By HENRY 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.

Exhibit 1

Brazil’s Valuation Does Not Appear Cheap
at Current Levels

Data as at April 25, 2012. Source: Factset.

Exhibit 2

…And It is Expensive Compared to History

NTM Forward Price-to-Earnings Ratio

NTM P/E

Current

Avg 2005-Curr

Stdev

Z-score

Argentina

2.9

9.0

2.7

-2.3

Poland

10.1

12.6

2.3

-1.1

China

9.8

13.5

3.7

-1.0

Russia

5.7

7.8

2.4

-0.9

EM

10.0

11.4

1.5

-0.9

India

11.8

13.3

2.3

-0.7

Korea

9.1

9.9

1.3

-0.6

Turkey

9.0

9.5

1.7

-0.3

Chile

15.6

15.9

1.9

-0.2

Taiwan

15.0

14.0

3.8

0.3

South Africa

11.2

10.7

1.2

0.4

Malaysia

13.7

13.0

1.3

0.5

Indonesia

13.3

12.1

2.2

0.6

Peru

10.1

8.5

2.5

0.7

Brazil

11.6

10.0

2.1

0.8

Thailand

11.9

10.2

1.5

1.2

Mexico

15.9

13.3

1.9

1.4

NTM = next twelve months. Data as at April 25, 2012. Source: Factset.

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.

Exhibit 3

Brazil Has Forged Ahead, While Many of its
Developed Market Peers Remain Mired in Deleveraging and Anemic Growth

Source: OECD for all countries except China.  China as per National Bureau of Statistics and Haver, 2007-2009.

Exhibit 4

Our Target Allocation Gains Exposure to Latin
America Through Global Equities, Emerging Market Debt, and Alternatives

Asset Class

KKR GMAA Target Asset Allocation (%)

Strategy Benchmark (%)

Difference (%)

Public Equities

50

53

-3

U.S.

20

20

0

Europe

12

15

-3

All Asia

12

12

0

Latin America

6

6

0

Total Fixed Income

25

30

-5

Global Government

5

20

-15

Mezzanine

5

0

5

High Yield

5

5

0

High Grade

5

5

0

EMD

5

0

5

Real Assets

10

5

5

Real Estate

3

2

1

Energy/Infrastructure

5

2

3

Gold/Corn/Other

2

1

1

Other Alternatives

15

10

5

Traditional PE

5

5

0

Distressed & Special Situation

5

0

5

Other

5

5

0

Cash

0

2

-2

Source: KKR Global Macro and Asset Allocation as at May 7, 2012.

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).

Exhibit 5

Emerging Market Dashboard Underscores Brazil is Heavy on Government Consumption, Government Savings, and Government Debt

GDP Composition per IMF for the year 2010. Shadow economy as per World Bank Development Research Group, Poverty and Inequality Team & Europe and Central Asia Region Human Development Economics Unit as of 2007. Government Finances, current account as a percent of GDP, real GDP and GDP per capita as per IMF WEO April 17, 2012. Exports and net exports as a percent of GDP per IMF Annual Statistics for the year 2010. Population growth as per United Nations World Population Prospects May 2011. Employment rigidity (0=Less Rigid, 100=More Rigid) as per World Bank World Development Indicators as of 2009 per April 2010 release. Private Credit % GDP as of 2010 per World Bank. Market Capitalization of Listed Companies as a % of GDP per World Bank as of 2010 per August 2011 update.

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.

Exhibit 6

For an Emerging Market, Brazil has Extremely High Corporate Tax Rates and Low Personal Income Tax Rates

Data as at March 31, 2012. While the United States does not impose a national VAT, most states, and some local governments impose transactional based taxes commonly referred to as sales and use taxes. Forty-five states and the District of Columbia impose a state level tax on the sale or use of goods and some services. Local governments in 34 states are authorized to impose local sales taxes. There are about 7,600 jurisdictions across the country that have chosen to impose a local sales tax. The state and local tax sales tax rate in the United States may range from 5% to 11%. Source: KPMG International, KPMG’s Individual Income Tax and Social Security Rate Survey 2011.

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).

Exhibit 7

The Economy is Now Heavily Skewed Toward
Service Industries

Data as at March 6, 2012. Source: Instituto Brasileiro de Geografia e Estatística, Haver.

