Investing in Brazil Brazil - Year Ahead 2019

Chief Investment Office Americas, Wealth Management | 26 November 2018 6:11 pm GMT Ronaldo Patah, Emerging Markets Strategist Brasil

Fig. 1: Brazil presidential results • We believe the outcome of the presidential election last % of valid votes in favor of candidate month will be a game-changer in the way of doing politics and business in Brazil. 60% • Brazil has opted to turn right, and we think Jair Bolsonaro 50% will lead the country on the strength of his promises to fight 40% corruption and improve the quality of public services. 30%

• The Brazilian electorate appears to understand that the 20%

government's failure to provide the most basic of public 10%

services in recent years owes to a supersized state machinery 0% that has become susceptible to corruption. Bolsonaro Haddad

• In our Brazilian tactical asset allocation, we keep equities and Source: Supreme Electoral Court (TSE), UBS, October global assets (USD) at overweight; inflation-linked bonds, 2018 hedge funds and real estate funds at neutral; and floating- rate bonds and nominal bonds at underweight. We also keep an overweight on USD-denominated bonds in our emerging market portfolio.

A real game-changer After 13 years under a leftist government and two under a centrist one with questionable legitimacy, Brazil has opted to turn right. Elected with an appreciable difference of 11 million votes, Jair Bolsonaro will lead the country on the strength of his promises to fight corruption and improve the quality of public services. We believe the outcome of the presidential election last month could be a game-changer in the way of doing business in Brazil. The Brazilian electorate appears to understand that the government's failure to provide the most basic of public services – healthcare, education, and security – in recent years owes to a supersized state machinery that has become susceptible to corruption. On the other side of the coin are companies reliant on subsidies and contracts from the government. In extreme cases, this symbiosis between business and government has resulted in illegal election financing to the benefit of all involved. The Lava Jato investigations ("Operation Car Wash") exposed this mechanism where few would gain at the expense of the rest of society. Still going on four years after it began, the probe started out as a money-laundering case that quickly snowballed to involve people in government, state-owned enterprises, and the private sector, and has resulted in the conviction of dozens of senior public officials, CEOs, and businessmen. This case would prove consequential to the general elections. Voters looked for candidates they considered honest – "outsiders" to the mechanism they have grown wary of. We believe that along with the new administration, it will have a lasting impact on the business environment in Brazil.

This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of the document. Investing in Brazil

The economic environment Box 1: Brazilian recommendations reference Assuming office on 1 January, Bolsonaro will take over at a time portfolio of reasonable domestic economic expansion face to face with a The recommendations discussed in this more challenging global environment. After three years in recession, publication are for a local reference the Brazilian economy has expanded in the last two years – 1% portfolio. The attractiveness of the in 2017 and likely 1.5% in 2018. But these growth rates are far different asset classes is exclusively below potential. As a result, the country's gross domestic product assessed relative to other Brazilian assets. is almost 5% below where it could be if the recession had not hap- The reference currency is the Brazilian pened. If the new government takes steps in the right direction, real. GDP could grow above potential for the next four years; To be sure, Brazil will face external headwinds, but they could be tolerable if the government does its homework. The US Federal Reserve is poised to continue to raise interest rates – often a headwind to emerging markets like Brazil – but, like this year, we do not expect it to derail Fig. 2: Brazil tactical asset allocation the economic recovery of countries addressing their fiscal imbal- underweight overweight ances, but severely punish those going in the wrong direction. Fixed Income - Floater Bolsonaro's new government has other advantages compared to the situation when his predecessor, Michel Temer, took over. Fixed Income - Nominal Bonds Inflation and interest rates are low and anchored, relative prices Fixed Income - Inflation-Linkers have readjusted, external accounts are balanced, and the GDP gap Equities is substantial – meaning the new government has many opportu- nities to show it is growing the economy. Hedge Funds Equally important, Brazil's banking system has deleveraged. As our Real Estate colleagues in UBS Investment Research say in Latin America Eco- Global Assets nomic Outlook 2019–2020: "(The) private banking sector largely new old avoided going through a balance sheet recession, and today these banks are seeing historically low levels of nonperforming loans (especially for consumers), high liquidity, and robust returns on Scale for tactical deviation: equity. This is potentially important for the prospects for higher + = moderate overweight versus benchmark growth in 2019 and beyond." ++ = overweight versus benchmark +++ = strong overweight versus benchmark On top of this, Brazil is set to enjoy bumper crop for the third year – = moderate underweight versus benchmark in a row. If the government addresses the fiscal deficit effectively, – – = underweight versus benchmark the economy may embark on a virtuous growth path. – – – = strong underweight versus benchmark Reform prospects n = neutral, i.e., on benchmark The new government has said it will focus on structural reforms Source: UBS, as of November 2018 in its first year. Brazil is running a budget deficit that we believe can only be addressed by strong social security reform. Other mea- sures will also be taken to address issues that became central during the election campaign, especially reducing violence in the cities. Without balancing the budget, however, we think these other mea- sures may only have limited reach. We believe the new government is facing tough challenges on the fiscal side, but can pick low-hanging fruits on the microeco- nomic side. Starting with the good news, Bolsonaro claims – and the market agrees – that his government will be pro-business. It aims to deliver a "competitiveness shock" that will advance Brazil's standing in ease-of-doing-business rankings. The program covers cutting taxes and simplifying the tax system for corpora- tions; deregulating industries for entrepreneurs; accelerating priva- tizations, concessions, and public-private partnerships; improving regulatory agencies; opening Brazil to trade agreements; affirming the Brazilian Central Bank's independence; and driving competition in the banking industry to encourage consumer credit. On the other hand, the new government has yet to define how it will address

