Brazil’s economy has been given a second chance. And so have prospective investors.
Brazil will use that second chance well – shouldn’t we?
Although there are a number of ways to play this promising “BRIC” (Brazil, Russia, India and China) market, including some excellent companies, the best way to capitalize on Brazil’s terrific prospects is through the iShares MSCI Brazil Index (NYSE: EWZ).
In this special in-depth report – in which you will benefit from my special emerging markets expertise – I will demonstrate just why you will want to by this exchange-traded fund (ETF) in increasing increments between now and the end of the year. The report is longer – and more detailed – than the typical Money Morning “Buy, Sell or Hold” report. But this feature has proven so popular, and the following so enthusiastic, that in the midst of this volatile and very-trying market we thought we should go out of our way to offer our loyal following something very special. This report is the result of our wish to show you our gratitude.
My Brazil Story
It was February 1994, and I was discussing Brazil with the chief operating officer of a second-tier Wall Street investment house – one that specialized in high yield and emerging markets bonds. I remember looking directly at him and saying: “I believe Brazil will have no option other than to default or devalue its currency – possibly both.”
My words caught him by surprise and he called the head of the investment-banking firm into our meeting. At that moment, this firm happened to have more than 50% of its trading book playing the “carry trade” in Brazil. That is, they were borrowing in Japanese Yen at very low rates and were investing the proceeds in Brazil – at the time, and consistently since then, one of the highest-yielding currencies in the world. The trade has been a winner for more than 15 years whenever the markets are relatively stable. A sudden forced unwinding of that trade would have been extremely damaging for that bank.
I had just successfully predicted the blow-ups of both Argentina (August 1994) and Mexico (December 1994) and managed to minimize any damage from such financially horrific events, thanks to the superb team I was a member of at Merrill Lynch & Co. Inc.’s (MER) Asset Management unit. The accuracy of my predictions had been a real surprise – even to me, I’ll admit. My estimate was correct within three weeks of the actual blow-up. Now, I was very concerned about Brazil succumbing to the “contagion” effect.
In fact, I was so concerned that I had used my January vacation to travel down to my native Argentina – to visit relatives but also to check on the situation with the Ministry of Economics, the central bank and the heads of the top three Argentine banks to gauge the possible future ramifications of the Argentine fiscal crisis and the “Tequila Effect”.
I also stopped by Brazil on my way back to the United States and conducted my personal “due diligence” in that market, too. I met with the top three banks and the top local brokers, some government officials, a former head of Brazil’s central banks and a local hedge fund. The Brazilians were all convinced that – even though the country was under extreme financial pressure from the markets – it would resist the economic and financial pressures then sweeping the region, and wouldn’t be force to devalue is currency, known as the “Real.”
At the time, derivatives contracts on the Brazilian Real had the largest open interest of all the derivatives contacts traded on the Chicago Mercantile Exchange, evidencing the incredible fight over the value of the currency that was playing out in the marketplace. In Brazil, a similar fight was taking place, with a huge number of local players buying protection against devaluation in the forward markets.
I did not believe them. I thought that surely the private sector would flinch, taking their currency in droves out of the country and forcing the government to devalue.
But Brazil was hanging on. Who was selling the protection? I found out: It was the government banks, defending the currency with all their firepower, knowing that they had green light from the government, who would recapitalize them if needed. The private sector did not panic. Brazil held on.
Fortunately, on this part of the “Tequila Effect,” I was wrong and Brazil survived the contagion to actually thrive. I missed the first third of a zooming “gapping up” rally on the table (missing out on the profits that would have come with that near-vertical jump). But I learned a valuable lesson as I watched the first part of that rally.
I realized that Brazil had made the tough, gradual adjustments on the fiscal side and stuck to defending the stability of its financial system, evidencing a very strong resolve from the locals to stand behind their country. And I learned to recognize those patterns when they appeared again. As they have.
Suddenly, the motto on Brazil’s flag, “ordem e progresso” (order and progress) did not seem far-fetched, as it had been during the second half of the 20th century.
In fact, in Brazil, the phrase “O mais grande do mundo,” which means “the biggest in the world,” is considered locally as the national slogan and is used commonly with national pride. Indeed, from the powerful Amazon River, to its iron ore reserves, to its incredible rain forest, Brazil has been richly endowed. And although economic and political disorder has delayed its development for decades, Brazilian ambition has never died. No wonder the national joke during the last couple of decades of the last century was that “Brazil is the country of the future…and it will always be.”
Even during this period, when there was no outward progress taking place, there were profound internal changes that were under way.