Exhibit 8

Public Administration Accounts for Almost ¼ of all Services Provided

Data as at March 6, 2012. Source: Instituto Brasileiro de Geografia e Estatística, Haver.

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).

Exhibit 9

High Fiscal Revenues Are Largely Offset
By Substantial Social Programs

Brazil Central Government Budget 2011

 

Billions Reais

% GDP

Total Revenue

990

24%

States and Municipalities

(172)

-4%

Total Net Revenue

818

20%

Payroll

179

4%

Social Security Benefit

281

7%

Current Expenditures (Health Care, Education etc)

203

5%

Other Capital Expenditures

55

1%

Other

6

0%

Total Expenditure

724

17%

Primary Surplus

94

2%

Interest Expense

(181)

-4%

Government Balance

(87)

-2%

Data as at March, 29, 2012. Source: Secretaria do Tesouro Nacional, Haver.

Exhibit 10

Brazil has a Primary Surplus, But High Interest
Expenses and Debt Loads Put Its Total Fiscal Budget
in Deficit Mode

Year

Primary Balance % GDP

Interest Expense % GDP

General Government Balance % GDP

2001

1.7%

-3.6%

-1.9%

2002

2.2%

-2.8%

-0.7%

2003

2.3%

-5.9%

-3.7%

2004

2.7%

-4.1%

-1.4%

2005

2.6%

-6.0%

-3.4%

2006

2.2%

-5.3%

-3.1%

2007

2.2%

-4.5%

-2.2%

2008

2.4%

-3.2%

-0.8%

2009

1.3%

-4.6%

-3.3%

2010

2.1%

-3.3%

-1.2%

2011

2.2%

-4.4%

-2.1%

Data as at March 29, 2012. Source: Secretaria do Tesouro Nacional, Haver.

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.

Exhibit 11

Brazil’s Trade Balance is Offset by Services and
Income Outflows

Data as at April 24, 2012. Source: Banco Central do Brasil, Haver.

Exhibit 12

The Current Account is Largely Financed by
Foreign Direct Investment

Data as at April 24, 2012. Source: Banco Central do Brasil, Haver.

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.

Exhibit 13

Brazilian Interest Rates are Still High

Data as at April 26, 2012. Source: Bloomberg.

Exhibit 14

Brazil Should Maintain Its Policy Rates Above Its Inflation Rate

Data as at April 26, 2012. Source: Respective Central Banks and National Statistics Departments, Haver.

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.

Exhibit 15

Brazil has a Large Population with a High
Consumption Rate

Data as at May 3, 2011. Source: United Nations World Population Prospects, IMF.

Exhibit 16

Private Consumption in Brazil Towers Over India

12 Most Populous Countries

Population millions

Private Consumption US$ Trillions

Consumption Per Capita US’ 000

1

U.S.

313

10.7

34.2

2

Japan

126

3.6

28.1

3

China

1348

2.6

1.9

4

Brazil

197

1.3

6.8

5

India

1241

0.9

0.8

6

Russia

143

0.9

6.0

7

Mexico

115

0.7

5.8

8

Indonesia

242

0.4

1.8

9

Philippines

95

0.2

1.7

10

Pakistan

177

0.2

1.0

Data as at April 26, 2012 for the year 2011. Source: United Nations World Population Prospects, International Monetary Fund.

Exhibit 17

Brazil has a Young and Growing Population

Data as at May 3, 2011. Source: United Nations World Population Prospects.

Exhibit 18

More than Half of the Brazilian Population is
Below Age 30

Data as at May 3, 2011. Source: United Nations World Population Prospects.

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.

Exhibit 19

Growing Employment is a Positive for GDP Growth

Data as at April 26, 2012. Source: KKR Global Macro & Asset Allocation estimates.

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

Exhibit 20

Rapid Acceleration in Reduction of Lower Income
Class Post 2003 Has Led to a Significant Rise in GDP
per Capita…

Data as at April 17, 2012. Source: World Bank, IMF WEO.

Exhibit 21

…But Overall GDP per Capita is Still Relatively Low

Data as at September 30, 2011. Source: IMF WEO, Haver.

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.

