By HENRY H. MCVEY May 08, 2012

Brazil’s rise as an important and largely self-sufficient economic power has been impressive. As we look forward, positive demographic and income generation trends should further benefit businesses providing consumer goods, healthcare, logistics and credit services to the Brazilian market. However, the trajectory of Brazil’s growth is still uncertain, and it will depend on the thoughtfulness of the country’s macroeconomic, social and regulatory policies. Without question, we believe these factors will play a crucial role in shaping Brazil’s competitive standing, economic strength and attractiveness to foreign investors. Here we discuss Brazil’s path towards progress, detail areas of opportunity to consider, and offer our perspectives on what investors should heed when entering the country in the years ahead.

While I’ve had the good fortune of spending a lot of time traveling throughout Asia in recent years, my visits to Latin America have been less frequent. So, a few weeks ago, I decided to follow former President Lula’s advice, brave another visit to Brazil, and “rediscover” the country firsthand along with a few of my KKR colleagues , many of whom have been active in the region for some time. I returned with no shortage of touristic anecdotes: waking up to an exquisite cup of local coffee; using Portuguese translators to communicate with locals and better understand their consumer-shopping patterns; and paying a hefty $20 for an appetizer-sized salad—a reflection of Brazil’s strong currency.

There is certainly a lot to digest when visiting any Latin American country, but in my view, Brazil is particularly complex as it is an amalgamation of some of the most compelling and most challenging macro trends in the global economy. To this end, I took some time during and after my recent visit to flush out some key macro insights that I think are worthy of investors’ attention. They are as follows:

GDP Growth per Capita Appears Likely to Continue at its Torrid Pace, Driving Further Consumption. My trip to Brazil reminded me a lot of my earlier visits to China, during which I observed a visible rise in the population’s living standards from one visit to the next. Nominal GDP per capita in Brazil has already quadrupled since 2003 to $12,800,1 but our discussions with leading policy makers, business leaders, and our own analysis lead us to believe that, with low unemployment and reasonable GDP growth over the next few years, this ratio could jump an additional 50% in the next six years. Consistent with this view, consumption patterns among the emerging middle class and the middle-to-upper class are literally booming. In our view, such strong positive socio-economic trends are an important macro investment tailwinds and suggest there is still ample opportunity for growth in the burgeoning retail, auto, healthcare, credit-related, and logistics businesses in Brazil.

Size Matters; Youth Does Too. With an annual GDP of $2.5 trillion, Brazil is the world’s sixth largest economy,2 surpassing even Great Britain. It also has a large and growing middle class that now accounts for over 50% of its nearly 200 million citizens, up sharply from 40% just before the turn of the twenty-first century.3 In addition to rising incomes, Brazil has compelling demographic prospects for the near term, with 51% of its citizens under 30 years old.4 As this demographic matures and enters financial independence, wealth creation and broad-based spending is expected to follow. However, Brazilians already consume 30% more in absolute monetary value than the population of India, despite being less than one-fifth of India’s population size.5 And, as we discuss later in the note, after lagging behind the developed world in education for many years, Brazil’s younger generation is becoming more educated, which historically tends to correlate with greater material and service needs in most economies.

Natural Resources Have Been an Important Tailwind. As somewhat of a back-door play on China, Brazil is rich in natural resources: It has a strong supply of hard and soft commodities including iron ore, sugar, cocoa, coffee, beef and soybeans. Over the past year, 17% of its exports went to China, which we expect to account for 30–40% of global GDP growth over the next five years6. Beyond the benefit of its prominent trade partner in Asia, Brazil’s abundance of commodities also allows it to be one of the more self-sufficient emerging markets, with an ability to ride out economic downturns and geopolitical events stronger than many of its peers, in our view. Further, our analysis shows that Brazil appears less dependent on China for growth than many similar commodity-rich countries, such as Australia and Canada.

