How will Brazil be with Lula?

Dear investors,

The dispute between Bolsonaro and Lula left the country extremely polarized, with campaigns characterized by many sensationalist speeches and few government proposals. After the heat of the battle, what is now interesting to know is: with Lula elected, what will the future of Brazil be like?

When evaluating a company, understanding its business model, market positioning and track record are more critical steps than evaluating who is the CEO. Similarly, Brazil's future depends a lot on the country's position today – the starting point for Lula's government – and the scenario he will have to face throughout his term. So, let's talk more about the country that will be governed than about its future ruler.

We will comment on how Brazil can be impacted by three major themes that are in evidence in the global macroeconomic scenario: i) generalized inflation, a side effect of the policies adopted during the pandemic that was amplified by the rise in commodity prices; ii) the geopolitical crisis caused by the war between Ukraine and Russia; and iii) the energy crisis generated by the embargoes created in the context of the war and by the policy of decarbonizing energy matrices.

Global Inflation

The whole world is having inflation problems right now because all countries have been hit by the pandemic and most of them have taken very similar courses of action. The main measures are well known: lockdown and emergency aid. Both contributed to creating the inflation that is being fought today.

The contribution of the lockdown came through the disorganization of production chains, which reduced the supply of several products and, thus, stimulated price increases. With the reopening and reorganization of economies, which took place some time ago, this factor has largely been overcome and is no longer a central cause of inflation.

The second factor is more difficult to reverse. Emergency aid, adopting the Brazilian nomenclature to also refer to programs of the same nature that governments around the world carried out, were mostly financed through expansion of the monetary bases - that is, governments printing money - a movement that reduces the value of money and therefore causes widespread price increases (inflation). This effect is inevitable, as the creation of new money is not accompanied by the creation of real economic value. In a simplified example: if all governments in the world double the amount of currency in circulation, everything will cost twice as much, as there will be twice as much money to represent the same existing goods. Obviously, central bank maneuvers do not have the power to make the world richer.

In practice, by printing money and distributing it in the form of emergency aid, governments expropriated capital from all those who invested in assets not corrected by price indices (fixed income securities, mainly), and distributed them to the most economically vulnerable populations. – quite rightly, in our view, as they were banned from working for their own livelihood during the lockdown. There is a subtlety to this arrangement: the loss of currency value is not immediate. It comes through a wave of inflation that erodes the value of money over time. This is what the world is suffering from today.

High interest rates, the bitter medicine

To combat the problem of inflation, central banks around the world resorted to the classic measure of raising interest rates. The logic of this action is that higher interest rates reduce economic activity, as they reduce the availability of credit for consumption or for new investments. As a result, the general demand for products and services is reduced and prices tend to fall. The problem is that high interest rates are like the fever caused by our immune system to fight a virus. It solves the problem, but only after putting us out of bed for a few days. To control inflation, it will be necessary to keep interest rates high for several months and, during this period, economic growth is severely impaired. This is where the risk of global recession that has been talked about comes from.

Inflation and high interest rates are well-known topics in Brazil. Due to the history of our economy, the Central Bank of Brazil has a lot of experience in dealing with inflation problems and knew how to act quickly. He raised interest rates in Brazil about a year before central banks in developed countries became convinced that such a measure was really necessary. It was also more vigorous in action. While the Federal Reserve increased the US interest rate from 0.25% per year, in March 2022, to 3.25% currently, Brazil started from a rate of 2.00% in March 2021 to the current 13.75%.

Today Brazil is, in market jargon, “ahead of the curve”. Because we started fighting inflation earlier and more vigorously, we are already much closer to having inflation under control than the United States and Europe. The market is counting on the beginning of interest rate reductions and the convergence of inflation to the usual levels (around 5%) already in 2023. Even controlling inflation earlier, Brazil will still suffer the impact of the global economic slowdown, but we have two mitigating factors for this negative effect. The first is that Brazil has a less globalized economy than the United States and Europe. Our foreign trade flow represented 39% of GDP 2021, compared to a global average of 52% of GDP 2020. This is not exactly good, as Brazil could have grown more in the past if it had opened its markets more. However, in this moment of global crisis, our economy is less exposed and should suffer less. The second mitigating factor has to do with the geopolitical crisis, which we will discuss below.

the new cold war

The war between Ukraine and Russia started in February 2022, eight months ago. The military confrontation was restricted to the territory of Ukraine, but the effects of the war went far beyond its borders. The West adopted the strategy of not interfering militarily with NATO forces – which would bring a considerable risk of a new world war – but positioned itself alongside Ukraine, supplying war weapons, financing its costs in the war and imposing economic sanctions on Russia. .