Exhibit 22

The Middle Class in Brazil has Grown by 1200bp to More Than Half of the Total Population, But the Upper Class is Growing Too

Data as at August 8, 2011. Source: Secretariat of Strategic Affairs of the Presidency (SAE) released the Classe Média em Números , http://www.brasil.gov.br/

Exhibit 23

The Middle Class Throughout Latin America is Set to Grow by More Than 100 Million in the Next 20 Years

Data as at January 31, 2010. Source: OECD.

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).

Exhibit 24

Private Healthcare is Increasingly a Focus on the
Middle Class in Brazil

Data as at April 18, 2012 for the year 2010. Source: World Development Indicators, Haver.

Exhibit 25

Growing Consumerism Driven by Growing Middle
and Upper Classes

Data as at December 31, 2009. Source: National Household Sample Survey (PNAD) 2009.

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.

Exhibit 26

Brazil’s Urbanization is Far Advanced…

e = United Nations estimate. Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2007 Revision, http://esa.un.org/unup.

Exhibit 27

…But It’s GDP Per Capita Has Yet to Catch Up

Data as at April 17, 2012, data for year 2010. Source: IMF WEO, World Bank.

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.

Exhibit 28

Brazil has a Large Informal Economy…

Data as at December 31, 2007. Source: The World Bank Development Research Group Poverty and Inequality Team & Europe and Central Asia Region Human Development Economics Unit July 2010.

Exhibit 29

Productivity is an Issue

As of 4Q2011. Source: Respective National Statistical Agencies, Haver.

Exhibit 30

Brazil’s Growth Has Not Followed the Path of Either Japan or Korea

Data as at April 26, 2012. Cabinet Office of Japan, Bank of Korea, Fundaçâo Instituto/Banco Central do Brasil, IMF, World Bank, Haver.

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.

Exhibit 31

Education Spending is Not as Effective as
Other Countries…

Latest data as per UIS Global Education Digest 2011 which is generally for years 2008 and 2009. Source: UNESCO Institute for Statistics (UIS) Global Education Digest 2011 © UNESCO-UIS 2011.

Exhibit 32

…Due to Insufficient Spending in Secondary Education

Brazil: Public Educational Expenditure as a % of GDP

Year

Pre-Primary

Primary

Secondary

Higher

2000

0.3

1.2

1.5

0.9

2004

0.4

1.3

1.6

0.8

2008

0.4

1.7

2.4

0.9

2009

0.4

1.6

2.2

0.7

Public Expenditure per Pupil (PPP) US$

Year

All Levels

Primary

Secondary

Higher

2000

891

750

723

3,896

2004

1,079

1,032

931

2,633

2008

1,988

1,931

2,030

2,877

2009

N/A

1,696

1,766

2,907

Public Expenditure per Pupil as a % of GDP Per Capita

Year

All Levels

Primary

Secondary

Higher

2000

12.7

10.7

10.3

55.6

2004

13.4

12.8

11.5

32.6

2008

19.1

18.5

19.5

27.6

2009

N/A

17.3

18.0

29.6

Gradual shift towards greater secondary school funding

Source: UNESCO Institute for Statistics (UIS), Global Education Digest 2011 © UNESCO-UIS 2011.

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.

Exhibit 33

A Major Producer of Food Products, Commercial
Metals, and Energy

Data as at December 31, 2011. Source: United States Department of Agriculture, United States Geological Survey, F.O. Licht, World Ethanol and Biofuels Report, Oil and Gas Journal, Haver.

Exhibit 34

Brazil’s Export Growth has been Driven by Prices,
Not Volume

Data as at December 31, 2011. Source: Fundaçâo Centro de Estudos do Comércio Exterior, Banco Central do Brasil, Haver.

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.

Exhibit 35

56% of Exports are Destined for Emerging Markets…

Past 12 months ended November 30, 2011. Source: IMF, Haver.

Exhibit 36

…China is the Fastest Growing Major Trade Partner

Data from 1980 through November 30, 2011. Source: IMF, Haver.

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.