Lower Rates Are a Positive Development. After spending much of my time in developed markets, where ZIRP (zero interest rate policy) and QE (quantitative easing) are the acronyms du jour, it was refreshing to visit a place in which real and nominal rates are 3.8% and 9.0%, respectively.7 These are high rates for today’s low-growth environment for global GDP and a far cry from Brazil’s hyper inflation rates of about 5000% during the 1990s. That said, we believe lower rates are an important positive for many reasons, including accessibility to mortgages in order to finance home purchases. At the moment, mortgage debt as a percentage of GDP is just 4.8% in Brazil versus 9.7% in Mexico and 89.4% in the United States.8 If inflation remains under control and underwriting standards remain firm (and during our visit we saw no signs of speculative housing-related lending), the trend towards increased mortgages should improve and extend the consumer story further in Brazil over the next 5-10 years.

However, Brazil Faces Competitive Challenges. With its high corporate tax rates, rising wages and strong currency, Brazil may face strong macro headwinds if it attempts to export anything beyond commodities. The country sports one of the lowest export-to-GDP ratios in Latin America, and our analysis shows that nearly 88% of the increase in exports in recent years has been from price increases (largely commodity-driven), not export volume.9 Meanwhile, corporate tax rates in Brazil are about 34%, notably above its emerging-market peers and eclipsed only by the United States (40%) and Japan (41%).10 According to the World Bank, Brazil ranked last of 181 countries on tax efficiency, making it the most complicated and cumbersome tax destination in the world.11 Unless changes are made to its tax system, we believe the government’s current preference for high taxes and sizeable social programs will prevent GDP growth from reaching its full potential.

And There is a Need for More Infrastructure. In our view, Brazil needs to invest much more in infrastructure so that it can reduce physical obstacles to reaching higher productivity and efficiency and alleviate cyclical inflationary pressures. Fixed investment, which we view as a proxy for infrastructure, is just 20% of GDP versus 48% in China.12 But you do not need to be a macro person to know that Brazil needs infrastructure. One just needs to spend a few hours in traffic getting from the airport to one’s hotel in a city like San Paulo and/or lose cell phone coverage 4-6x along the way to appreciate the level of under-investment. Get outside the major urban areas, and infrastructure needs in the rail, road, and logistics area become even more apparent. Without question, we view improvements in “supply” areas, including infrastructure and innovation, as necessary steps towards allowing Brazil to actually drive its GDP above 3.5-4.5% on a sustained basis. However, to do this in a balanced manner, we believe internal savings in Brazil must go up, and there is little indication that this is going to happen in the near term.

And A Greater Focus on Longer-Term Thoughtful Macro Policies. In recent months the government has once again been pursuing a lower nominal exchange rate via intervention and lower interest rates. In addition, during our visit in April, the government announced another round of selective tariffs on imports to protect local businesses in 15–20 industries13. In our view, these types of macro policies appear to offer only short-term benefits and could actually be harmful in the longer run. Our conversations with everyone, from pedestrians to leading policymakers, lead us to believe that the country’s macro policies are still focused on stoking demand, which we view as yesterday’s battle. Supply and competitiveness are today’s real impediments to growth and what truly need to be addressed, in our view. And if the goal is to lower the currency to more competitive levels, long-term policies that lower inflation and increase savings are required. Our visit also left us wondering whether the government’s emergency playbook to stimulate growth during the Great Recession—dispensing significant subsidies and easing its public banks’ lending policies, among other measures—has become the norm under the administration of President Dilma Rousseff. Looking ahead, we think that more private savings, more fixed asset investment, and less government intervention (or at least more directed towards infrastructure) are necessary to create a more balanced and sustainable economy.

Looking at the big picture, our target asset allocation continues to favor overweight positions across all emerging markets, including Brazil and its Latin American counterparts. Nominal growth is hard to find these days, and countries like Chile, Columbia, and Brazil, with their thriving middle classes, are likely to be solid growth performers over the next 5–7 years, in our view. Brazil also has the economic tailwinds of the World Cup and the Olympics, two events that are likely to raise infrastructure spending (including some much needed private involvement), consumer spending and tourism levels in the near future.

However, as we detail below, we are not convinced that the traditional public equity markets are the most beneficial way to gain exposure to Brazil right now. We believe debt, infrastructure, macro, and private equity all appear more compelling if executed properly with the right managers. Regardless of the investment vehicle chosen, investors may need to heed the price of entry: Using public equities as a proxy for risk assets, and as Exhibit 1 shows, valuations do not appear cheap at current levels, so we suggest patience and a long-term focus.

