Vila Nova Monthly Spotlight

‘Politics is like football; if you see daylight, go through the hole’
- John F. Kennedy

In this month’s Spotlight, which is the first of a two part report concentrating on Brazil, we take a brief look at the
background, and outlook, for the interest rate cycle in Brazil, during a year widely expected to be challenging, at
least from a macroeconomic perspective, rather than potential footballing success at the World Cup.

As a brief background, interest rates in Brazil have been rising since April 2013, but more recently the decision to
hike rates further has become more difficult due to the economic backdrop which has seen the economy slow with
GDP growth falling below 2% per year. Benchmark rates, after the most recent rise of 50bps, now stand at 10.5%,
the highest in 2 years after seven consecutive rate rises by the central bank.

Brazil Economy: Interest rates, Inflation trends and GDP growth (2001-Present)

Source: Bloomberg

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We see Brazil facing a tough political and fiscal conundrum in the coming year, with a weaker currency and more
modest economic growth being unfortunately combined with the adverse effects of an inflation rate which has
been at the top end or higher than the 4.5% (+2% tolerance) targeted by the central bank.

Why the rate rises?
Primarily for Brazil, the country has been battling a war against inflation, with December 2013 figures rising by
0.92% in just one month, which is the highest figure since April 2003, and giving a year on year rise of 5.91%, far
above the consensus expectations of 4.5% for the year, and ahead of expectations made by the Brazilian Central
Bank Governor, Alexandre Tombini. Drilling down into the figures, we also note that when looking at Services based
inflation, although unchanged year on year, is currently running at close to 8.7%, enough to cause serious concern
for central bankers and politicians alike.

Secondly, the Brazilian currency has depreciated against the Dollar over the past year with more money flows out
of the country than at any-time since 2002, which has significantly increased the cost of imports, coupled with a
global environment of higher commodity prices which has also not been beneficial for input cost inflation.
Additionally, recent moves by the US Federal Reserve to scale back its bond-buying program have added to
pressure on many emerging market currencies, including the Brazilian Real. This scaling back of quantitative easing
in the US will most likely persist in 2014, putting a continued pressure on these emerging market currencies,
increasing the cost of imports and adding to inflationary pressures in countries.

More related to the inflationary problem, is the other major political based problem being faced in Brazil, notably
Brazil’s increasingly bloated levels of public spending, which is putting further pressure on prices across the
country. In absolute numbers, the budget gap for instance reached R$157.6bn at the end of 2013, the highest level
seen since 2002. We see an urgent need by the government to address this fiscal deficit in order to protect further
risks to the state of the nation’s balance sheet, which has recently been placed on negative watch by Standard &
Poor’s. Despite this need for urgent budgetary reform, we take a sceptical view that any real progress will be made
this year, particularly as never in an election year for Brazil has there been any notable cutbacks in public spending.
Rather, we would look to a post-election delivery of promises for any meaningful change, but are not holding our

Separately to the main issues mentioned, we do not share the view that external factors such as droughts are
pushing up food prices to unsustainable levels, as these are issues facing many other nations with much lower and
stable levels of inflation, and prefer to point out the requirement for structural labour reforms across the country.
We do however acknowledge that the current economic backdrop in Brazil, whilst showing relatively modest levels
of economic growth overall, is still operating with almost zero levels of unemployment in many cities and sectors,
pushing up prices, and increasing demand for goods and services. Should there be labour market reform and a shift
in unemployment higher, this could have more damaging effects on the domestic economy.

The threat of inflation
‘Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man’- Ronald Reagan
Inflation is a worry for many parts of the economy and has to be controlled as much as possible, and in that respect
we commend the central bank in its most recent surprise 50bps (versus an expected 25bps) rate hike.

All spectrums of society can be affected by this inflationary threat and the subsequent higher interest rates
imposed by central banks to curb the problem. Lower income consumers, with more limited disposable incomes,
begin to struggle to pay for the increased prices of daily staples, including food, utility bills and public transport
costs, whilst higher earning middle class, who have taken on more debt in recent years when credit availability
rapidly loosened, are now having to deal with higher debt servicing costs for depreciable assets such as cars and
personal finance.