Exhibit 37

Commodity Country Exposure to China

 

Exports to China % Total Exports

China Exports % GDP

Current Account % GDP

FDI % GDP

Portfolio Flows % GDP

Real GDP Correl vs China ‘06-­11

Impact of a 100 bp Change in China Real GDP y/y

4Q2011 Real GDP Y/y

China Vulnerability Score 1=Low, 10=High

Australia

25.1%

4.3%

-2.2%

4.5%

4.7%

85%

50bp

2.3%

10

New Zealand

11.1%

2.5%

-4.1%

2.1%

2.9%

77%

60bp

2.1%

9

Canada

3.3%

0.8%

-2.8%

2.3%

5.6%

47%

50bp

2.2%

7

Chile

24.6%

8.0%

-1.3%

7.0%

4.2%

45%

60bp

4.8%

7

Brazil

15.2%

1.4%

-2.1%

2.7%

0.7%

58%

80bp

1.4%

5

Peru

18.3%

3.6%

-1.3%

4.4%

0.3%

46%

70bp

5.6%

4

India

7.9%

1.1%

-2.8%

1.4%

0.5%

75%

80bp

6.5%

6

Norway

1.7%

0.5%

14.6%

0.5%

2.9%

63%

50bp

1.8%

2

Russia

5.3%

1.3%

5.5%

2.9%

-0.4%

72%

200bp

4.6%

2

Indonesia

9.9%

2.2%

0.2%

2.1%

0.7%

34%

10bp

6.4%

1

Average

12.2%

2.6%

0.4%

3.0%

2.2%

60%

71bp

3.8%

Median

10.5%

1.8%

-1.7%

2.5%

1.8%

60%

60bp

3.5%

China

2.8%

3.0%

0.2%

8.7%

Overall Rank is the equal weighted rank of (1) China exports % GDP, (2) Current account balance, (3) Portfolio flows % GDP, and (4) Quarterly Real GDP Year-over-year correlation against China between 2006 and 2011. Exports to China as of 2010 per IMF; India FDI and Portfolio flows for last 12 months ended 3Q2011. All other data as of 2011. Source: Respective National Statistical Departments, IMF, Haver.

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.

Exhibit 38

Little Room for Improvement in Participation Rates

Data as at December 31, 2009. Source: International Labour Organization, http://kilm.ilo.org.

Exhibit 39

For Now, Population is Still Growing in Brazil’s Favor

Source: United Nations World Population Prospects May 2011.

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.

Exhibit 40

Mortgage Penetration is Still Very Low…

Data as at March 6, 2012. Source: Brazilian Central Bank, Projections by Bradesco - DEPEC.

Exhibit 41

…Particularly Among Small and Medium Businesses

Source: World Enterprise Survey, March 2011.

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.

Exhibit 42

The Top 5 Banks Hold 76.1% of Total Deposits

Data as at December 31, 2011. Source: Sisbacen, Banco Central do Brasil.

Exhibit 43

Bank Capital Ratios

2011 Capital Ratios

Banco do Brasil

Bradesco

Itaú Unibanco

Santander Brasil

BIS Ratio

14%

15%

16%

20%

Tier 1 Ratio

11%

12%

13%

17%

Equity / Total Assets

6%

7%

8%

15%

Loans / Assets

41%

31%

44%

48%

Loans / Deposits

90%

110%

153%

167%

2011 Capital Ratios Data as at April 17, 2012. Source: Company Data, Morgan Stanley Research. Brazilian Banks Capital Ratios Data as at July 30, 2011. Source: Banco Central do Brasil, Tesouro Nacional.

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

Exhibit 44

Wide Gap Between Earmarked and Non-earmarked Funding Rates

Data as at March 31, 2012 and BNDES as per press release dated Apr 3, 2012. Source: Banco Central do Brasil, Haver, http://www.bndes.gov.br.

Exhibit 45

Consumer Interest Rates are Also High

FIES = Financiamento Estudantil. Data as at March 31, 2012. Source: Banco Central do Brasil, Haver, http://minhacasaminhavidainvestment.com/programme.php.

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

Exhibit 46

Credit Growth has been Strong…

Corporate includes Commercial and Industry sector; Individuals includes Housing, Rural Sector, and Individuals. Data as at March 31, 2012. Source: Banco Central do Brasil, Haver.

Exhibit 47

But Is Starting to Slow

Data as at March 31, 2012. Source: Banco Central do Brasil, Haver.

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.

Exhibit 48

Public Equities are Dominated by Materials and Energy…

Sector % Market Cap

 

MSCI Brazil

Bovespa

S&P 500

Materials

20.7

24.8

3.6

Energy

21.5

17.4

12.1

Financials

24.6

18.1

14.2

Consumer Discretionary

4.3

14.7

10.9

Consumer Staples

11.5

9.1

10.8

Utilities

6.6

5.0

3.4

Industrials

3.4

4.5

10.8

Telecom Services

3.4

3.1

2.7

Information Technology

3.0

2.8

20.2

Health Care

0.9

0.5

11.3

Data as at February 29, 2012. Source: MSCI, S&P, Bloomberg, Factset.

