Update March 14, 2016. The New York traded ADRs of Brazil’s Itau Unibanco (ITUB) were up 37% for 2016 to date as of the close on March 11. Most of that move has taken place in the last couple of weeks. Since the close on February 26 at $6.14, the ADRs (American Depositary Receipts) were ahead 45.9%
The ADRs fell 1.9% today, March 14. More on what that might mean later in this post.
What has driven the gains?
Certainly not Brazil’s improving financial picture. On February 26, the very day that Itau Unibanco started its big upward move, Moody’s Investors Service downgraded 29 Brazilian banks, including Itau, on a cut to Brazil’s sovereign debt rating to junk, and a continued deterioration in bank profitability, asset quality and capitalization. (Standard & Poor’s cut Brazil to junk status in September and then downgraded the country’s credit rating again in February. Fitch Ratings cut Brazil to junk in December.)
Certainly not a pickup in Itau’s big credit card business, a market that Itau Unibanco dominates in Brazil and in Brazil’s Latin American neighbors. The credit card processing market will grow at just low single digits this year, Itau said on March 3.
And certainly the bank’s fundamentals continued to decay in this period. On February 2 Itau Unibanco reported fourth quarter earnings and guided to a 17% drop in net profit this year. Even that guidance might be too optimistic since it assumes credit conditions in Brazil won’t get much worse. If the bank’s guidance for 2016 profit is accurate, Itau Unibanco’s return on equity at 17.5% will fall below the bank’s cost of capital.
So why are the ADRs up nearly 46% in two weeks?
Thank Brazilian President Dilma Rousseff–or more precisely rising expectations that she will be impeached not very far down the road.
Investors and traders have been down this path with President Rousseff before. In 2014 when she was running for reelection, every dip in her standing in the polls resulted in a move up by Brazilian equities. In 2015 when it looked like Dilma might face impeachment proceedings, every dip in her approval rating led to a rally on the Sao Paulo market.
In 2016 impeachment seems extremely likely and Brazilian financial markets have advanced strongly on the idea that with Dilma out the current gridlock in Brasilia will break and the country can get its fiscal house in order, beat back run away inflation, and restore growth to the economy.
You can feel the likelihood of impeachment settling in around Dilma as the pace of a corruption probe named Operation Carwash accelerates. On February 22, Rousseff’s top campaign strategist, João Santana, was arrested for allegedly receiving $7.5 million in a bribery scheme at national oil company Petrobras, which is at the center of the scandal. Then magazine IstoE reported that the government’s former leader in the senate, Delcídio do Amaral, had told prosecutors as part of a potential plea bargain that Rousseff had pushed judges to release political allies imprisoned on charges of graft. On March 4, Federal Judge Sergio Moro had former President Luiz Inácio Lula da Silva detained for questioning about favors he and his family allegedly received, and on March 9, a state prosecutor charged Lula with money laundering and hiding assets.
Dilma’s allies are deserting her. The Democratic Movement Party, or PMDB, Rousseff’s largest ally in the ruling coalition, will discuss voting on ending ties with Dilma or, at the least, setting members free to vote for impeachment, in a national convention on March 12. Her opponents are planning nationwide protests on March 13 to call for her impeachment. Rousseff’s deputy leader in the lower house, Silvio Costa,says he still has enough votes to defeat a formal impeachment request, but the margins seem to be eroding. Think tanks in Brazil say the odds are now 55% to 65% in favor of an impeachment.
The thinking in the financial markets is that a Dilma impeachment would break the gridlock that has prevented any action on reducing Brazil’s government deficit or attempting an economic stimulus plan or tackling inflation. Inflation hit a 13-year high of 10.7% in 2015. On March 2 the Banco Central do Brasil left its benchmark Selic rate at 14.25%. The Brazilian economy has been in recession since the second quarter of 2015–as you might expect with interest rates of 14.25%. But the Dilma government and the national legislature have been unable to agree on anything that might effectively tackle the country’s economic problems. In the last 14 years government spending as a percentage of GDP increased from an already hefty 18.6% to 20.2% in 2014. (In Mexico, by comparison, state spending accounted for only 12.2% of GDP in 2014.) Social programs, infrastructure and public pensions ate up 13% of GDP in 2012. Those programs helped raise 40 million poor Brazilians into the middle class in the last decade but many of those are now threatened with sliding back from those ranks.