But over time we want exposure to this market. In our view, Brazil has a unique growth profile that is better prepared than most for a Phase III14 environment. Its economy has rebounded from the Great Recession with more vigor than essentially every other country except China and India (Exhibit 3). Its strong population dynamics and shifting socioeconomic landscape we believe make it a prime candidate for sustained GDP growth in the 3.5%–4.5% range in the quarters ahead. Although our forecast is below the government’s stated goal of 4.5%, Brazil may offer more growth potential over the next few years than all but of a few of the turbo-charged emerging market economies.

However, we believe there are two considerations about Brazil that should be factored into any investor’s return profile. First, it is not one homogenous territory but five disparate regions that vary by terrain, education levels, their populations’ occupations, socio-demographic profiles and cultural orientations. As a result, investment opportunities and return potential can vary greatly throughout the country. Second, some argue that Brazil’s government should do even more during the current period of outsized prosperity to prepare for the future—a time when the positive effect of current demographic trends ebbs and the commodity boom recedes. A long-term opportunity may be missed if Brazil doesn’t sufficiently promote savings, improve competitiveness, and heighten productivity. At worst, Brazil might also lose a serious competitive edge vis-à-vis its emerging-market peers if the latter continue to bolster their economies and invest in making them more resilient in the long run.

Better Understanding the Macro Backdrop in Brazil

There are many reasons to go to Brazil: Its beef, coffee, beaches, chocolate, and soccer (yes, the mighty Edson Arantes do Nascimento, or “Pele” is from Brazil) are all legendary. Regrettably, it is also known for its legendarily poor infrastructure. Unlike China, which spends 48% of GDP on infrastructure investment, Brazil spends just 20%—not enough to support a rapidly rising middle class. By comparison, private consumption makes up nearly 60% of GDP compared to just 35% in China. These stark compositional differences have earned Brazil the nickname “upside-down China” (Exhibit 5).

Any conversation surrounding the macro environment in Brazil also quickly leads to the fact that this economy is being driven by huge government spending (21% of GDP) and high corporate taxes, which are among the highest in world (see Exhibit 6). Against strong economic growth, we believe this combination of high taxes and heavy government spending has been a boon for Brazil’s lower and middle class, which have benefitted handsomely from government subsidies/payouts.

And despite Brazil’s reputation as chiefly a commodity exporter, its economy is actually heavily skewed toward services, which account for about 57% of the economy, whereas just 24% of GDP is now attributable to industry—down 1000 basis points since 1994. We link the substantial decline in manufacturing to higher wages, currency headwinds, and uncompetitive corporate tax rates (Exhibit 7). Additionally, public administration accounts for almost a quarter of all services provided (Exhibit 8).

Given its strong growth profile, Brazil enjoys a primary surplus of around 2–3%, on average, each year (Exhibit 9). Total government revenues in 2011 were roughly BRL 990 billion, of which BRL 172 billion were collected by state and local government; BRL 179 billion were spent on government payroll; BRL 281 billion were reserved for social security; BRL 203 billion were spent on such government services as health care and education; and capital expenditures reached BRL 55 billion. Even with heavy spending on social programs, Brazil is still left with a primary surplus of BRL 94 billion—but its primary surplus turns into a deficit after interest expenses are included (Exhibit 10).

We believe Brazil is unique among emerging markets in having incurred both fiscal and current-account deficits. It has used its government debt to fund heavy commitments to better social equality, and as a result, its debt-to-GDP ratio now stands at 66%, versus 44% for Mexico, 35% for Columbia, and 10% for Chile.15 In 2011 it ran a current-account deficit of 2.1%, though it had a trade surplus of 1.2% of GDP16. As Exhibit 11 illustrates, the positive trade balance of goods is more than offset by services outflows (largely travel services boosted by the strong exchange rates) and net income outflows of dividends and profit remittances.

Given its current growth clip and interest-rate profile, it does not face any difficulty financing its deficits. In fact, Brazil has been a major beneficiary of direct investment flows versus shorter-term and often more speculative portfolio flows (Exhibit 12). Last year, direct investment flows in Brazil were exceptionally high, at US$68 billion, compared to an average of US$20 billion between 1996 and 2010.

