During November the strategy outperformed the MSCI Emerging Markets Index by 1.7% in what was the first down-month for our markets since the start of the year. The stronger performance was driven primarily by stock selection which limited downside in the portfolio. Key contributions came from Korea and Taiwan as well as continued strong returns from precious metals miners. India, China and Brazil were all a drag on relative returns.
We have been active in Korea where volatility and interventions by the regulator created some trading opportunities and remain overweight in the market. We have also added to Indonesia and India exposure with both markets having lagged significantly this year although valuations keep us significantly underweight in the latter. Conversely, we have continued reducing exposure to Brazil and Taiwan with these markets having seen a substantial re-rating this year.
As we look ahead, we hear that investors are very positive on Brazil. Foreign investors have net bought US$5.6bn worth of stocks year-to-date, after three consecutive years of outflows. Despite returning over 50% in dollar terms this year, we are told the Brazilian market looks “cheap.” This is superficially true relative to other EMs, with a forward P/E of only 9.6x for MSCI Brazil against over 13x for the EM index. Brazilian expected dividend yields are in the high single digits. Despite this, we are more sceptical.
North of South’s investment philosophy is based around using an appropriate cost of capital, derived from local bond markets. Currently domestic bonds in Brazil yield a little under 14% while the central bank is holding yields at 15%. This makes a prospective earnings yield (the inverse of the P/E) of just over 10% a lot less attractive than elsewhere. While the market did trade at a higher P/E of 10-12x between 2016 and 2020, it was in the context of steadily declining bond yields which fell from 12% to around 7%. This was supportive of higher valuations for equities as domestic investors were searching for alternatives to fixed income.
The Brazilian equity market saw a significant derating after the post-Covid inflation and rates spike. We wrote about this in January and May 2022 when we saw the market trading on 6-8x P/E with prospects for rates to decline as post-Covid inflationary pressures dropped out. Indeed, MSCI Brazil did return 50% in US dollar terms between January 2022 and the end of 2023, even as the MSCI Emerging Markets index declined by 10%.
Perhaps with this lesson learned, the equity market has front-run a rate-cut cycle during 2025 but this leaves little upside. To support current equity valuations, interest rates need to come down a fair bit, but the Banco Central do Brasil (BCB) has yet to commence its rate cut cycle. This requires a combination of falling inflation (which has unfortunately been rising since mid-2023) and a relatively strong currency (which we have indeed seen this year). Additionally, the BCB has an eye on government fiscal discipline which has been put in question by the Lula government. Latest developments with a fracturing right-wing opposition put into question the hope of a more conservative government after next year’s presidential election too.
We agree that current rates are very high – close to 10% in real terms, and ought to eventually normalize somewhat. But Brazil has a structural problem with lack of domestic investment leading to low productivity growth. As its demographic dividend has faded, this has created an economy with low potential growth and constant threat of inflation.
Brazilians know the drill – when they have the ability to lock in 10 year interest rates at close to 14%, the equity market needs to be very inexpensive indeed to lure them back. Unsurprisingly, domestic equity funds have been seeing outflows this year. We tend to think like domestic investors, even though we are not able to buy those bonds in our equity strategies. Our preference among traditional EMs is for markets such as South Africa and Indonesia where cost of capital is declining but there has not been a corresponding re-rating.
