How our Brazilian holdings are growing amidst fiscal complexity.

It is clear that an economic samba-of-sorts is occurring in South America’s largest economy. The interplay between fiscal policy and monetary policy has created an environment where the Brazilian government and the Brazilian Central Bank (BCB) seem to be out of step with one another.

The government's expansive fiscal policies under President Lula da Silva have contributed to a significant increase in public debt, which now stands at nearly 80 per cent of GDP. This fiscal largesse, while aimed at supporting social programs, has raised market concerns about long-term fiscal sustainability, contributing to a sharp decline in the Brazilian real in 2024. In response, the BCB has maintained a hawkish stance, with interest rates reaching 12.25 per cent by the end of the year, bucking the trend of easing seen in many other Emerging Markets.

As we take stock of our largest country overweight position, it’s important to address a fundamental challenge for Emerging Market investors upfront: currency volatility.

Our starting point has always been to deliver strong hard currency returns for our clients. In Emerging Markets, exchange rates can be more volatile due to factors such as political instability, economic policy changes and global market sentiment. The Brazilian real’s depreciation against the US dollar underscores this point. Many companies that look attractive in local currency terms are not when you convert back to a hard currency. So why do we persist with our overweight in Brazil?

At the core of our Brazilian exposure lie two companies that epitomize our fundamental, bottom-up research approach – MercadoLibre and Petrobras. Despite the current macro situation, both demonstrate resilience and growth potential driven by powerful long-term structural tailwinds.

Being ‘macro-aware’ can often throw up opportunities in sectors that are dominated by exogenous factors such as future supply-demand imbalances.

Take MercadoLibre, the e-commerce and fintech giant, which has demonstrated robust revenue growth, with a compound annual growth rate (CAGR) of over 50 per cent over the past five years. Such strong performance has enabled the company to generate positive hard currency returns for our clients, effectively outpacing the headwinds posed by exchange rate fluctuations. Moreover, with a starting point of 12-13 per cent ecommerce penetration in Latin America, versus >25 per cent in the US, >30 per cent in the UK, and >40 per cent in China, there is clearly scope for further growth. While MercadoLibre does have a significant presence in Brazil, generating over half of its annual revenue there, the company's pan-Latin American operations also provide a crucial buffer against Brazilian macroeconomic volatility. Operating in 18 countries across Latin America, this geographic diversification has helped to mitigate the risks associated with any single country's economic challenges.

Despite various news headlines, oil demand is forecast to continue growing and will remain an important part of the global energy mix for many more years.

On the other hand, Brazilian energy company Petrobras’ share price is typically driven by global oil prices. Being ‘macro-aware’ can often throw up opportunities in sectors that are dominated by exogenous factors such as future supply-demand imbalances. We believe Oil is a commodity that will face this dynamic going forward, along with copper, lithium and platinum. Our investment case in Petrobras is underpinned by the quality of its upstream asset base. The Santos pre-salt layer is the world’s lowest cost source of supply beyond the Middle East and is unusually productive, with relatively low decline rates and levels of carbon intensity.?

Despite various news headlines, oil demand is forecast to continue growing and will remain an important part of the global energy mix for many more years. Petrobras is one of the few majors that is growing production 22 per cent over the last 5 years vs other oil majors where production has reduced on average by 5 per cent. As the world moves away from fossil fuels over the long term, the lowest lifting cost carbon reserves will likely be the last to have their ‘taps turned off’. Despite this, Petrobras is priced as a company without a future with a PE ratio of around 4x. Our long-standing conviction in Petrobras has been tested by economic cycles before, yet patience has consistently rewarded our clients - Petrobras remains a top contributor to portfolio performance across most time periods.

The rest of our Brazilian holdings are in an eclectic mix of companies that offer exposure to different facets of the Brazilian economy.

These include Natura&Co, a multinational cosmetics giant undergoing a transformation; B3, the country's stock exchange operator; and a selection of banks. Natura's turnaround strategy is showing promise with 18.5 per cent year-over-year revenue growth in constant currency. B3, while facing headwinds in the current high-interest environment, has significantly expanded its retail investor base which we believe will unlock future growth.

...high government debt, while concerning, is predominantly domestically held and denominated in local currency.

In banking, we're closely monitoring the disruption caused by digital challenger Nubank, which has rapidly expanded across Latin America. Our varying position in Nubank across strategies reflects our nuanced approach to balancing growth potential with valuation considerations in this dynamic market.

Looking ahead, it seems a lot of bad news is priced into Brazilian assets. That being said, the high government debt, while concerning, is predominantly domestically held and denominated in local currency. This potentially reduces the risk of capital flight by foreign investors – a typical trigger for economic crises in Emerging Markets.

Brazil’s fiscal challenges are also not new. In fact, over the past two decades the country has oscillated between periods of fiscal discipline and deterioration. The potential for positive change exists, particularly as we look towards the 2026 Brazilian presidential election and the possibility of a shift in political dynamics.

Moreover, while the macroeconomic dance may seem out of step, the individual performers in the portfolio are hitting their marks with precision.

Written by Baillie Gifford's Emerging Markets team.

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This communication was produced and approved in November 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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