Russia has reacted to the sanctions by restricting the supply of commodities, especially oil and natural gas, to countries that support Ukraine. The main impact of this action is the current energy crisis in Europe, which depended on Russian natural gas to maintain its heating systems and electricity production. We'll return to this topic shortly, but first let's explore a broader geopolitical trend that the war intensified.

Until a few years ago, the world followed a trend of economic globalization. Increasingly integrated supply and production chains were being created, pursuing David Ricardo's ideal of taking advantage of each country's cost advantages to achieve the greatest possible economic efficiency. This movement began to reverse with the trade friction between China and the United States, then under the presidency of Donald Trump. Now, Ukraine's war seems to have convinced the rest of the world that globalization has gone too far and it's time to take a few steps back.

The war made the risks of highly integrated economies even more concrete and visible to all. Angela Merkel's Germany decided to make its energy matrix very dependent on Russia, which supplied about 55% of natural gas and 35% of oil imported by Germany. The decision was not economically irrational. Russia had good prices and enough capacity to continue supplying for a long time. However, it is now costing him to have ignored the political aspect involved: having a relevant part of his country's energy under the pen of Vladmir Putin. Interestingly, this risk was pointed out by Donald Trump at a NATO conference in 2018. German politicians judged it as unwarranted extremism by Trump and dismissed the matter.

There are other relevant risks of the same kind that have not yet become problems. For example, today Taiwan produces more than 90% of high-tech processors (<10 nm) no mundo e entre 30 e 50% dos processadores em outras categorias. Isso explica, em boa parte, a tensão política envolvendo Taiwan e China, com a interferência dos Estados Unidos para que Taiwan permaneça um território independente.

Brazil in deglobalization

With the world more aware of the risks of dependence on other countries for the supply of critical commodities and products, we expect to see over the next few years a movement towards the decentralization of production chains and the reduction of trade relations with politically disaligned countries. This movement is not simple and can take decades, but it is a trend that can cause huge economic impacts.

The logic behind the decentralization of production chains is well known in the business world. It is not advisable to have a deep dependence on a supplier, as this greatly reduces your bargaining power and exposes the business to the risk of sudden price increases or discontinuity of supply.

Companies take this precaution even though they can enter into long-term contracts and go to court to enforce them. Countries do not have a global court to which they can turn to enforce agreements, so there should be additional concern in selecting as partners countries that are unlikely to become politically hostile, as Russia has become to the West.

In practical steps, the expectation is that part of the production chains currently dependent on China will be transferred to countries that are closer and politically more aligned with the United States and Western Europe. This trend has been called friendly-shoring, in analogy to the off-shoring policy that made China what it is today.

The current scenario presents a unique opportunity for Brazil, which has the sixth largest population in the world, cheap labor, extensive territory and abundant natural resources. Furthermore, it is close to the United States and Western Europe and closely aligned with Western politics. In this way, we are strong candidates to receive part of the demand currently met by China, which can bring a wave of foreign investment and boost our economic development.

energy crisis

Let's return to the issue of gas shortages in Europe. The story began with the plan to decarbonize the economy to combat global warming. This theme ended up mixing scientific and political agendas, but, in a very simplified way, the relationship between CO2 concentration in the atmosphere and the increase in average temperature on Earth has been known for over a century. In fact, an article published in 1896 by Sven Arrhenius, winner of the Nobel Prize in chemistry in 1903, estimated the relationship between the increase in CO2 concentration and the increase in atmospheric temperature with reasonable precision. Despite this, only in recent decades has a joint action been organized by several countries to deal with the problem, whose main measure is to reduce the amount of CO2 emitted by economic activity.

In this context, reducing CO2 emissions in the production of electricity was one of the main planned measures. As a result, Europe has been deactivating its thermoelectric plants that used coal and oil and replacing them with natural gas thermoelectric plants, which emit about 50% less CO2 than coal and 40% less CO2 than oil for the same amount of electricity produced (emissions vary greatly depending on the efficiency of each thermoelectric plant). Germany was one of the countries that most engaged in this movement and, therefore, is suffering a lot with the cuts in the supply of Russian natural gas.

