When she won re-election to a second term as President of Brazil on Sunday, October 26, Dilma Rousseff promised change.
Well, change is what the markets in Brazil got yesterday although it was change of a kind that surprised just about everyone. And the surprise is big enough and has enough positive long-term implications for Brazil’s finances and stocks that I will be adding the New York traded ADRs of Itau Unibanco (ITUB) to my 12-18 month Jubak’s Picks portfolio http://jubakam.com/portfolios/jubaks-picks/ tomorrow, October 31.
In the Banco Central do Brasil’s first meeting after the election, Brazil’s central bank raised its benchmark Selic interest rate by 0.25 percentage points to 11.25%. The bank had pretty much sat on its hands during the election campaign while inflation climbed well above the upper edge of the bank’s target. In-country and overseas investors and economists decried the inaction as evidence of the central bank’s lack of independence. Of course, the critics said the bank wouldn’t raise interest rates in any already slow economy when any further slowing might cost Dilma the election. Worries about the politicization of the bank rose to such a pitch that the markets had started to anticipate that Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings would move relatively quickly to downgrade the country’s debt.
A 0.25 percentage point rate increase isn’t a huge move and it certainly doesn’t restore the central bank’s reputation, but given how pessimistic financial markets had become, this surprise produced a rally in Brazilian stocks a day after they had sold off on Dilma’s victory. The iBovespa stock index climbed 2.52% in today’s session in Sao Paulo.
The positive market reaction to a move that will cost the economy growth in the short-term is extremely interesting—and is the reason that I’m buying Itau Unibanco now.
The move to raise rates, the markets believe today, is a sign that Dilma’s second term will move back toward a more orthodox policy of fighting inflation in order to restore faith in Brazil’s economy and its financial discipline. While we’ll have to wait and see how far this move toward fiscal discipline goes—it’s going to take work from Dilma to curb the appetite of the legislative arm of Workers’ Party for more spending and more subsidies—Dilma has the opportunity to send the markets a powerful signal when she appoints a new Finance Minister to replace the thoroughly discredited Guido Mantega. (“Discredited” is what happens when you predict 4% growth and deliver 1% with 6.3% inflation.)
If her choice—and this seems likely after the Banco Central do Brasil’s move—is seen as a voice for fiscal discipline, the markets will cheer. And Brazil will be likely to stave off a credit rating downgrade.
That’s the background for my pick of Itau Unibanco and the reason that I’m pulling the trigger on this pick now.
But I like Itau Unibanco as an individual stocks because the bank, the largest privately owned bank among the six banks that control about 75% of Brazil’s market, has worked hard to control costs and to prevent an erosion of loan quality during Brazil’s consumer credit boom. In the second quarter of 2014, for example, the 90-day delinquency ratio fell by 10 basis points. Net interest income in that quarter grew by 8.9% from the previous quarter as net interest margins improved by 70 basis points.
Going forward Itau Unibanco has a strong domestic and Latin American story to tell. The company is the market leader in credit cards in Brazil with 62 million accounts through its Hipercard and Itaucard brands. (In 2012 it bought the remainder of Redecard, Brazil’s second-largest credit card payment processor. That market share in credit cards would give Itau Unibanco a huge boost to revenue and earnings–if Brazil can right its economic ship so that the economy can generate a little more growth so that tapped out consumers have a little more room on their balance sheets.
In Latin America Itau Unibanco has been a major beneficiary of the divestiture trend by the world’s biggest banks. Partly out of a need to raise capital but also partly out of evidence that it is really, really hard to run a bank that does business everywhere, big global banks such as Banco Santander (SAN), HSBC Holdings (HSBC) and CitiGroup (C) have been selling off banking units to super-regionals such as Itau Unibanco. In 2014 Itau Unibanco acquired control of Chile’s Corpbanca (BCA), which had already acquired Helm Bank in Colombia. Itau is also making a strong push into Mexico where CitiGroup, one of the market leaders, has experienced a series of scandals.
The ADRS of Itau Unibanco popped 10.7% on October 30 on the central bank’s surprise. The move to $14.75 at the October 30 close in New York still leaves the ADRs well short of their September 2 high at $18.32 and even the October 14 “Dilma is trailing in the polls” high of $16. (Caveat investor—this is very volatile stock right now. In between those highs, Itau Unibanco has seen $13.25 on October 1 and $12.86 on October 27, the “Dilma wins” plunge.)
A return to $18, near the September 2 levels, would be a 22% gain from the October 30 close. I think that’s a reasonable initial target price while we see if Dilma can keep surprising the financial markets. One of the advantages of being as disliked by the financial community as she was before the election is that gaining a higher approval rating is a relatively easy task.
It does get harder from there, of course.