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Regina Chi is vice-president and portfolio manager of AGF Investments Inc.

People walk past a Banco Santander branch in Rio de Janeiro, Brazil on April 29, 2019.Sergio Moraes/Reuters

When Brazilian President Jair Bolsonaro won the runoff election in October of 2018 that would bring him to power, investors paid far more attention to his promises of economic reform than to moderates’ concerns about his populist, far-right social policies, and Brazilian equities surged.

And yet there was plenty of room for skepticism over whether the good times would last. Mr. Bolsonaro, a former military officer, had limited experience in federal government, let alone Brazil’s infamously byzantine one. Many leaders before him had vowed to rationalize the emerging market’s creaky, inefficient economy – some even came close – only to fail. So, if you had concluded in the fall of 2018 that little would come of Mr. Bolsonaro’s promised reforms or investors’ optimism in the emerging market, you would have had history on your side.

And you would have been wrong.

Market enthusiasm has endured, or at least was rejuvenated in the last quarter of 2019, as Brazil became one of the year’s best-performing equity markets. Despite lacklustre (sub-1 per cent) GDP growth and low corporate earnings, the MSCI Brazil Index rose by 20.3 per cent in 2019, easily beating the MSCI Emerging Markets Index, which was up 12.9 per cent. And that’s largely because Mr. Bolsonaro has defied skeptics and began to make good on his promises, including the most significant one: passing legislation to reform Brazil’s wildly generous pension system, which accounts for nearly half of federal government expenditures even though the population is still relatively young, and has been in deficit for years.

To understand why Mr. Bolsonaro’s achievement represents such a seismic shift, one needs to go back to 2012. The end of the decade-long global commodities boom hit Brazil particularly hard, where raw materials comprise nearly half of all exports. The government under Dilma Rousseff tried, but failed, to counter the downturn with credit expansion and spending, but those measures proved futile; in 2014, the economy spiralled into recession. The drop in tax revenue, along with demographic factors, rapidly increased the pension deficit.

Cuts to discretionary spending and the economic recovery of 2017 helped put Brazil’s fiscal position into surplus – but only if you didn’t count pension expenditures. By 2018, the pension system was in the red by 195 billion reais (about $60-billion), according to Bloomberg. So Mr. Bolsonaro inherited a surplus of nearly 2.5 per cent of GDP excluding social security – but a primary deficit of 1.5 per cent of GDP when social security was included.

That made robust pension reform a necessary condition for stabilizing Brazil’s fiscal position in the medium to long run. Last October, Mr. Bolsonaro made it happen. After decades of failed attempts by previous governments, he worked with an infamously obstreperous Congress to pass a pension reform package that is worth around 800 billion reais, representing 9.4 per cent of GDP over the next decade.

That is a momentous achievement, to be sure, and it paves the way for future reform efforts. Those include the “federative pact” amendment, which would shift 400 billion reais from the federal level to states and municipalities over 15 years; the “fiscal emergency” amendment, which would free up 50 billion reais over 10 years; and a “public funds” amendment, which would reclaim 220 billion reais.

Over the long term, this package of reforms could help rationalize the wasteful, corruption-conducive political and fiscal climate that has long plagued Brazil’s economy. And it could institutionalize a framework that will bring some discipline to Brazil’s budget, control indebtedness and restrain fiscal mismanagement by states and municipalities.

What does this mean to investors? The most important implication is that Brazil could regain investment-grade status within a year or so. And to the extent that fiscal and political uncertainty has contributed to poor economic performance, a continuation of the reform cycle should mean higher levels of investment and growth.

Notably, the government has a full slate of administrative and tax reforms on the agenda for 2020-21. The central bank is playing its part, as well. It has lowered interest rates to 4.5 per cent – a record low – and is moving fast to deregulate financial services, especially for financial technology. Meanwhile, consumer confidence is rising. And many companies are ramping up growth plans; M&A activity is increasing after being basically dead for years. If these trends continue, they could transform Brazil’s economic and investing climate – toward consumer-focused goods and services, more innovation and deregulation, and away from government control and reliance on commodities.

Investment opportunities

One company poised to capitalize is Localiza Rent a Car SA (RENT3-Bovespa), a car rental business known as the Hertz of Brazil. It has an exclusive relationship in Brazil with Uber, whose mapping technology and ride-hailing platform have helped Localiza boost its market share to 57 per cent from 45 per cent in just the past year. Localiza also operates a fleet management business, which stands to benefit from improved corporate earnings and a more dynamic business environment. Other companies are notable for their M&A-driven growth plans; among them are Totvs SA (TOTS3-Bovespa), a business software provider, and private educational firm Yduqs (YDUQ3-Bovespa), which is targeting growth to enhance its postsecondary education offerings.

Under Mr. Bolsonaro, Brazil’s economy may have finally turned a corner, but the next few months will show whether it can continue on its path of reform. Last year, optimism drove gains in the Brazilian stock market; this year, investors will be looking for real earnings growth to support valuations. In short, 2020 will put Brazilian equities – and Mr. Bolsonaro’s economic legacy – to the test.

Full disclosure: AGF owns stock in Localiza Rent a Car SA, Totvs SA and Yduqs.

The views expressed are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies. References to specific securities should not be considered as investment advice or recommendations.