It would be nice to think that removing Rousseff, her party, and her allies from power would fix all–or indeed any of this. But the truth is that Brazil’s political class as a whole is deeply committed to a system that uses state resources to grease the wheels of power. There’s not much disagreement among non-Brazilian economists that necessary structural reforms include reining in government subsidies at the Brazilian Development Bank reducing energy subsidies, raising the retirement age or reforming public pensions, and cutting transfers from the national to state governments. Without these reforms, I don’t see Brazil recovering its investment grade credit rating–won with so much struggle–short of new boom in global commodities strong enough to paper over the economy’s basic problems.
On Sunday, March 13 somewhere between 3.6 million (police estimates) and 6.9 million (protest organizers) Brazilians took to the streets to demand that Dilma resign or be impeached. The Braziian supreme court is set to clarify the impeachment process on Wednesday and the lower house of Brazil’s legislature is likely to convene an impeachment committee shortly after that.
Today we saw a pull back in Itau Unibanco (1.9%) and in the iShares MSCI Brazil ETF (2.91%.) That could have been a sell on the news after the protests but I think it was more likely a reaction to weaker commodity prices and a stronger dollar. I think we’re likely to see still more euphoria in the financial markets as Brazil moves closer to an impeachment of resignation by President Rousseff.
That euphoria will then yield to the darker realities of the depth of the country’s problems and the likelihood that a new government won’t be magically more successful at passing a reform program that the Rousseff government has been.
I think it’s worth hanging on to shares of Itau Unibanco, a member of my Jubak Picks portfolio, for the likely buzz of an impeachment/resignation, but I’d certainly be thinking of selling on that news.
The good times that are likely to be priced into Brazilian stocks by that point will be very tough for anyone to actually deliver.
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.
Is the discount big enough?
The Brazilian government has reportedly offered to settle its tax dispute with iron ore miner Vale (VALE) for about half of the $14 billion the government has claimed the company owes in taxes on the sale of foreign subsidiaries from 1996 through 2008. And under the settlement Vale would get to pay the $8.5 billion in the settlement over 15 years.
The company has maintained that it doesn’t owe the taxes the government claims and has been fighting the case in court. The company could continue that fight or it could take the offer.
This hasn’t been a great year for mining stocks and for iron ore miners in particular as slower growth in China has cut into demand while past investments in new mines have added to supply. But shares of Vale have decidedly underperformed shares of competitors such as BHP Billiton (BHP) and Rio Tinto (RIO) because of the uncertainty of this tax case. The amount of the government claim is, after all, three times net profit from 2012. In the last 12 months shares of Vale were down 5.03% as of November 19 while shares of BHP Billiton were up 4.04% and shares of Rio Tinto were ahead 10.37%.
If Vale takes the deal, it would remove substantial uncertainty from the stock and close the valuation gap with BHP Billiton and Rio Tinto. Read more
The New York traded ADRs of Brazilian airline Gol Linhas Aereas Inteligentes (GOL) went on a tear during the first two days of this week on a jumbo jet full of good news. (Gol is a member of my Jubak Picks http://jubakpicks.com/jubak-picks-50/ long-term portfolio.)
The ADRs climbed 9.4% on October 21, and another 4.6% yesterday. Today they pulled back 0.54% along with the general market.
What was the news? Read more
Brazilian utility stocks are taking a pounding on new government policies that will end the practice of automatic extensions of 20-year, no-cost concessions to provide electric power, that will increase the price of concessions to the point where inefficient utilities might not be able to make money, and that will pay very low prices for the replacement value of assets to utilities that lose their concessions.
The goal of the new policies are to cut some of the world’s highest electricity rates in an effort to reduce inflation. The new rules are projected by the government to reduce electricity rates by as much as 28%
The changes, announced yesterday September 11, whacked 5.3% today off the share price of a utility such as CPFL Energia (CPL). CPFL is a member of my dividend income portfolio http://jubakpicks.com/jubak-dividend-income-portfolio/ )
And that’s the good news in the sector. Shares of Cia. Energetica de Minas Gerais (CIG in New York), Brazil’s largest utility by market value, are down 20.8% today. Shares of Cia. de Transmissao de Energia Electrica Paulista (TRPL3.BZ in Sao Paulo or CTPZY in New York) are down 37.1% in Sao Paulo.
What accounts for the big differences in the impact of these changes to companies in the sector? Read more