Brazil remains one of the few places in the world with high real and nominal rates (Exhibit 13)—a common feature of countries with historically high inflation rates, a concentrated bank sector, and heavy government involvement in the economy. Yet to no surprise, with near-zero real rates in mature markets like Europe and the United States, capital continues to flow aggressively into a country with real rates of 3.8% (Exhibit 14), an inflation rate of 5.2%, and nominal rates of 9%. While these flows can be supportive of a country like Brazil with fiscal and current-account deficits, it can often put upward pressure on the currency, which can adversely affect competitiveness in trade. In the near-term, we think that the currency is likely to be a major headwind. Real rates in Brazil are so much higher than in the developed world, and any temporary weakness in the Real is likely to be met with strong buying, we believe. Over time, however, if and when rates fall further, we think that the currency could become more competitive.

Because of the unintended consequences linked to non-traditional macro policies, our work leads us to believe that an appropriate range for real-GDP expectations would be 3.5–4.5%—not the government’s stated target of 4.5%—and that inflation is likely to range between 4.5%–6.5%, not the government’s target of 2.5%–6.5%. But will Brazil’s macro policies, which may likely cause GDP to grow below its full potential, diminish the country’s investment appeal? Our answer is no. Current macro-economic policies in Brazil could be improved, but — even in spite of current polices — it would be hard for investors in Brazil not to enjoy many of the significant benefits that a rising middle class and rich natural resource reserves should bring to its domestic economy over the next 5-7 years.

Favorable Demographics and a Rising Middle Class Are Strong Tailwinds

My last trip to Brazil was in the depths of the 2008 global recession, so it was notable how much more upbeat, in the spring of 2012, the Brazilian locals with whom we spoke feel about the future — and with good reason. Unlike many other countries, Brazil did not sustain a major setback during the Great Recession. Moreover, it recently enacted government policies, including stimulating domestic credit provisioning, to aid the emerging middle class and the upper middle class, and these initiatives are clearly yielding impressive near-term results. People literally feel energized about their ability to have a better life for themselves and their kids, and in our view they are reflecting this optimism by buying things that are able to help further improve the quality of their life. This includes cars, magazines, washers & dryers, beauty products, and basic consumables.

Though Brazil is not as large as China or India, we believe the country’s consumption trends in absolute dollars are already compelling. Brazil’s population is much smaller than India’s (Exhibit 15), yet private consumption is already 30% larger (Exhibit 16). Throughout the 1990s and 2000s, consumption grew in real terms at 2.9% and 4.3%, respectively, outpacing real GDP growth of 2.5% and 3.8%, respectively.17 Looking ahead, we expect a similar clip of real consumption outpacing our real GDP forecast of around 3.5–4.5% over the next 3–5 years.

What businesses are benefiting from rising Brazilian consumption? Our work shows global companies with familiar brands such as McDonalds, Nestle, Unilever, Avon, Coca-Cola, Kraft, Johnson & Johnson and Samsung are enjoying unprecedented demand for their products in Brazil. But local Brazilian companies in the retail, healthcare, financial services, and auto industries are also seeing strong growth in their business. Driving this trend is a young, vibrant generation of Brazilian consumers located not just in metropolitan hubs like San Paulo and Rio, but also in their outskirts, in our view.

Besides these demographic tailwinds powering consumption and economic growth, Brazil’s population is undergoing a major shift in composition following aggressive social policies by the government in recent years that have lifted millions out of poverty and ignited upward class mobility. For example, the Bolsa Familia program,18 introduced in 2003, has provided financial aid to poor families; and the Minha Casa, Minha Vida (“my house, my life”) social housing policy, enacted in 2009, has provided affordable loans to many low-income families throughout the country.19

These social programs may have helped reduce extreme poverty levels from 9.3% in 2001 to 3.3% of the population in 2009,20 and today we estimate that the poverty rate is even lower than 3%. Annual GDP per capita has surged from $3,042 in 2003 to $12,789 in 2011 (Exhibit 20). This four-fold increase is one of Brazil’s greatest since its annualized growth rate of 24% between 1973 and 1976, and in line with China’s current productivity growth.21

Income groups in Brazil are classified in five categories (Exhibit 22), from Class A (the highest income) to E (the lowest). The largest shift has occurred in the growth of the middle-income (or Class C) population, now earning an annual household income of R$1,126–4,854. Between 2003 and 2009, Class C gained 30 million Brazilians from Classes D and E, making it the biggest segment of the total population, at 50%. We believe this newly expanded Class C, which is 95 million strong and with estimated purchasing power greater than Class A and B combined,22 is bringing change not just to the social fabric and political sway of the country’s citizens, but also in fashion and food consumption.

