Batten down the hatches. Brazil, the media-darling of the world financial press and the poster child for emerging-markets investing, is heading directly into the eye of the storm.
Until now, Brazil has provided investors with a thoroughly rewarding run. Investors who followed Money Morning's October 2008 call to buy the iShares MSCI Brazil Index (NYSE: EWZ) have notched a 160% return.
But with this BRIC country now clearly running into trouble, it's time to trim any holdings you may have.
Here's why…
When Good Governments Go Bad
Since the 2009 run-up, it has become clear that the Brazilian government under Luis Iñacio (Lula) da Silva has not really changed its anti-business approach. Yet next month's combined presidential and parliamentary election (Oct. 3 with a possible runoff election on Oct. 31) looks like it will reward this "bad behavior" with a victory for Lula's handpicked successor, Dilma Roussef, and their leftist coalition.
To understand what we mean, let's start with a look at public spending. Official government spending was budgeted in December to increase by a moderate 10.7% in 2010, and has been subject to modest further trimming since the spending plan was unveiled.
However, spending in Brazil's 119 state-owned companies – which has been accelerating in recent years – is currently expected to increase by 32% this year. Moreover, lending by the Brazilian Development Bank (BNDES) is expected to double from where it was in 2008 to reach 150 billion reals ($87 billion) this year, while housing lending for the first half of the year was up 51% from the same period in 2009.
In addition, the government recently announced an $886 billion infrastructure investment plan for the next seven years, the Program to Accelerate Growth. Brazilian state banking lending has increased in the last few years from 1% of gross domestic product (GDP) to more than 7%, and that figure should realistically be added to the official budget deficit.
Hidden Deficit
A second area of Brazilian backsliding is in the oil sector. The oil law passed last year gives the state full control over oil resources, and it has used that control to charge the partly state-owned Petroleo Brasileiro SA (NYSE ADR: PBR) $8.51 per barrel for rights to 5 billion barrels of oil the company itself discovered (plus all the various other extortions already in place).
As a result, in a market that can best be described as difficult, Petrobras is being forced to raise $65 billion in equity to pay the government and to finance the capital investment needed to exploit its sub-salt Tupi oil resources. Meanwhile, the $42.5 billion to be received by the government is, of course, accounted for as revenue, so the stated deficit should be increased by this amount – another 2.8% of GDP
Combine these two effects, of state bank lending and Petrobras' cash subsidy, and you can see that the forecast of a deficit equal to 2.1% of GDP that was put forth by the Economist panel of experts is actually more like a deficit of 10-12% of GDP. Yet, unlike the U.S. and British economies that have suffered under deficits of this magnitude, the Brazilian economy is in the middle of a roaring boom, with projected GDP growth of 7.8% for this year, according to The Economist.
It's not as if Brazil was under-indebted, either; the excessive public debt nearly sent the country into bankruptcy in 2002, and the leeway before debt repeats the process is less than Brazilian commentators seem to think.
Political Risk
Until a few months ago, it was commonly believed that Lula would be succeeded by Jaime Serra. Granted, Serra is a pretty uninspiring old hack; but he's a centrist who could at least be relied upon to be reasonably favorable to the private sector – and to be not too profligate with public spending.
In recent polls, however, it's Roussef – Lula's preferred successor and former development minister – who is leading handily. Economically unsophisticated voters seem to be giving the government credit for a boom that has in reality been produced by high commodity prices and excessive state spending.
Roussef is a true believer in creating growth through government spending and income redistribution. So if she wins, bet that current policies will be intensified.
Indeed, the road map for their intensification has already been set out.
However, with a true public-sector deficit of 10% of GDP and public spending that's already the highest in Latin America, there isn't much room to expand the state sector before the country runs into big trouble. While commodity prices keep rising, the commodity-dependent Brazil will at least be able to borrow the money it needs.
But if commodity prices falter, a crisis of confidence would be more or less inevitable.
There are positives. Brazil's central bank (the Banco Central do Brasil) continues to maintain an admirably sound interest-rate policy, which has kept the Selic short-term rate – currently 10.75% – far above the current inflation level of roughly 5%. That has prevented the inflationary spiral that would otherwise be well underway.
However, central bank governor Henrique Meirelles declined the opportunity of running as Roussef's vice president, and is likely to retire if she wins. Needless to say, monetary policy would quickly change if an inflationist were appointed as his successor.