Exhibit 49

…and the Top 10 Companies are Half the Market Cap

Top 10 Companies by Market Cap in MSCI Brazil

Company

Weight

Sector

Petrobras Petroleo Brasileiro

17.8

Energy

Cia Vale do Rio Doce

14.1

Materials

Itau Unibanco Holding

8.3

Financials

Banco Bradesco

5.9

Financials

Companhia de Bebidas das Americas

5.2

Consumer Staples

Itausa-Investimentos Itau

2.8

Financials

BRF-Brasil Foods

2.3

Consumer Staples

BM&F Bovespa

2.2

Financials

OGX Petroleo e Gas Participacoes

2.2

Energy

Banco do Brasil

1.6

Financials

Total Top 10 Companies

62.4

Data as at February 29, 2012. Source: MSCI, Factset.

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.

Exhibit 50

Consumer and Industrial Sectors are Now Pricey

Data as at April 16, 2012. Source: Factset Aggregates.

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.

Exhibit 51

Private Equity Investment in Brazil Grew to
US$4.6B in 2010

Data as at December 31, 2010. Source: Emerging Markets Private Equity Association.

Exhibit 52

Private Equity Penetration is Low

Data as at December 31, 2010. Source: Emerging Markets Private Equity Association.

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.

Footnotes

  1. As of March 31, 2012. Sources: Fundaçâo Instituto, Banco Central do Brasil, Haver.
  2. As of April 17, 2012. Sources: IMFWEO, Haver.
  3. As of April 30, 2012. See Exhibits 16, 17, and 22. Sources: The U.N., Secretariat of Strategic Affairs of the Presidency (SAE), Haver.
  4. As of May 11 2012. Source: U.N. World Population Prospects, May 2011.
  5. As of May 3, 2011. Source: United Nations World Population Prospects.
  6. Twelve months ended November 2011. Data as of April 2, 2012. Source: IMF.
  7. ZIRP = zero interest rate policy; QE = quantitative easing. Nominal policy rate as of Apr 26, 2012 was 9.0%, inflation 5.2%; and real rate 3.8%. Source: Banco Central do Brasil, Instituto Brasileiro de Geografia e Estatística, Haver.
  8. As of December 31, 2011. Source: Federal Reserve Board, Bureau of Economic Analysis, Banco Central do Brasil, Instituto Brasileiro de Geografia e Estatística, Banco de México, Instituto Nacional de Estadística Geografía e Informática, Haver.
  9. As of February 9, 2012. Price increase in exports between 2006 and 2011 was 102.0% while volume increase was 6.9%, and total export increase 116.0%.
  10. Corporate tax rate for 2012. Source: KPMG International.
  11. Based on Time to Prepare and Pay Taxes (Hours) as of 2011. Source: World Bank, Doing Business 2012.
  12. Refer to Exhibit 5.
  13. Bloomberg News, April 3, 2012.
  14. See our paper entitled “Phase III: The Last Stage of a Bumpy Journey,” October 2011, available at KKR.com.
  15. See Exhibit 5.
  16. Data as at March, 29, 2012. Source: Secretaria do Tesouro Nacional, Haver.
  17. Between 1991 and 2001, real GDP grew at an annualized pace of 2.5% while real consumption grew at 2.9%. Between 2001 and 2011, real GDP grew at an annualized pace of 3.8% while real consumption grew at 4.3%. Source: Instituto Brasileiro de Geografia e Estatística, Haver.
  18. Bolsa Familia was created in 2003 by the administration of President Luiz Inácio Lula da Silva. The World Bank, which has been involved in the design and refinement of the Bolsa Família from the outset in 2003, cites the program as “having the greatest impact on the lives of millions of low-income Brazilians.”
  19. Minha Casa Minha Vida (MCMV) was launched by the Brazilian Federal Government in March 2009 to reduce the inequality gap and address the housing shortage. It aims to provide homes to thousands of working-class families with a monthly income of less than ten times the minimum wage (R$545). Phase I of the program, announced in March 2009, was to construct 1 million units by the end of 2010, and Phase II, announced in June 2011, was to construct an additional 2 million units over the following two years. In the process, MCMV also aims to expand the Brazilian mortgage market. All funds are made available by the government through the state-owned Caixa Economica Federal Bank (Caixa), which provides mortgages for families eligible for a housing unit of the MCMV program. These mortgages offer preferential financing terms (up to 100% of the home’s value), interest rates (around 5% annually) and loan periods (usually 30 years). Families are not required to pay a deposit for the house and payment starts with the first mortgage installment when the family moves in. Sources: http://www.minhacasaminhavidabrazil.info/general_information.html, http://minhacasaminhavidainvestment.com/programme.php.