Our analysis shows that this population segment is poised to continue growing over the next two decades—a prediction that applies to other Latin American countries as well. According to the latest OECD estimates, the middle class population in Central and South America will grow 1.7 times over the next two decades from 181 million to 313 million (Exhibit 23); spending will double from $1.5 trillion to $3.1 trillion; and demand will rise for consumer products, healthcare (Exhibit 24), and we think financial services. Companies that can customize their products to cater to local needs and maintain competitive pricing stand to benefit the most.

In our view, parts of the population of Brazil and its Latin American neighbors are still in the process of becoming acquainted with—and acquiring—basic consumer goods and services, including Internet access, healthcare services, beauty and luxury products, electronics and leisure goods. There is also significant momentum in the consumption of more durable goods, including autos and home appliances (Exhibit 25).

What does this mean for investors? We expect more initial public offerings, increased private investments, and a deeper lending market as companies seek capital to grow their businesses. We also think greater private infrastructure will also be required to accommodate growth in consumerism, travel and communication.

We anticipate more and bigger merger-and-acquisition (M&A) transactions as industries consolidate, and although there are mega players (such as Vale and Petrobras) in the commodity area, our work shows the consumer staples and healthcare industries are still very fragmented. We foresee the debt markets offering new opportunities for global investors as more local- and dollar-denominated debt is issued, offering exposure to strong growth trends, reasonable balance sheets and attractive relative yields (even when adjusted for foreign penalty taxes, in many instances).

Brazilian Urbanization: An Interesting Dichotomy

During our visits to emerging markets, we spend a fair amount of time analyzing their populations’ urbanization rates as key metrics, and have usually found that urbanization leads to an increase in a country’s GDP per capita. But in Brazil we found an anomaly: Urbanization has surged—yet GDP per capita has not. Brazil’s urban population in 2010 was nine times its size in 1950 (Exhibit 26), having grown at 2.4 times the rate of the country’s overall population growth.23 However, until recently, GDP per capita has failed to appreciate commensurately with the urbanization rate (Exhibit 27), and much of the latest improvement appears to have been driven by government handouts.

We believe there are many theories of why this has occurred, but we focus on three. First, the size of Brazil’s shadow economy—the underground markets involving goods and services that are paid for in cash and not declared for tax—is substantial and accounts for more than a third of the total economy, according to the World Bank (Exhibit 28). Generally, the loss of business to the shadow economy reduces tax revenues and other gains from official business that can lead to more investments in productive technology and infrastructure. Second, productivity in Brazil has greatly lagged behind its peers (Exhibit 29), resulting in smaller increases in GDP per capita. And finally, in our view, Brazil’s long-held focus on commodity production has diverted important resources away from industrial manufacturing, technology and investment in logistical capabilities.

We believe Brazil also needs to raise its population’s education in order to improve human capital, particularly among the emerging middle class. According to the United Nations Educational, Scientific and Cultural Organization (UNESCO), Brazil spent 5.4% of GDP on education in 2008—one of the highest among emerging markets, but the return on investment has been low, with adult illiteracy still at 10% (Exhibit 31).

We link this outcome to ineffective education spending: Too many funds are diverted to high-end universities and advanced education, which seems odd, given that only 25.9% of the population has completed secondary school.24 As a result, while the emerging middle class has enjoyed an increase in wages, it has not yet enjoyed a proportionate advancement in the education needed to progress or maintain its socioeconomic status (Exhibit 31).

The good news is that, with Brazil’s current administration aiming to achieve a national literacy rate of 100%, more recent education budgets have allowed for increased spending on primary and secondary education. Public expenditures on secondary school education per pupil have already more than doubled between 2004 and 2008 (Exhibit 32), and there is now more attention being paid by this administration to attract and retain better teachers through higher compensation and by incorporating learning technology into the classroom.

