Buy, Sell or Hold: It's Time to Book Profit on Brazil

Nearly one year ago – Oct. 27, 2008 – I recommended buying the iShares MSCI Brazil Index (NYSE: EWZ). That week, the exchange-traded fund (ETF) reversed its decline and rallied 31%.  Today it is about 110% higher than our original entry point, which pretty much marked the bottom. 

In that article, I highlighted two top Brazilian companies that would lead the recovery: Petroleo Brasileiro (NYSE ADR: PBR) and Vale (NYSE ADR: RIO). And a few months later I specifically recommended Petrobras in “Buy, Sell or Hold” column.  It has since rallied 66%.

Now that circumstances and valuations have changed dramatically, we must revise those forecasts.

My initial recommendation was in a market that had priced in an end-of-the-world, doomsday scenario. I expected massive measures to be implemented by central banks and governments to contain the crisis. 

In Brazil, specifically, my recommendation hinged on the structural strengths that government had painstakingly built into the nation’s economy. I was focused on fiscal and monetary discipline and the country’s decades-long successful struggle to wean itself from imported oil.  And it doesn’t hurt that this commodity powerhouse has just about everything the world needs to grow – other than lithium.

I also highlighted the highly professional central bank, which, independent of political pressures, kept real interest rates high in the Brazil’s commodities-crazed bonanza years. That restraint kept the economy from overheating, built a rock-solid cushion of international reserves to be deployed precisely in a crisis like the one we experienced last year, and resulted in a healthy internal banking system.  The recommendation of EWZ worked like clockwork.

The inevitable critics, many of who laughed at the concept of decoupling, have been proven wrong.  Brazil was the last Latin American economy to go into recession and the first one to come out.  Brazil posted a second-quarter growth of 1.9% and next year it will grow almost 5%.  The economy has added 1 million jobs, which replaced the 800,000 jobs lost during the crisis.

When a country enjoys twin surpluses (primary fiscal and current account) and is sitting on some $200 billion of international reserves, the risk of capital flight that could cripple the economy is minimized.  In Brazil’s case, its high level of foreign reserves and a flexible, floating exchange rate were enough to insulate the economy from the global banking freeze and provide the financing to keep exports rolling. 

The fact that Brazil’s economy is only 13% dependent on foreign trade limited the downside effects of the global crisis. The fiscal surplus and strong banking system allowed for ample fiscal stimuli and credit expansion to take place.  BNDES, the Brazilian development bank, was responsible for a full 39% of credit expansion. Tax cuts and fiscal spending increased, replacing some export-led growth lost.

This has been and will continue to be very positive for equity valuations, as accelerating growth points to rising profits.  But the $64,000-dollar question is: Can this pace be maintained?

To be sure, Brazil is seeing some slippage in its key strengths.  And some of those setbacks have been the result of political developments.  Brazil will hold its presidential elections on Oct. 1 of next year.  As in any presidential election around the world, the incumbent party has a strong incentive to be more stimulative on the fiscal front than it would otherwise be.  And the fact the current President Lula de Silva cannot run will make the election even more heated. 

Additionally, bias toward growth will be very well received by advanced economies that welcome any possibility of generating local jobs via exports.  So the markets are likely to treat any slippage as benign, as Brazilian growth and company profits will “surprise” Wall Street in the second half of next year.  And Brazil is, after all, “slipping” from a very strong position. 

Despite the government’s expected increase in fiscal spending – which is already some 35% of gross domestic product (GDP), excluding interest on debt – Brazil will increase its 2010 fiscal surplus to a full 3.3% of GDP from 2.5% of GDP this year.

However, this fiscal spending and loose monetary policy will increase inflation expectations.  Actually, with key short-term rates at 8.75% and inflation right below 4.5%, Brazil’s monetary policy is one of the tightest in the world.  But these levels are at record lows for Brazil, which traditionally runs tight monetary policies to prevent its economy from overheating. 

There is little risk that Brazil will move rates up anytime soon, since inflation is still expected to remain at these levels though the elections.  If anything, I expect Brazil to be slightly behind the curve on the monetary side until the elections, as the growing fiscal surplus provides some cover.

The International Monetary Fund just published a book entitled “Crisis Averted – What Next?”  In it, the IMF highlights the fact that commodity exporters like Brazil are leading the recovery and will have to exit monetary and fiscal stimuli earlier than the rest of the world. The organization suggests that such nations exit their fiscal stimuli well before they act on their monetary side. 

Brazil’s superbly-managed central bank last week left its rates unchanged at 8.75%, and signaled that it would not move them for quite some time.  Some analysts, including me, don’t expect Brazil to hike rates until after next year’s Oct. 1 presidential elections. 

Brazil’s trade balance also requires attention.  Its September trade surplus was $1.3 billion, down from $3.1 billion the prior month.  The strong appreciation of the Brazilian real, which has rallied some 35% against the U.S. dollar this year, was the main impetus behind this decline.

It is natural that the dollar suffers as the U.S. and other advanced economies slog through a slower recovery. And as Brazil’s economy expands strongly into next year, the nation’s current account will turn negative, to between $18 billion and $28 billion in 2010. 

Imports will grow much faster than exports, but this won’t be a problem for a country that boasts $233 billion in international reserves. And as the current account weakens and turns negative, the real’s appreciation will slow and even start to reverse in the second half of next year.

In the meantime, Brazil’s attractive equity market and fixed-income yields, and its appreciating currency, will continue to attract large inflows of foreign investment.  These inflows will add to Brazil’s international reserves, but this “self-insurance” war chest against global crisis will be costly.  That’s because the returns that the Brazilian Central Bank obtains on its U.S. dollars are very low compared to what international investors get in Brazil’s fixed-income markets.  Hence, in order to slow down the inflows and the appreciation of the real, Brazil enacted a 2% tax on fixed-income and equity investments to deter speculators.

This concern is not unique to Brazil. Many other countries are considering, or have already taken measures to prevent bubbles in their internal markets.  In Asia, the central banks in Hong Kong, Taiwan, the Philippines, Thailand, Indonesia and South Korea have all taken measures to weaken their currencies to counteract recent weakness in the dollar.

European, Canadian and Singaporean government officials have openly voiced their concerns about a weak dollar, and Colombia is considering capital controls. Brazil’s tax is a step in this direction.  At the end of the day, countries will do well to focus on the structural issues that hinder the competitiveness of their companies, rather than resorting to stopgap, distortive measures.

All in all, these setbacks will not detract from the allure of a strengthening economy with pricing power in its commodity exports in a non-inflationary environment.  And strong inflows will continue, even though portfolio inflows will be somewhat lower because of the newly administered tax.

So, we will continue to go long on Brazil, but since we’re up 110% on my previous EWZ recommendation, we should lock in some profits for risk management purposes.

EWZ fell 1.08% Friday to close at $74.34 a share.

Recommendation: Rebalance your portfolio by selling half of your position in the iShares MSCI Brazil Index (NYSE: EWZ) (**).  That is, extract the original capital and leave the profits running, effectively playing with “house money.”  For investors that do not already have EWZ in their portfolios, take advantage of volatility from here to the end of the year to average into a full position.

(**) Special Note of Disclosure: Horacio Marquez holds no interest in the iShares MSCI Brazil Index (NYSE: EWZ).
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