During the subsequent five years, many other crises reverberated around the world, and we watched as Russia and Asia – including South Korea – blew up. While it’s true that Brazil has sold off violently in response to external events or occasional internal problems, it’s important to note that Brazil has never defaulted on its debt nor resorted to a major devaluation as a policy response – unlike its nearby South American neighbor, Argentina. In Brazil, there was clearly a commitment to become a serious, orderly country.
The only two pronounced incidents of weakness involving the Brazilian Real came as its Mercosur partner Argentina defaulted and devalued its own currency by a three to one ratio at the end of 2001, and in a second episode toward the second half of 2002, in anticipation to the inauguration of current President Luiz Inácio Lula da Silva, known by his nickname “Lula,” since the markets believed he would lead Brazil deep into leftist policies.
In both those instances, the markets (and investors) were once again wrong to bet against Brazil. The Real came back every time, especially after President Lula launched one of the most responsible fiscal and monetary policies in the world, and also deepened structural reforms.
At the time, a friend of mine traveled to Brazil with the CEO of a major U.S. company that invests heavily in Brazil to find out what Lula would do. Would he turn Brazil into an economic island or would he keep Brazil on track? They came back from Brazil very pleased. And we have all been pleased with Brazil’s order and progress since then.
Even during the “Goldilocks” stretch of the commodities boom, Brazil kept its interest rates high in real terms, avoiding any possibility of an overheated economy, bringing inflation and managing its economic house with an efficiency that some of the world’s most advanced economies could learn a thing or two from.
And Brazil achieved all of this while its major commodity and industrial exporters continued to invest heavily, expanding both their domestic sales and exports quite smartly.
Brazil’s Shrewd Game Plan for the Current Financial Crisis
Vale (ADR NYSE: RIO), formerly known as Companhia Vale Rio Doce, is the largest exporter of iron ore in the world. It has thrived and continued to expand production of this critical resource, supplying China, Japan, Europe and other major global steel-making operations. The story behind Petroleo Brasileiro SA (ADR NYSE: PBR) is even more impressive: After decades of government initiatives focusing on oil self-sufficiency – which includes deep-sea drilling and the now-vaunted sugar-cane ethanol program – Brazil achieved that goal last year. Now, with the biggest oil discoveries in the world in decades, Brazil is well on its way to becoming an oil superpower.
As President Lula said, “God has given Brazil one more chance.”
And us, as well.
Late last week, Brazil’s hopelessly mismanaged neighbor, Argentina, had to seize its privatized pension fund money in order to meet its fiscal obligations. We’re also watching as Hungary, Belarus and the Ukraine approach the International Monetary Fund (IMF) for help. This directly contrasts with Brazil, which has amassed $200 billion in foreign reserves, having become a net creditor of the world.
So, in this crisis, both the Central Bank of Brazil and the Brazilian government have acted very quickly to backstop the liquidity effects against their banks. The Central Bank of Brazil has been continuously superbly managed, despite changing administrations: and is very experienced in crisis management. It is currently managed by Henrique Meirelles, a highly experienced and greatly respected international banker. Meirelles has operated in the tradition of Brazil’s inflation-fighting central-banking pioneer Gustavo Franco. Franco was one of the economic advisers who put together the Plano Real, which brought Brazilian inflation down dramatically under former President Fernando Henrique Cardoso. Franco was followed at the Central Bank by Arminio Fraga, formerly associated with George Soros in the Quantum Fund, and finally by Meirelles, who was formerly with Fleet Bank.
It’s important to note that the Lula administration has many officials who have previously held senior positions with major international banks. This is a clear indication of professionalism, transparency and commitment to serious macroeconomic and monetary policy management. No more “brincadeira” – playing around.
President Lula went on to say that the government will buy bank stakes in order to shield its financial institutions from the global crisis. This is happening today, as the government’s largest banks have been authorized to buy stakes in Brazilian banks. Much like the U.S. Federal Reserve has done in here in the United States, the Brazilian Central Bank also has been authorized to enter into swap operations with other central banks in order to restore liquidity to the Real, which has been under pressure.
To add further liquidity, the Brazilian Central Bank has reduced minimum reserve requirements for the banks, extended an almost $2 billion line to the banking system to finance exporters and injected some $71 billion to ease liquidity. The Central Bank explicitly requires the banks to lend the money and monitors closely their activities to prevent them from instead using the capital to buy – and sit on – government bonds.