Chief Investment Office Americas, Wealth Management 26 November 2018 2 Investing in Brazil

pension reform, which is crucial to balancing the budget in the coming years. The numbers We believe that Brazil is at the beginning of an expansion cycle that started after the impeachment of Dilma Rousseff in 2016 and could last as long as 10 years if our assumptions are met. We expect that 2019 will bring strong and sustainable growth on the back of a legitimately elected government with a pro-business stance, a Congress willing to deliver reforms after being shaken up by the elections, and credit markets in expansion. This combination could result in economic growth rising to 3% a year, backed by an 8% annual increase in investments, largely financed by a 1%-of-GDP widening of the current account deficit. We also expect private consumption to grow 3.5%. For the near term, we forecast unemployment falling to 10.5% from 12%, which should boost consumer confidence that will be met with better credit conditions in the banking system. In this environment, we believe the central bank (BCB) will have to adjust the Selic rate significantly upwards from 6.5% during the next year, to accommodate some inflation pressure as companies try to recover the margins they lost during the recession years. Keep in mind that the BCB has cut its inflation target from 4.5% to 4.25% in 2019 and 4% in 2020. So even without inflation pressure, some adjustment may be needed to keep inflation expectations on target. Another important variable for monetary policy is the impact of the global markets on the Brazilian real (BRL). The bottom line The challenges facing Bolsonaro are mighty but we believe the new government has the map and the compass to reach better levels of social and economic achievement for the country. Much of this will depend on their ability to negotiate with legislators and perhaps usher in a new era for politics in Brazil. In they succeed, Brazil could take the first step to a new way of doing business and dealmaking that can take the country to a more developed stage.

Chief Investment Office Americas, Wealth Management 26 November 2018 3 Investing in Brazil

Tactical asset allocation for local investors Fig. 3: Nominal bond yield (%) National treasury notes series F (NTN-F) 2025 Local fixed income – nominal bonds 12.5 After the election, lower energy and food prices and a stronger BRL have allowed the BCB to abandon the beginning of its interest rate 11.5 hiking cycle in 2018. As the minutes of the last policy committee (Copom) meeting show, the risks of higher inflation are now less asymmetric. We now see the IPCA consumer price index at 4.2% 10.5 in 2018, versus 4.6% before, and at 4.5% in 2019. 9.5 Next year, however, we believe the risk on interest rates will be biased to the upside again. As the economy accelerates and 8.5 business and consumer confidence improves, market players may mar-17 set-17 mar-18 set-18 be tempted to adjust prices higher in a attempt to recover the Source: Bloomberg, UBS, as of November 2018 margins they had lost during the recession. This will be fueled by the credit expansion that we believe will happen as banks lend more to expand their credit portfolios. Many other factors will influence inflation next year. Domestically, food prices will be pressured down again by an expected third straight year of an agricultural super harvest. The official forecast is Fig. 4: Inflation-linked bond yield (%) for volumes similar to 2018, which was only 5% below the highest National treasury notes series B (NTN-B) 2026 ever recorded, in 2017. Globally, the interest rate pressure will be 6 on the upside as the US Federal Reserve looks set to continue to drain global liquidity by hiking rates, which would strengthen the US dollar and in turn depreciate emerging market currencies like the 5.5 BRL. We therefore believe the BCB will have to tighten the policy rate during the year. 5 We believe the new government will face big hurdles in advancing the much-needed reforms to overcome the country's fiscal chal- lenges next year. Our base case scenario assumes that a reasonable 4.5 pension reform will be approved before the end of 2019. In this mar-17 set-17 mar-18 set-18 case, nominal bonds with a 10-year maturity will tighten around Source: Bloomberg, UBS, as of November 2018 50 basis points. In the positive scenario of a stronger reform, these bonds will trade 130bps below current yields. The risk case scenario is that the reform will not be approved, sending the bonds 200bps above today's prices. We now see the risk premium as low at current levels, so we keep nominal bonds at underweight. Local fixed income – inflation-linked bonds In inflation-linked bonds, markets are pricing in a normalization of risks after positively reading the outcome of the elections. The bonds' spread over inflation is currently close to 4.6% across the curve, a fair level in our view as it is close to what we believe to be the neutral policy rate given the country's current fiscal situation. Any further tightening would depend on the outlook for pension reform. If the new government proposes deep changes to the social security system, builds a solid base of support in Congress, and proves that it has the political ability to negotiate, the neutral rate could reach a record low. If none of these conditions take place, however, the market may demand higher levels of return to carry inflation-linkers. In our view, the Bolsonaro administration will be able to pass a reasonable pension reform, but the process will be long, with the approval likely only in the second half of the year. In this case, inflation-linked bonds with a 10-year maturity will tighten around 20bps. In the positive scenario of a strong reform, the bonds will trade 70bps below current yields. In the risk scenario of no