In terms of anecdotal evidence, one only needs to look at the social effects through protest by over a million
people towards rising bus prices in Brazil in 2013, to see how the population is unwilling to accept further pressure
on their wallet, and in many respects the population are signaling to the politicians that enough is enough.
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From an economic and investment standpoint, one of the easiest ways to measure this effect is to look at
consumer confidence across the country, and in recent months this has not painted a bright picture, and a similar
situation is seen with Industrial confidence by corporates.

Industrial Confidence in Brazil (2010 to present): Increasingly unhappy corporates

Source: Bloomberg

What are the other levers available to Governments?
Aside from the headline interest rate hikes, Brazil has tried over the last year to keep down prices as much as
possible, utilising as many policy measures as it can think of. A few such active examples include the reversal of the
public transport price rises in Brazil, as a response to social unrest in mid 2013; the decision to drop fuel duty to
zero; and the reduction of utility bills by state owned operators.

The difficulty facing Brazil is that these additional levers are limited and cannot be sustained longer term. During an
election year when interest rates are almost unchanged over 4 years, and inflation still a problem, this will be a
salient topic of conversation for competing politicians in the run up to voting time.

Where next for rates and inflation?
Market expectations are for one further rate rise towards 10.75% at the next meeting in February, but this still is
subject to a large degree of uncertainty, and should inflation rates seasonally decrease in February, we see the
possibility for the central bank to maintain the current 10.5% levels. Nevertheless, there seems no chance of seeing
single digit interest rates which were promised by current president Dilma Rousseff in the foreseeable future.

In terms of the continued threat of inflation in the country, central bank estimates look for 6% inflation towards
2016, which we see providing the possibility of closer to 12% for the benchmark Brazilian interest rates should
there be upside pressure to consumer prices. Supporting this theory is our view that for policy action, the central
bank will quite rightly continue to concentrate on tackling inflation head on, raising rates where necessary, and
prioritising this over the threat of lower economic growth. We see the possibility for rates to reach 12% in 2015
should inflation continue at its current pace of close to 6%.

In terms of political shocks, any reversal of government incentives pose a further upside risk to inflation levels in
Brazil. Subsidies, regulated prices, and reduced tariffs cannot last forever, and once these are removed there must
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be some form of reversal to avoid a dislocation between balance sheets of public versus private corporations,
particularly where they compete directly, such as utility firms. Subsequently there will be a form of delayed
upwards adjustments in prices which will need to be made across many sectors.

Conclusion and some positives
Clearly we are taking a cautious view towards the macroeconomic and political backdrop for 2014, and see this
making decisions more complicated when contemplating investing in Brazil. However, in conclusion, despite these
economic headwinds in the short-term, we note some positive aspects to the investment climate in Brazil.

 Following the share price declines in 2013, valuations for many small-cap and blue-chip companies listed
on the stock market have reached levels which warrant attention. Many of these companies have long
term structural growth drivers.
 There are also a number of investment opportunities in Brazil which offer good inflation hedges, both for
certain companies listed on the stock exchange, as well as the obvious inflation hedge of investing in
appreciable assets such as real estate.
 For investors looking for income, the double digit interest rate environment continues to offer a number of
opportunities for fixed income investors, albeit for foreign investors this is also coupled with a currency
risk which needs to be managed.

Looking further forward post the election in Brazil, 2015 could also see some improvement in the macroeconomic
and corporate environment. Should this materialise, stock markets typically discount information 6 months in
advance, making the second half of 2014 a potential interesting entry point for long term investors should there be
some brighter economic data on the horizon for Brazil, either directly or through its major trading partners, or
through developed market counterparts.

Coming up….
In part two of this spotlight, next month we will be discussing the following areas of investor interest.

 The potential for further emerging market contagion, plus Chinese slowdown and implications on global
investment, particularly with respect to recent comments regarding the ‘Fragile 5’.
 For Brazil, an investigation of the problems being faced by the country in an historical context and how
lessons have or have not been learnt.
 The implications of more aggressive fed tightening, and the counter argument of a risk of global
deflationary threats.

In addition to these items, and more controversially, we will speculate on the potential positive economic impacts
should Brazil get knocked out early in the World Cup

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