Brazil has had these bursts of growth before, and they have always been ended by a debt crisis followed by a period of forced austerity that has wiped out the previous boom's income gains and worsened the country's huge inequality. If Roussef wins, as seems likely, this pattern is likely to repeat within at most two years.
For Brazilian investors and citizens alike, that will certainly be a pity after such a strong run.
The only exceptions to this "sell now" market call are such stocks as Vale S.A. (NYSE ADR: VALE) and Fibria Celulose SA (NYSE ADR: FBRF) that are directly benefiting from the global commodity boom.
[Editor's Note: Why is it that Money Morning's Martin Hutchinson has been right on the money with every one of his political predictions for each of the last three years?
The answer is quite simple. The same skills that made him a successful global merchant banker – where he was easily able to identify winning trends for his clients – also make him one of the very best political prognosticators.
Just look at some of his most recent global predictions. Earlier this year, just a week after Hutchinson recommended Germany, the European keystone reported much stronger-than-expected GDP. He recommended Chile back in December, and three of the stocks he highlighted have posted strong, double-digit returns – and one is up nearly 25%. He again recommended Korea – which analysts were downgrading – only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.
A longtime international merchant banker, Hutchinson has a nose for profits instincts – as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon – while also warning us about the potentially ruinous pitfalls hidden just around the corner.
With his "Alpha Bulldog" investing strategy – the crux of his Permanent Wealth Investor advisory service – Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.
Take a moment to find out more about "Alpha-Bulldog" stocks and The Permanent Wealth Investor by just clicking here. You'll find the time well spent.]
News and Related Story Links:
- Money Morning Buy, Sell or Hold:
Buy, Sell or Hold: iShares MSCI Brazil Index - Wikipedia:
Luis Iñacio (Lula) da Silva - Brazilian Development Bank:
Official Website - Wikipedia:
Dilma Roussef - People's Daily:
Brazil to launch Program to Accelerate Growth - Bloomberg News:
Petrobras' Tupi Oil Field May Hold 8 Billion Barrels - Wikipedia:
Henrique Meirelles - Banco Central do Brasil:
Official Website
I am Brazilian and sadly I have to agree with Martin Hutchinson's analysis.
I would only add another reason for the Brazilian economic success this decade further to commodities boom: former Brazilian president Fernando Henrique Cardoso reforms which eliminated the inflation, cut state deficit, huge privatization program and the implementation of other measures which helped modernize Brazil.
Dont count your chickens too soon. Whilst the northern so called "first world" collapsed
financially, leaving millions out of work etc etc. and this trend is still obvious, most countries
in South America opted to change their policies from capitalist to socialist……including Brazil.
It took Lulo quite a while to recognize this, but finally the penny dropped. Hence the
continued growth not only in Brazil but other countries as well, much to the envy of europe and the USA. Bill Clinton once placed his hand on Kirchners arm during a visit to the USA, and said:" I have to congratuale you on your success, but how on earth did you do it".
To create sucess, one has to stimulate not only growth, but spending as well, hence, making the usual belt tightening, and cut backs, one does the exact opposite……increase government spending including pensions, as these will result in further economic growth. Simple right?
I guess the other insight is to stop being so darned greedy, especially banks and financial
institutions, as these bring eventual diaster to the respective countries…..but….they get bailed out and the horror starts all over again.
WHEN WILL YOU LEARN??????'
Re Hutchinson:
In an Aug 30 piece he wrote concerning the "Tobin Tax":
"The major international banks – and Wall Street in general – are simply "rent-seeking;" that is, extracting profits out of the global economy while offering nothing in return. That's another reason to really like the Tobin tax: It would reduce the size and trading speed of both "fast-trading" and the global derivatives market, would raise revenue from this activity and reduce its volume, benefiting us all."
Here is a comment from our son Robin, a Fourth Year at U Chicago, with whom I shared this article:
"Raising transaction costs has only ever served to reduce efficiency. Hutchinson fails to realize that "rent-seeking" is a process which makes markets possible while increasing their efficiency. To suggest that the consumer would be better off with a less efficient market is ludicrous.