Chief Investment Office Americas, Wealth Management 26 November 2018 4 Investing in Brazil

approval, the bonds will trade 100bps above today's prices. Mean- while, we see the current breakeven inflation rate trading at fair levels. We keep inflation linkers at neutral for now as we see them fairly priced for the scenario ahead. Local fixed income – floating-rate bonds The increased level of global and local risks has made this asset class more attractive, but because the current policy rate in Brazil Fig. 5: Ibovespa equity index is very low, we keep our exposure at underweight as a way to Weekly values compensate for the overweight in equities. Exposure to floating- 95,000 rate bonds should be done through selected corporate credits and financial-institution bonds or notes. 85,000 Equities We are positive on Brazilian equities in the medium term as we 75,000 see some upside to the undemanding valuation multiple of 11x P/ E, in line with the long-term average and the consensus earnings 65,000 growth estimate of 25% on a 12-month-forward basis. Following Bolsonaro's election victory, we believe economic growth will accel- 55,000 erate from 1.5% this year to 3% in 2019 driven by higher produc- mar-17 set-17 mar-18 set-18 tivity and a controlled inflation that allows for low interest rates. Source: Bloomberg, UBS, as of November 2018 The new government faces tough challenges on the fiscal side, par- ticularly on pension reform, but, as discussed above, it can spur economic activity through easier-to-implement measures such as Fig. 6: Hedge funds business tax cuts, privatizations, and opening up Brazil further to BTG Multimercados Index international trade agreements. 12 With the election over, the next drivers for the equity markets are related to Bolsonaro's formation of his economic team, his 11.5 administration's ability to build a strong base of support in Con- gress, and finally its ability to build a strategy for much-needed 11 reforms. Let's not forget that the market will face headwinds from the global environment, which will provide additional volatility as 10.5 Brazil is a high-beta market. 10 In this light, we keep our tactical allocation in equities at mar-17 set-17 mar-18 set-18 overweight. Source: Bloomberg, UBS, as of November 2018 Hedge funds The hedge fund industry has successfully navigated the market's increased volatility amid the election uncertainty, and their perfor- Fig. 7: Real estate funds mance for the year is positive on average. The current low level of B3 Real Estate Investment Fund Index policy rate will probably stay for longer, so the level of risk in the 2,500 funds will have to stay high in order to compensate for the fees. For the next six months, we believe hedge funds will have to keep looking for diversified sources of alpha, especially in the challenging 2,300 offshore market. Real estate investment funds 2,100 As the economy continues to slowly improve and interest rates stay at very low levels, we think that this environment favors an allo- cation to real estate in the coming years. The main advantage of 1,900 real estate investment funds is that they allow investors to partic- mar-17 set-17 mar-18 set-18 ipate in assets related to the real estate market without, in fact, Source: Bloomberg, UBS, as of November 2018 having to buy a property. Also, individuals may be exempt from income tax upon meeting certain rules. In a low-interest-rate envi- ronment, this asset class provides not only better diversification but also good prospective returns for investors with risk appetite

