In emerging markets (Ems), trade tensions between the U.S. and China have been top of mind for most investors lately. However, emerging markets are much larger than this conflict, and there are opportunities in other corners of the EM universe.

We believe that Brazil may present attractive opportunities for EM investors. In recent years, the Brazilian government has undertaken an agenda of structural changes. They began with the election of right-wing, pro-market Jair Bolsonaro as president in 2018. His administration has focused on economic reform and making Brazil a more business-friendly nation. The foremost of his pro-market reforms is pension-reform, which Brazil’s Senate passed in October.

The pension system in place before President Bolsonaro took office left Brazil with a large national budget deficit that some argued would grow to the point of unsustainability within the next few years. Bolsonaro’s reform plan, which includes raising the retirement age, increasing workers’ pension contributions and changing the method for calculating benefits, was created to combat this risk.

Pension reform and other pro-market reforms have resulted in promising local capital market development. On top of this, fundamentals are strong in Brazilian equities. Earnings yields offer the best ratio ever against bond yields right now. And Brazil, like many other countries across the globe, has moved toward lower interest rates, which could amplify this dynamic.

However, Brazilian interest rates haven’t just dropped a few basis points. Fifteen years ago, interest rates were above 25%. Now they’re less than 5%.  This interest-rate change represents a once-in-a-generation type of shift, which signals a potentially significant opportunity for investors.

The change in the interest-rate environment coincides with the expiration of large sums of Brazilian government debt. These factors have all come together to begin driving a rotation from fixed income into equity.

Within five years, BRL 2.9 trillion is set to mature. Of this, BRL 1.6 trillion is from types of fixed-income investments that are likely to be renewed at different rates than when they were issued.[1] This makes them prone to conversion into other types of investments. Last time there was a major expiration, in May 2019, there was a BRL 88 billion inflow into equities.[2]

Investors have been accustomed to safe, high-yielding investments in Brazilian fixed income. Historically, they haven’t needed equity allocations to generate healthy returns. In the past, interest rates were so high, fixed-income investors have been able to all but double their investments every five years.

But now, thanks to these lower rates, government bond yields alone are unlikely to generate sufficient returns. Investors will have to turn elsewhere to pursue the returns they’re used to.

We believe they may turn toward bond-like, defensive stocks. Most likely, these new-to-equity investors will seek low-volatility equities with high cash generation and positive dividend track record.

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