Since private financing is the main hurdle to tertiary education, the government introduced a revamped student lending program (FEIS) in 2010 in order to facilitate higher-education access to a growing number of students completing secondary school. Further, the Bolsa Familia program is designed to encourage scholastic achievement by denying financial aid to low-income families whose children do not achieve a school-attendance rate of 85%25.

Our broad conclusion is that while Brazil’s government has helped pull millions out of poverty and achieve higher literacy rates through new education programs, there is still much to do for Brazil to catch up with the likes of China and India. Specifically, we believe it should do more to encourage savings and vocational training, and ultimately empower its expanding middle class to become more economically productive, socioeconomically established and less dependent on government assistance. The current administration certainly understands that education is a long-term agent of change, and as such, we expect an increasing amount of resources to be dedicated to this area of social need in the coming quarters.

Natural Resources: An Important Tailwind

Brazil is large, populous and influential, boasting the fifth largest sovereign landmass in the world and a wealth of natural resources to match. It is the world’s largest producer of sugar, oranges, orange juice, and coffee, and second largest of soybean oil, cattle, beef, and veal (Exhibit 33). We believe its rich resources are especially advantageous given excess government liquidity and rising geopolitical tensions around the world.

Brazil’s export growth over the past five years has been driven largely by price increases—not volume. In 2011, 87% of export growth was linked to higher prices—particularly of commodities. Volume growth accounted for only 2.9% of the 26.8% year-over-year growth (Exhibit 34). We also find it surprising that, as a commodity-exporting country, Brazil’s gross exports are only 10% of GDP26. By comparison, gross exports for Chile, Mexico, and Peru are 35%, 29%, and 23% of GDP, respectively27.

Not surprisingly, in our view, Brazil’s export economy is largely linked to China and fueled by the latter’s growth. In fact, exports to the United States have fallen to a 10% share of all exports in 2011, down from 22% in 2000, while China has increased its share of exports to Brazil to 17%, up from 2% during the same period (Exhibits 35 and 36). Brazil’s key export to China has been iron ore, which now accounts for approximately 45% of all exports from Brazil to China. Soybeans, too, have seen explosive growth and now account for more than 25% of total exports from Brazil to China.

Where are we headed from here? Given that China is expected to account for 33% of total incremental global GDP growth during the 2010-2016E period28, we believe Brazil’s wealth of natural resources should play to its advantage. In addition to iron ore and soybeans, Brazil’s oil production is poised to rise sharply and could even double by 2015 if recent offshore discoveries yield solid results.

Interestingly, despite all the fear of a hard landing from folks when I am in Europe, the USA, and Asia, both policy makers and corporate executives in Brazil do not seem too concerned about a Chinese hard landing. We concur with this view, but we did take the time to analyze the beta between China and Brazil to make sure we were not misreading the situation. As we detail in Exhibit 37, Brazil actually appears less vulnerable than many of the other commodity countries, such as Australia and Canada.

Banking, Rates, and Lending: Focus on the Mortgage

As someone who has covered the stocks of financial institutions for many years, I’ve always placed a heavy emphasis on the financial “plumbing” that is expected to facilitate growth in any economy. So, when retailers in San Paulo told me they thought that extending more credit to Brazil’s rising middle class would be instrumental to business growth, I cringed. Then I realized that consumer credit in Brazil does not appear to be in perilous territory after all: Unemployment is near multi-year lows, income is rising, and labor participation rates are high amid decelerating population growth (Exhibits 38 and 39), which is making it harder for companies to find qualified workers at low wages. This has been a boon for wages, which have been rising at an annual rate of 10–14% in many sectors29.

Meanwhile, amid rising house prices (which have doubled over the last two years), the duration of credit is being extended from 1.5 years to 10 years or more, as locals shift from consumer credit towards mortgage credit to fund their recent home purchases. If rates remain at about 10%, our work shows that Brazil should end up with longer-duration credit backed by tangible, hard assets and less restrictive financing levels. There appears to be a lot of opportunity as mortgage penetration is one of the areas in which credit penetration is still low. Mortgages accounted for just 4.8% of GDP in 2011 (compared to 9.7% in Mexico, 15.4% in China, and 89.4% in the United States30) and are expected to reach 10.5% by 2020 (Exhibit 40). A key element to this increased penetration will be that, given the dramatic rise in wages in recent years, there are approximately 15–20 million new home buyers who are expected to enter the market over the next five years or so, according to Itau, a leading Brazilian bank.

