How to Invest and Protect Yourself from Brazil’s Rising Fiscal Risk

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Bloomberg Línea — The first announcements of Brazil’s new government of President Luiz Inácio Lula da Silva have exacerbated investors’ concerns about the medium- and long-term fiscal risk in Brazil.

The scenario of fiscal uncertainties is added to the prospects of a recession in the United States and Europe, the worsening pandemic in China, and the increasingly high-interest rates of developed central banks: the result is a more complex picture for investors.

According to analysts consulted by Bloomberg Línea, the moment indicates a lot of instability and recommends an even greater need to diversify the investment portfolio.

Macro Scenario

In a report at the end of 2022, XP Investimentos said that the scenario for Brazil may remain positive, with the eventual removal of geopolitical tensions (such as the war in Ukraine) and the rise in commodity prices, which benefits the country. Global risks, highlighted the brokerage, exist, but “Brazil seems to be well positioned for them”.

XP said it is still early to define how the third mandate of Lula should be.

“In addition to fiscal, other issues such as tax reform, the public-private partnership model, the role of BNDES and that of Petrobras (PETR3, PETR4) will also be fundamental to Brazil’s economic performance in 2023 and beyond,” analysts said.

Guide Investimentos indicated that there are still uncertainties about the economic policy to be adopted by the new government, which leaves the domestic scenario more unstable.

“In our view, the lack of clarity about the economic policy of the next government is behind the fall in asset prices in Brazil. The effect of uncertainty seems greater than the worsening of expectations,” said the brokerage in a report, citing the Focus report, the Central Bank, and projections for GDP growth, inflation, and interest rates in 2023.

On Sunday, Lula said in a speech that “the State will be the one to induce investment to resume economic growth,” as he advocated and repeated throughout the election campaign.

“Public banks, especially the BNDES, and companies that induce growth and innovation, such as Petrobras, will play a fundamental role in this new cycle,” Lula said.

The guide stated in the report that this is not the time for investors to panic. Calm and caution are the keywords for the year that has just begun.

Is it time for fixed income?

For Toro Investimentos, Santander Brasil’s platform, it is time to protect yourself, allocating resources to fixed income and taking advantage of the rise in interest rates, which are at 13.75% per year since last August.

“Even with great uncertainty both in the macro scenario and domestically, having a divided portfolio is ideal. One way to protect against political instability would be to invest in fixed income products, especially post-fixed with a short duration of one or two years since the prospects are that there is no cut in an interest rate until mid-2023,” said analyst Gabriela Sporch.

According to Toro’s Sporch, depending on how the economic scenario will look in 2023, “this could stress the long yield curves and then more attractive investment opportunities arise.”

“Another possibility would be a direct exposure to the international market or through exchange-traded funds, believing that the dollar can strengthen against other currencies and benefit from this movement,” he added.

For BlackRock (BLK), the world’s largest manager of managed assets, a more benign scenario is possible “as valuations begin to reflect these economic impacts, or if we believe that markets have sufficient clarity to increase risk sustainably”. The manager, however, does not anticipate a “new decade of simultaneous bullishness in the equity and fixed income markets”.

“Finally, fixed income is offering attractive returns, particularly in short-term government bonds and high-quality corporate bonds,” said Cristiano Castro, head of BlackRock Brazil’s wealth segment.

“But the new manual in this new regime does not consider that long-term government bonds will fulfill the traditional role of being an insurance against corrections in risky assets such as, for example, equities,” said the wealth management division specialist.

BlackRock also stated that, in fixed income, “the new manual highlights the attractiveness of investment grade corporate bonds, as well as inflation-indexed bonds, in a scenario of persistent inflation”.

Multimarket funds gaining ground

Stephan Kautz, a chief economist at EQI Asset, indicated that multimarket funds should benefit from the uncertain environment of 2023, as they can “react more quickly and make investments in international markets if a more pronounced domestic deterioration materializes”.

The same allocation point of view is defended by XP, which stated in a report that high exposure to this asset class should be maintained, “being quite selective in the composition of funds (local and global) chosen for the portfolio”.

ETFs and BDRs

For BlackRock, ETF BDRs (foreign traded asset receipts) and local ETFs can be considered in the portfolio.

“In the context of volatility, ETFs are flexible and agile vehicles. Navigating markets will require frequent portfolio changes and more granular views across sectors, regions, and sub-asset classes, rather than broader exposures. And ETFs are ideal vehicles for tactical and opportunistic allocations,” said Paula Salamonde, head of BlackRock Brazil’s institutional and iShares ETF segment.

Equities

According to BlackRock, in the global equity market, the strategy is more defensive, “favoring industries such as healthcare and energy producers”, which should benefit from policies expected during the Lula government.

Other sectors, such as education, mining and steel, pulp and paper, and oil and gas, should be bullish on Brazil in 2023, according to XP Investimentos.

The brokerage said to be optimistic about oil prices, believing that it is a bull market already existed for some years.

For education, “there is still room for consolidation of the sector and we do not rule out the possibility of one or more transformational transactions”, according to the analysts.

Some sectors, according to the specialists, may not have such a positive year not only because of the domestic scene but also due to external pressures such as the recession, high-interest rates, and the increase of Covid-19 cases in China.

The technology sector, on the other hand, continues to be evaluated by XP, but it advised caution “despite the recent pressure on the price of some shares in our coverage, reflecting in good measure the scenario of monetary tightening in Brazil and worldwide”.

For Toro, the moment is to stay away from technology and retail assets, “as they are institutions that suffer a lot in a scenario of high-interest rates, with the increase in default and increase of discount rates in their cash flow, respectively”.

XP states, however, that retail has favored the exposure to more defensive segments, “with food retail being the preference, but pharmacies being a possible alternative”.