The Brazilian Central Bank also has had to resort to selling only about $23 billion of its more than $200 billion in total reserves, in order to cushion the decline of the Brazilian Real. The upshot: Brazil today operates from a position of macroeconomic strength, like China, India and Russia.
And the Central Bank has stimulated housing by easing liquidity requirements and encouraging banks to lend more. This policy will soon gather more strength.
Similarly, the government banks, rather than international investors, are the most likely to finance a huge electricity project coming for bid. And Brazil’s plans for a major infrastructure build-up should not have problems obtaining financing.
For example, Petrobras should easily be able to finance the estimated $163 billion needed over five years to continue developing its ambitious mega-oil project out of its own cash flow, government and bank financing and profit-sharing arrangements where it chooses. Vale and other major exporters should likewise have little difficulty in moving forward. These companies, like the government, are committed to continuing with their long-term investment plans, despite the current problems.
Nor have Brazil’s market-supporting measures stopped there. Brazil has required all companies to report their derivatives positions and even to estimate future potential losses under certain scenarios on a quarterly basis, starting immediately. This will greatly increase transparency, dispel fears and increase confidence. Some companies saw their currency derivatives positions get hit hard in the recent sell-off. But these hits, which in some notable cases wiped out the quarter’s profits, are a one-time effect, so it represents a buying opportunity in those stocks.
Finally, the Brazilian banking system is sound, with strong capitalization and low delinquencies. Credit expansion has been strong in the recent years, but not overdone. And banks like Spain’s Banco Santander SA (ADR NYSE: STD), government banks and others are taking advantage of the crisis to buy loan portfolios from their weaker rivals, as has been the case in most liquidity crunches in emerging markets.
The critics will refer to this crisis as the first major test for Lula. And many doubt whether he will resist the temptation to throw monetary and fiscal prudence out the window. But Brazil, as has been seen for decades, is much more than just Lula. Its technocratic administration and central bank have decades of experience in crisis management. Brazil’s strong local companies, which are world leaders in many industries, and committed investors, including major multinational companies, are heavily vested in the country’s success.
Going for Growth
As the Brazilian government has done in the past, I expect it to stay the course for the long term, to maintain its inflation-targeting discipline (as the Central Bank recently announced), and stimulate its economy as inflation drops markedly. That will keep Brazil in the running to be one the engines of growth in the world for the next couple of decades.
As we’ve seen, the country’s prudent monetary and fiscal policies, coupled with its solid macroeconomic position, strong reserve position, and controlled inflation will lead to good growth. Gross domestic product (GDP) is expected advance at a rate of between 4% and 5% next year. And since only 13% of GDP comes from exports, Brazil will have lots of room to maneuver. The slowdown in the advanced economies will give Brazil – as well as India, Russia and other emerging economies – room to start cutting domestic rates as inflation abates, just as China is doing right now.
In China, savings are 10% of GDP more than investment, so a slowdown in foreign capital inflow to China is a blessing, since it will allow the Beijing government to deploy its own capital to work and increase China’s internally driven growth as opposed to export-driven growth. The same phenomenon will be pervasive throughout the emerging markets that – like Brazil, India and China – have not squandered their newly found wealth.
Hence, at the current prices, Brazil is – if you’ll pardon the Wall Street slang – a “screaming buy.” In fact, as we speak, foreign investors are flying in droves to Brazil to buy beachfront property at a discount. Prices of financial and real assets have been hit by excessive fears of a Global Depression. When you see that G7 nations have injected more than $3 trillion into their economies in order to backstop the credit crunch, and another economic stimulus plan in the United States is almost a given, you have to realize that this will have an enormous positive impact on the fragile global market situation we are seeing today. As the credit markets thaw out, despite ongoing hedge-fund de-leveraging, we will see renewed waves of buying and Brazilian financial assets will be amongst the biggest winners. Do not be left to watch from the sidelines as I once was.
Recommendation: Buy iShares MSCI Brazil Index (NYSE: EWZ) in increasing increments over the next eight weeks. This means that you will be increasing the amount of money deployed every week, until you’ve invested the total amount that you’ve set aside for this ETF purchase, between now and the end of the year.
News and Related Story Links:
Money Morning Special BRIC Report (Part I):
Special Report: Hit the BRICs for a Global-Investing Double Play.
Money Morning Special BRIC Report (Part II):
Special Report: Hit the BRICs for a Global-Investing Double Play.
The Real Currency Unit.
[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as PepsiCo Inc. (NYSE: PEP), Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), . (Nasdaq: CS), . (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]
** Special Note of Disclosure: Horacio Marquez holds no interest in iShares MSCI Brazil Index.