Hutchinson also seems to suggest that the tax would decrease the volume and "trading speed" of the global derivatives market and that this would benefit us all. Firstly, I fail to see how a tax would slow an electronic transaction. Secondly, what business is it of his (or the public) if BP, for example, wants to hedge it's interest rate risk with derivatives (never mind the speed at which it does so)? What makes a smaller derivatives market better? I'm inclined to think the opposite is true.
Another example of someone wanting something for nothing without understanding the nature of the transaction he wants to tax."
Well said young feller! Definitely a chip of the old block. Guess who will be handling our investments. I do enjoy reading Hutchinson, but like most talking heads, inflated with their own methane, he is often "Off the mark". My own particular theory fashioned long before I had even heard of the Oracle of Omaha, is this: …if you do not understand the market, you have no business trying to game it. You have even less business trusting a talking head with your money. There is only one solid way to profit – especially in these perilous times – educate thyself; tread as if tippy toeing on a truck load of rotten eggs; invest cautiously; do not put all your eggs (fresh please) in one basket; be sure to pull it all out to safety if you smell even the hint of an eggy discharge of gas from the collective rectum! And remember beyond remembering, if it sounds to good to be true …. IT IS!
Personally I will be buying puts and related strategies on just about everything States' side, until I see a solid flame return in late 2012/2013. I smell gas, a lot of it, and its about to blow!
What about smaller Uruguay?
As tax cut for the wealthy, Obama's right to put the stop on it. Look, they already enjoyed the tax cut for a decade. How many jobs they created?
1) They actually shipping jobs oversea.
2) Since they possess most of the wealth in the country, they must pay much bigger share of tax to rebuild the country.
You wear the color green with envy well. You are obviously a salaried worker who has never had a business or employed anyone. Take a look around and open your eyes. The very people you want to ROB from are the only reason you have a job. In case you have not noticed, when those same people are over regulated and overtaxed (robbed) they lay people off or close their doors, hence 9.6% unemployment. You don't get it. When a business owner is only going to make a little more than his employees, there is no incentive to be a business owner. I hope you know where the nearest welfare office is. The well informed ! Not the NAIVE !
I have to agree with Martin Hutichinson,I have many shares invested in the IBOV and since last year there has been little or no movement in value now with the presidential election(appointed new president Dilma) I am afraid that Brazil will go from bad to worse in the next couple of years There is already an indication in the housing market that there is a housing bubble ready to burst in Brasilia,Rio and Sao Paulo it is only a matter of time for this to burst and with this " new Government" I am afraid it will be soon
First we see Government control in Petrobras and next will be Vale that will be controlled by government since the government sees a company doing well it needs the coruption tactics to take a stake from it and drive it into the ground like TELBRAS , PETROBRAS and soon VALE
Robert
You must know the priorities of the governments like Brazil and China is to lift their population off poverty and create jobs. Not serving the greedy Americans investors who are no more than leeches to suck these countries bone dry. Even an idiot can see that from reading the news letter headline such as " Make Cash 1,000% profit over Crash!" "How to double triple your money in this or that trade…" etc etc.
Look at the poverty and the % of poor people in those countries, where do you think the profit come from? And how much they will let you to rob them? Yes, they might have to let you take great advantage of them that at the beginning when they have no choices. But then later as they are doing well and have more choices, they all started to protect themselves.
Interesting point. I don't see people laboring and sweating in the sun to allow Citibank raise its dividend
Nothing is said about future Olympics or World cup! How does this affect future economic growth?
Larry A.
I was and am hoping the BRIC countries would take off and get their act together in the next couple / few years. Perhaps it's about time another country becomes the world reserve currency to enable the citizens to reap the benefits other than the US who I believe was "given" the opportunity (they didn't earn it) to become the world reserve currency with many thanks to the Brits!
Most of the tax cuts for the wealthy went to foreign investment. Take a look at census data. Should we give more money to the wealthy so they can invest elsewhere? Only if we are really stupid!
By the way, Dilma Rousseff and Lula are more centrist than the article seems to understand. I don't see much difference in the policy proposal from Jose Serra (not Jaime Serra!) and Rousseff. This left vs right politics is not part of Brazilian politics.
Lula's victory 8 years ago created the same doom and gloom in the market and fear of a hardcore leftist taking over. But we got a nice centrist who continued the policies of Fernando Henrique Cardoso and a lot of investors made a ton of cash. Regardless who wins, the new government will be a continuation of Lula.
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