Chief Investment Office Americas, Wealth Management 26 November 2018 5 Investing in Brazil

and long investment horizons. We keep this asset class with a neutral allocation recommendation. Brazilian real Fig. 8: USDBRL We moderately revise our USDBRL forecasts to 3.50, 3.70, Weekly data and 3.70 in three, six, and 12 months (from 3.6, 3.8, and 3.8, 4.5 respectively). Bolsonaro wasted no time forming his team since winning the election with 55% of the valid votes in October. He has already 4 appointed the market-friendly Paulo Guedes as economy minister. Guedes will head the new Ministry of Economy, which merges the finance and planning ministries. Bolsonaro's immediate priorities 3.5 are to move ahead with the social security reform and formalize the independence of the central bank. Markets will also closely follow other appointments, but so far the names that have been in the 3 news are considered market-friendly, including board members at mar-17 set-17 mar-18 set-18 the BCB and executives at the state oil company. Source: Bloomberg, UBS, as of November 2018 Global environment: The Brazilian real, like other emerging market currencies, continues to be affected by tighter global liquidity con- ditions and trade friction worries. Rising US interest rates will remain Fig. 9: Country risk a challenge, especially if the new government fails to deliver on Five-year credit default swaps (CDS) expected reforms. 300 Economic outlook: Our GDP growth forecast of 3% in 2019 will depend on the implementation of reforms. We expect inflation to be close to the BCB's target this year (4.2%) and in 2019 (4.25%). 200 External balance: The 12-month trade surplus as of October stood at USD 60bn (3% of GDP). The strong surplus and foreign direct investment (USD 71bn in the last 12 months) support the real. 100 mar-17 set-17 mar-18 set-18 Monetary policy: The BCB has kept its policy rate at 6.5% in recent months amid two-way risks for inflation, i.e., the persistent output Source: Bloomberg, UBS, as of November 2018 gap on one hand, and potential reform delays and external risks on the other. We keep the USD exposure at overweight in our tactical asset allocation to account for tighter Fed monetary policy, which favors the US dollar versus emerging market currencies. USD denominated bonds: To benefit from Bolsonaro taking the right first steps Since his victory, Bolsonaro has made key announcements related to economic policy that have been supportive of our overweight position in Brazilian USD-denominated bonds in our emerging market credit model portfolio. His nominations for the most important members of cabinet have been well received by the market. The same applies to his selection of professionals to lead the most important quasi-sovereign institutions. These and other steps suggest that the incoming administration is serious about pursuing an ambitious reform agenda and changes aimed at reducing red tape, encouraging private sector initiative, and increasing the com- petitiveness of the Brazilian economy. His government still has to define how it plans to address the pension reform, which is crucial to balancing the budget in the coming years. In a baseline scenario, we expect Bolsonaro’s gov- ernment to be able to pass changes to Brazil’s social security system through Congress. A deep fix is unlikely, however, and risks of delays and outright failure exist given the politically complex nature of the task and the fragmentation of the Brazilian Congress. This month,

Chief Investment Office Americas, Wealth Management 26 November 2018 6 Investing in Brazil

we have nonetheless upgraded Brazil's sovereign credit outlook to Improving. We believe the ongoing political change will ultimately lead to improved sovereign creditworthiness. We also maintain an overweight in our credit model portfolio as we believe the Brazilian bonds should benefit from the abovementioned trends, and expect continued quasi-sovereign to sovereign spread compression.

Chief Investment Office Americas, Wealth Management 26 November 2018 7 Investing in Brazil

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Chief Investment Office Americas, Wealth Management 26 November 2018 8 Investing in Brazil

Appendix

Emerging Market Investments Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt changes in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. CIO GWM generally recommends only those securities it believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual State registration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law, CIO GWM may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued in jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws. For more background on emerging markets generally, see the CIO GWM Education Notes, Emerging Market Bonds: Understanding Emerging Market Bonds, 12 August 2009 and Emerging Markets Bonds: Understanding Sovereign Risk, 17 December 2009. Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in the investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign has defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yielding bonds for shorter periods only.

Research publications from Chief Investment Office Global Wealth Management, formerly known as CIO Americas, Wealth Management, are published by UBS Global Wealth Management, a Business Division of UBS AG or an affiliate thereof (collectively, UBS). In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/ or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS). All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS and its employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law.

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Version as per April 2018.

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Chief Investment Office Americas, Wealth Management 26 November 2018 9