Despite the problem with Russia, the main western economies should continue the decarbonization movement of the economy, with the goal of reaching neutrality in carbon emissions by 2050. The plan is quite daring and involves widely reducing the use of fossil fuels . We will not enter into the discussion of how likely it is that the objective will be met, but we will comment on why this decarbonization policy favors Brazil.

Brazilian energy

Our country has a very different electricity production matrix compared to the rest of the world. In 2021, 67.4% of the world's electricity was produced from fossil fuels, China produces one-third of global electricity, 65.9% from fossil fuels, 63.2% from coal. In contrast, only 20.3% of Brazilian electricity comes from fossil fuels, and only 3.7% from coal.

A first advantage of the Brazilian electricity matrix is its lower exposure to price fluctuations of fossil fuels in the market. With 77.4% of our electricity coming from hydropower and renewable energy, we are more dependent on rainfall and other weather factors.

Another advantage is that our energy is quite clean, especially compared to China. A kWh produced in China emits, on average, 541 grams of CO2 and a kWh produced in Brazil emits 142 grams of CO2, almost 4 times less. This is a differential to attract countries that seek carbon neutrality. Shifting demands for industrial activities with high consumption of electricity from China to Brazil could reduce 74% of CO2 emitted by the chain.

This generation's opportunity

It is not every day that we see Brazil coming out of a macroeconomic crisis before the developed countries, in an extremely favorable position to reap the benefits of a migration trend of important production chains and with an energy matrix that is now becoming highly valued due to the global economy decarbonization project. It is an opportunity that we should not pass up.

It is not necessary for our government to do something brilliant for the country to benefit. It would be enough to demonstrate to the world that it will be a serious and responsible government, that seeks to facilitate the development of business in the country and aware that financing populist measures with fiscal irresponsibility is a strategy that takes its toll in the future and destroys good economic prospects. In short, a government strategy focused on not making big mistakes, instead of trying to carry out far-fetched projects, would already be an excellent start.

The counterweight to that hope is that Brazil has an unfortunate history of wasting good opportunities. Our population still has little political maturity and formal education, which sometimes generates great public discussions around agendas of low practical impact for the country, leaving aside what could really make a difference in our lives. In any case, the risk of wasting a good opportunity is always a better scenario than having no opportunity at all.

What to expect from Lula

Now with the victory guaranteed, we hope that Lula will reveal who will be nominated for Minister of Economy and provide more transparency about his government plan. The biggest risk is that Lula does away with the spending cap and returns to economic intervention policies, as he defended during his campaign, but we believe that the configuration of the new National Congress and the alliances created to win the elections are relevant brakes for policies in this direction. . If not completely prevent them, they should at least postpone them and make them milder.

Incidentally, with a center-right National Congress and a left-wing president, negotiations tend to be slower and more contentious, making the Executive's actions in general more difficult. Therefore, it is to be expected that Lula will adopt a more center-oriented stance. That is, if you do not resort to the same type of strategy that you used in the past to guarantee the support of the Legislative in a more “direct” way.

On the positive side, Lula has a good international image, especially among European countries. This favors the success of the diplomatic agenda necessary for us to attract foreign investment and establish new international trade agreements. Lula is especially well positioned to leverage the discourse that Brazil has a clean economy, echoing with his campaign flags.

How are our investments?

Despite the macroeconomic angle we adopt in this letter, our investment decisions always depend much more on analyzes made about each investment thesis in particular. Even without this macro bias, we ended up investing predominantly in companies that depend more on the Brazilian domestic market than on the global economy. In part, because they were simpler theses to analyze in the current scenario – which makes our estimates of future results more assertive – and, in part, because Brazilian exporting companies are, for the most part, sellers of commodities. Despite the upward cycle in commodities caused by geopolitical turbulence, the evolution of their prices in the coming years is unpredictable and we understand that the risk of a decline is greater precisely when prices are above their historical average. With the complicated external scenario, it seems convenient for us to continue with the portfolio that is more dependent on the domestic market.

The share price, as usual, was a determining factor in the investment decisions we made this year. The Brazilian stock market remained cheap throughout the year and we took advantage of this good season to gradually buy more shares in excellent companies at very discounted prices.

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