payouts) needs to be taken into account. As last year benefited from higher-than-usual dividends due to the cyclical commodity/energy upswing, future distributions are likely to normalize lower. A reversion to the historical average would indicate a run rate closer to around half of last year’s distribution.
New Fiscal Framework Emphasizes a Balanced Budget but Comes at a Price
The government’s new fiscal framework (recently submitted as a draft law) is slated to replace the prior spending cap that targeted constant real terms government spending growth. Per the draft, spending growth will be tied to ~70% of the prior year’s revenue growth, while investment spending will be subject to a BRL70-80bn floor on an inflation-adjusted basis. Using this framework, the government has projected a rapid improvement in the budget over the next few years, with a balanced budget as soon as 2024. From a -0.5% primary deficit as a % of GDP this year and 0% next year, the Lula administration is targeting a 0.5% and 1.0% surplus in 2025 and 2026, respectively.
At first glance, the updated fiscal framework is a positive step toward balancing the budget – limiting spending growth and incentivizing compliance via penalties are encouraging signs of fiscal responsibility. While the framework was well-received by the market on the announcement, I suspect underwriting lower government spending and the proposed fiscal balance projections could prove a tad optimistic. Given the scale of federal spending programs and other policy pledges by the Lula administration, the focus will likely turn to increasing tax revenues to fund spending (negating the need for spending reforms), particularly with Finance Minister Haddad already calling for new fiscal measures such as higher sports betting taxes and a ‘digital tax’ on e-commerce businesses. Expect more announcements along these lines in the coming months, with the end result likely to be a significantly increased corporate tax burden and, by extension, negative growth and private investment implications. FLBR’s large-cap holdings are unlikely to be exempt from the high tax/low growth one-two punch and could underperform as a result.
BCB’s Hawkishness Sustained Amid Unanchored Inflation Expectations
Brazil’s central bank, the BCB, continues to defy government pressure to ease monetary policy. At its latest policy meeting, the BCB kept the benchmark Selic rate on hold but, more importantly, set a more hawkish tone in its policy statement. Staying on the tightening course may come as a surprise to some, given the increasingly dovish Fed stance and easing inflation data. The key issue, however, is inflation expectations, which appear to have de-anchored amid expectations of heightened fiscal risks. Per the BCB’s latest survey, inflation is expected to remain well above target at ~6% for 2023 before easing to 4.1% for 2024.
A ‘higher for longer’ inflation and rate scenario doesn’t bode well for GDP growth, investment, or job creation; FLBR’s domestic-focused portfolio could see earnings downside as a result. While the fund’s banking allocation could see some margin benefit from higher rates, the negative impacts of lower lending activity and deteriorating asset quality will weigh on the bottom line. Also clouding the outlook are reports of a potential interest rate cap on revolving credit card debt, which could limit any margin benefits for the sector from higher rates. The second-order impact from a cap is uncertain at this point, but given the significant % of Brazilian household consumption dependent on credit cards, any pullback in issuances could throttle consumer spending as well.
Fiscal Issues Remain the Key Overhang on Brazilian Equities
Brazil’s economic growth looks set to decelerate this year as economic data continues to portray weaker underlying fundamentals. Not only are consumer and business confidence down since the election, but inflation expectations have also been unanchored in reaction to the elevated fiscal risks posed by the new administration. So even with inflation moving lower amid weakening domestic activity and the government pressuring the BCB to reverse course, a ‘higher for longer’ rate environment could persist in Brazil. Further weighing on valuations is the government’s new fiscal framework – while the move toward fiscal responsibility is commendable, the focus on funding the budget via tax revenues (vs. spending cuts) entails increased tax burdens, especially for the state-backed entities in FLBR’s portfolio. At ~6x P/E, FLBR is valued cheaply, but against a challenging domestic backdrop, I remain on the sidelines.