  20. Brazil’s poverty rates in 1992, 2001, and 2009 were 22.6%, 17.4%, and 8.4% of the population, respectively, and those in extreme poverty was 11.2%, 9.3%, and 3.3% respectively. As of March 31, 2012. Source: 2010 Census, Pesquisa Nacional por Amostra de Domicílios, Instituto Brasileiro de Geografia e Estatística.
  21. Brazil GDP-per-capita growth in US$ for 1973, 1974, 1975, and 1976 was 32%, 30%, 15%, and 21% respectively, or an annualized rate of 24.1%. From 2004 to 2011, Brazil’s GDP-per-capita grew an annualized rate of 19.5%, while China grew at an annualized rate of 19.2%. Brazil’s GDP-per-capita growth was interrupted in 2009 falling 3%, then rebounding 29% in 2010 and 14% in 2011. Ex-2009. Brazil GDP-per-capita grew at an annualized rate of 22.7% while China grew at 20.3%. As of April 30, 2012. Sources: IMF, World Bank, Fundaçâo Instituto/Banco Central do Brasil, Haver.
  22. As of August 8, 2011. Sources: Secretariat of Strategic Affairs of the Presidency of Brazil (SAE), www.brasil.gov.br.
  23. Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2007 Revision, http://esa.un.org/unup.
  24. Source: UNESCO Global Education Digest, 2011.
  25. Ibid.18.
  26. Data as at December 31, 2011. Source: Fundaçâo Centro de Estudos do Comércio Exterior, Banco Central do Brasil, Haver.
  27. Data as December 31, 2011. Source: Respective Central Banks and National Statistics Departments, Haver.
  28. Source: IMF WEO Apr 17, 2012.
  29. As of December 31, 2011. Source: Banco Central do Brasil, Haver.
  30. As of December 31, 2011. Sources: Banco Central do Brasil, Instituto Brasileiro de Geografia e Estatística, Banco de México, Instituto Nacional de Estadística Geografía e Informática, The People’s Bank of China, China National Bureau of Statistics, Federal Reserve Board, Bureau of Economic Analysis, Haver.
  31. As of December 31, 2011. Source: Banco Central do Brasil.
  32. The Brazilian Development Bank or BNDES (Banco Nacional de Desenvolvimiento Economico e Social) is a federal public company associated with the Ministry of Development, Industry and Foreign Trade. Its goal is to provide long-term financing for endeavors that contribute to the country’s development.
  33. As of March 31, 2012. Source: Banco Central do Brasil, Haver.
  34. As of February 29, 2012. Source: MSCI, Factset.
  35. Petrobras and Vale next twelve months forward Price-to-Earnings ratios are 7.4x and 6.2x respectively. As of April 16, 2012. Source: Factset Aggregates, Factset Estimates.
  36. Of the 15 Factset sectors, only six have data going back to Jan 2005. Average is from Jan 2005 to April 2012. As of April 16, 2012. Source: Factset Aggregates.
  37. See Exhibit 13.
  38. Source: Based on information from Fundação Getúlio Vargas, Conjuntura Econômica [Rio de Janeiro], various issues.

Important Information

The views expressed in this presentation are the personal views of Henry McVey of Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”) and do not necessarily reflect the views of KKR itself. The views expressed reflect the current views of Mr. McVey as of the date hereof and neither Mr. McVey nor KKR undertakes to advise you of any changes in the views expressed herein. In addition, the views expressed do not necessarily reflect the opinions of any investment professional at KKR, and may not be reflected in the strategies and products that KKR offers. KKR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation.

This presentation has been prepared solely for informational purposes. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither KKR nor Mr. McVey guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

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