Another positive for Brazil’s financial services sector is that Brazilian banks are well-capitalized. The country’s central bank requires conservative capital ratios of at least 11%, or 3% above Basel requirements (Exhibit 43). The banking sector is also highly concentrated: as detailed in Exhibit 42, Brazil’s five largest banks control 76% of total deposits while Banco do Brasil, Itau, Bradesco, BNDES, and Caixa Economics Federal control 69% of the loan market.

The bad news is that heavy government intervention—the kind found in Brazil—typically leads to uneven credit prices, particularly on the corporate side. Brazil’s Tesouro Nacional—the country’s federal treasury—owns significant stakes in three banks: 59% in Banco de Brasil, 100% in Caixa Economic Federal (which controls 76% of mortgage lending), and 100% in BNDES, a government development bank committed to providing funding for infrastructure—three institutions with more than a 40% share of Brazil’s entire credit market.31

Another aspect of Brazil’s financial sector concerns small and medium-size banks. While data are hard to come by, we’ve learned that delinquencies and defaults in this part of the corporate lending market were up sharply in recent months, we believe partly because small companies now face larger competitors in consolidating sectors, and partly because of credit absorption by small and medium enterprises in recent quarters.

Credit growth in Brazil has been robust (Exhibit 46), running at an average rate of 22.2% since 2005, and total credit as a percent of GDP has now reached 48.8% of GDP versus 24.2% in March 2004. This increase is linked to earmarked credit expansion by the Brazilian development bank BNDES,32 and an increase in loans related to housing construction and ownership. Non-housing consumer credit had been running at high levels in recent years, and it now appears poised to subside (Exhibit 47).

Looking ahead, we think that credit growth is poised to slow, which should dampen GDP growth trends in the near term. Our base case is that consumer credit growth will moderate toward the mid-teens. We also expect heavy government involvement in the economy—particularly that of the BNDES—to continue as Brazil focuses heavily on its infrastructure investment before the World Cup series in 2014 and the Olympic Games in 2016. On the consumer side, our view is that the growth in mortgage debt remains elevated but will moderate to an annual 30–40% from its high of 54% in November 2010, while other non-mortgage consumer debt will grow at a rate of 10–15%, down from its growth clip of 14–19% over the last two years.33

Overall, we think that Brazil’s banking sector is in healthy shape and in a competitive position relative to such markets as China, which is dominated by state-run banks. And while mortgage lending may be a lower-margin business than short-term consumer loans, it is typically a steadier one over time and certainly more conducive to long-term economic growth. Beyond traditional lending, we think that M&A, asset management and the insurance industry are also likely to see significant growth. We also believe there is an opportunity for foreigners to share some of their operating and technology expertise with local Brazilian financial services to help them better realize their growth potential.

Public Markets May Not Provide the Optimal Exposure to Brazil

Our view is that the public equity market in Brazil may not be the most beneficial way to gain exposure to local investment opportunities, much like the view we’ve expressed on China, and for similar reasons. Local equity indices of emerging markets are not yet broad and representative enough of the opportunity set—and are heavily tilted toward specific industries (Exhibits 48 and 49). For example, the top 10 stocks on the Bovespa index (consisting of Brazil’s largest companies), which account for almost 50% of the index, include just one consumer-products company.34 The rest are large financials companies, as well as energy and material providers.

Moreover, many top stocks in Brazil have emerged as “national champions” with cozy government relationships—a potential detriment to shareholders, who might be exposed to unfriendly business practices. In pursuit of investment opportunities, we favor active equity managers with focused strategies who follow private or semi-private opportunities that exploit the local trends we mentioned earlier, which have the potential to offer strong returns over time. Given the macro trends at play in Brazil, we also find macro strategies appealing and were fortunate to meet with several local macro managers who have delivered attractive annual returns in recent years.

