Guest Notes From The Sales Desk - Can Brazil Get Its Groove Back?

Submitted by Brian Rogers of Fator Securities

Can Brazil Get Its Groove Back?

“Ever since I was a little girl I always heard Brazil was the country of the future. Now that the future is here, I am starting to fear it will be brief,”
- Cynthia Benedetto, the chief financial officer of Brazil’s flagship manufacturing firm, Embraer SA, the world’s No. 3 jet maker

Is the Samba Beat in Brazil A Little Off-Key These Days?

From my recent conversations with emerging market portfolio managers, it is becoming quite clear that the enthusiasm investors had placed in Brazil as a domestic growth story earlier in the year is running thin.  Buy why is the bloom coming off the rose? 

Some of the things portfolio managers are saying range from an experienced small-cap Latam buyer who said, “Inflation, Mantega going Don Quixote fighting wars that nobody creates other than themselves with high inflation.  There is just no visibility,” to a large global fund manager who said, “I am in Brazil this week, it’s slowing down here for sure...”

Banco Fator head of equity research Lika Takahashi made some very insightful comments this morning on this topic.  In her view, there are couple of factors.  First off, valuations in Brazil remain high.  Especially considering that it’s likely the global slowdown coupled with high inflation domestically will crimp margins going forward, something she believes is not fully priced in yet.

Another reason Lika highlights is the diminishing strength of the domestic growth story in Brazil.  Earlier in the year there was a big emphasis on the growing domestic theme in sectors like apparel, consumer electronics and housing. 

If you compare the returns on the IBOV with the S&P, Brazil trounced the US by 13% from June 2009 to April 2010 (+51.5% for the IBOV vs +38.5% for the S&P).  QE3 kicked in from Sep 2010 to approximately June 2011.  This was the period when a number of IPOs launched in Brazil, many focused on domestic stories.  During that time period, Brazil massively underperformed the US during this timeframe by -29% (-10% for the IBOV vs +19% for the S&P).  Even during the latest European “hopium” bounce from early September 2011 to now, Brazil has underperformed the US by about 2% (+10.4% for the IBOV vs +12.3% for the S&P).

My sales trader, Mark Webb, is also highlighting the premium, or rather lack-thereof, between ADRs and local shares.  Typically the average premium is somewhere close to 2%, while today it’s only around .4%.

So you’ve got the domestic story losing steam while the central bank keeps cutting rates which has many concerned about an inflation rate that is already running above the upper band of the central bank’s target.  Investors generally unhappy with the level of visibility from Dilma and Mantega on future economic actions.  Meanwhile, the strong commodity story is also falling flat as concerns abound about an imminent collapse – hard, soft or otherwise – in China.  Since China has replaced the US as Brazil’s number one trading partner, you can bet that any pain felt there will be shipped overseas to the land of caipirinhas.

Wither Brazil?

Hardly.  Yes, they are likely to have an inflation problem to deal with, particularly when the US Fed launched QE3 in earnest.  Yes, they are going to suffer as China inevitably slows down.  Yes, massive government spending is needed on infrastructure projects to boost productivity and in tried and true corrupt fashion, much of this will end up in the pockets of politicians and their sycophants.  And yes, all of the above could lead to stagflation. 

But here’s the joke, so will every other country on the planet.  And in most places, the damage will be much worse.

Over the long run, do you really think the US will be able to outperform Brazil?  Our government is massively over-leveraged and quickly surpassing the Rogoff-Reinhart threshold for eventual default.  Our consumers are also saddled with boatloads of debt and weak job prospects to service that debt.  Our monetary policy as dictated by the Oracles at the Fed is bloated beyond any reasonable expectation of what was originally expected when the Fed was created in 1913.  Our corporations, while “loaded with cash” as is frequently stated on the financial news channels, are addicted to manipulated low rates.  How competitive will our corporates be when rates begin to rise meaningfully in the US?

What about Europe?  Are they better off?  Not even close.  It remains to be seen what’s going to happen regarding the EFSF and the bank recapitalizations, but no matter what road they take, it’s likely the unintended consequences will overwhelm any plan they glue together.

How about Asia, meaning China and Japan?  China has been working overtime building non-productive assets in a massive “make-work” effort.  Problem is, the non-performing loans associated with all of that growth is going to be huge.  At some time, there will be a big bill to pay in the form of their own bank bailouts and when this day comes, you can kiss their $3tr in currency reserves goodbye.  Some think the Chinese will never, ever sell their Treasuries.  Good luck with that view.  Once the domestic situation in China deteriorates as they are unable to generate enough jobs building unoccupied malls, unused roads and bridges to nowhere, they will sell so fast your head will spin.

And Japan?  Over 200% debt/GDP.  History is clear on this one, it will end in tears.  It may take longer than most economists think but it’s coming.

Keep the Faith

Despite the current negative environment for Brazil as discussed above, the country remains one of the best emerging market destinations on the planet, relatively speaking, of course.  Brazil can boast of solid demographics, huge commodity resources and more flexibility with their monetary and fiscal policies than almost any other economy of comparable size.  The domestic story may have slowed but it’s far from dead.  In fact, over the long haul, Brazil’s population of 200 million consumers will keep demanding a better diet, higher quality education and better housing.  With this in mind, investors would be well-served to use these downturns to scoop up bargains in the domestic sector. 

Perhaps that buying opportunity isn’t today, we’re still a long way away from the Great Reset.  But in a world where fiat currencies are devalued and consumers over-leveraged, it’s going to be commodity rich Brazil and their young population that will do the best on a relative basis.



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