The year 2012 has been a good one for Brazil’s stock market. After declining by 18.1% in 2011, the Bovespa is up 9.2% year-to-date through April 2012 and now trades at 11.5 times one-year forward estimates, compared to a historical average of 8.7 times since 2001.35 Ex the two largest constituents, the index trades even higher, at 14 times, which seems quite lofty to us. Driving valuations upward are the consumer and industrially related sectors (Exhibit 50), which are trading at 18–20 times forward earnings. As a result, such sectors as process industries (such as chemical process and manufacturing, textiles, agricultural commodities and milling) and non-durable consumer goods are 39% and 24% above their historical averages,36 respectively.

There is also strong investor interest in private equity in Brazil (Exhibit 51), Chile, Columbia, and Peru. Private-equity penetration remains small in Brazil relative to other markets (Exhibit 52), but there are significant challenges to deal-making in Brazil: Those unfamiliar with the country’s macroeconomic backdrop, industry profiles and potential business partners may find it difficult to select the most appropriate industry and optimally time their entry into and exit out of positions.

Looking ahead, we expect more foreign capital to flow into Brazil’s markets, including its debt, public equity and private equity markets. Brazil’s growth is higher than many of its peers and its interest rates are strong relative to low-rate markets37. And although Brazil has its share of macro challenges, it is beginning to look far more appealing than formerly high-flying markets like India.

As the market develops, we think that there will be two factors on which to focus: inflation and government policy towards foreign business. On the inflation front, we are not arguing it actually needs to come down materially from 6-6.5%, which is the high end of the current government range. What we are saying is that it can’t go much higher than current levels on a sustained basis. Otherwise, the perceived cost of capital and the risk to value destruction through inflationary pressures both become too high for investors to ignore, in our view.

Lastly, we expect the Brazilian government to continue embracing policies that support “national champions”—essentially a select group of large, successful businesses—in the corporate sector. The same applies to almost any emerging market we visit—and we accept that. But what we wouldn’t want happening in Brazil is what is now unfolding in places like Argentina, where governments capriciously alter laws and regulations in sectors receiving foreign private capital—much to the disadvantage of investors. We don’t foresee such a scenario playing out in Brazil, but we suggest investors in Brazil should monitor government policies carefully and continually.

Summary

One of my lasting impressions from my recent visit to Brazil is the frustration that some local investors and business executives feel about the country not progressing fast enough, or about the government not doing enough to spearhead further reform. But as someone who visits numerous different emerging markets each year, I’ll take the liberty of putting those frustrations into perspective. Consider that from 1980 to 1994, Brazil had 5 presidents, 15 finance ministers, 14 central-bank governors, 6 currencies, and an average annual inflation of 730%38. By comparison, from 1995 to 2010, Brazil had 2 presidents, 3 finance ministers, 5 central-bank governors, one currency, and an average inflation rate of 7%. So, while Brazil is not moving forward as fast as many locals had hoped, it is moving forward indeed; progress is being made; and the opportunity set remains Interesting.

Moreover, we believe Brazil is moving forward whereas much of the rest of the world has stalled or is even going backwards—a fact that explains massive foreign capital flows into Brazil to take advantage of its high interest-rate environment and strong currency.

What this means is that Brazil’s policymakers—and investors—need to pay particular attention to macroeconomic policy—more so than in the past few years—in spite of the significant progress the country has made over the last two decades. The rise of Brazil’s middle class is among the strongest macro tailwinds we see in the global economy these days, and it should help to power growth in the years ahead. Additionally, in a world in which natural resources are becoming scarcer by the day, our research shows that Brazil possesses plenty—and also stands a chance to raise its annual oil production by 50–100% by 2020 if its energy-exploration endeavors yield fruitful results.

Against such a positive backdrop, the question is not whether the country will grow and its people prosper. Rather, it is by how much. Former President Lula da Silva had it right when he said that even back in 2003, “Brazil has rediscovered itself, and this rediscovery is being expressed in its people’s enthusiasm and their desire to mobilize to face the huge problems that lie ahead of us.” The good news is that many of the social problems that previously plagued the country have now abated. It is now up to Brazil’s government to think forward when shaping its macroeconomic policies and create an environment that allows the country to achieve its full potential in the years ahead.