Brazilian Optimism: Proceed with Caution

The month of April so far has been a veritable celebration of Brazil’s unique position in the global economic crisis. President Obama kicked it off at the G20 meeting by expressing his admiration for Lula and recognizing his status as the most popular world leader (“that’s my man right there, I love this guy”).

Next was the news that Brazil was to become an IMF creditor, offering further validation of the country’s stability. It culminated with the World Economic Forum (WEF) on Latin America held in Rio de Janeiro last week, where economists, strategists and business executives spent two days praising Brazil’s ability to weather the storm and emerge stronger as a consequence. Lula boldly stated that Brazil did not create the problem but is a fundamental part of the solution.

Facing this wave of optimism, the prudent investor should always look to potential weaknesses and shocks that may arise. Some of the participants at the WEF put forward cautionary words. Former President Fernando Henrique Cardoso expressed concern about the inefficiencies of public spending. Former Treasury Secretary Joaquim Levy pointed out that education continues to be a problem and Former head of the Brazilian Central Bank Arminio Fraga noted that taxes were burdensome at 40% of GDP.

A report by the Fundacao Dom Cabral further emphasized the structural weaknesses present in Brazil. In a 2008 ranking of competitiveness, Brazil ranked 64^th out of 134 countries with particularly weak scores in infrastructure (78^th place) and government institutions (91^st place). The main reasons for the poor results were excessive bureaucracy, frequent legislative changes, overlapping and conflicting roles of the federal, state and municipal government and overwhelming regulatory constraints.

For the most part, these issues are the same that have plagued the country over the last few years. The fact that Brazil has experienced remarkable growth recently is even more impressive considering that it has prevailed despite these endemic drawbacks. Though investors should continue to be vigilant about developments in these areas, the true shocks that may derail the current wave of hope may lie elsewhere.

The most immediate concerns are continuing weakness in exports, rising unemployment and the delicate balancing act of lowering interest rates without creating the threat of inflation. There is a fourth element that will gradually take on more importance over the months to come that can potentially give rise to another shock.

In 2002, ahead of Lula’s ascent to the presidency, the Brazilian Real dropped tremendously from fear that he would introduce damaging policy changes. Lula, ever the pragmatist, abandoned the leftist ideology of his party and chose to remain on the tracks of the Plano Real successfully implemented by his predecessor. The 2006 election had a less turbulent effect as a Lula victory was never in any danger.

However, the upcoming 2010 election will bring forth a new wave of uncertainty since Lula cannot run for a third term. The potential candidates appear to be Dilma Rousseff, Lula’s current chief of staff, who was once a member of a leftist guerilla group and may potentially bring the Worker’s Party back to its ideological roots. The candidate from the more conservative PSDB, appears to be Sao Paulo governor Jose Serra who lost to Lula in 2002. There is a possibility that Minas Gerais governor Aecio Neves will also look to be the PSDB candidate. A year and half is still very early in the Brazilian election process so many revelations about the potential candidates’ positions and popularity remain unclear.

However, over the next 18 months investors in Brazilian stocks and ETFs should follow this election closely as it has the potential to shake up the current stability and optimism.

Comments

[tc1:]

Steve, thank you for these caveats about Brazil.
I'd note that Brazil's 2010 presidential election, whereas it will surely bring some temporary volatility in that nation's markets due to the "uncertainty" factor, may not be so horrific in the aftermath if Dilma Rousseff wins, as your words imply.

Despite his far-left background years ago, surely, as Lula's chief of staff, Rousseff must have noticed that his country gets massive infusion of foreign investment and all levels of Brazilian society do well by having a president who runs a slightly left-of-center administration, not a far-left regime. I seriously doubt that, if elected, Dilma, seeing up-close Lula's overall impressive results (and huge popularity both within and beyond Brazil), would make a huge break from his predecessor's policies and try to emulate Fidel Castro instead!!

Apr 22 10:06 AM

[old guy:]

You forgot to ad China as a very positive part of Brazil's future....PBR,RIO... etc..I am doing a double in my holdings ....so far so good!

Apr 22 11:19 PM

[oldfolkdancer:]

A Canadian woman of Chinese descent who works for a Brazilian firm told me the relationship between Brazil and China is excellent. If this is true Brazil will continue to benefit from China's need for natural resources.

Apr 23 10:50 AM

[Dustinian:]

Very good article.

Another point to remember is that many of Lula's social policies reduce profit margins of corporations, and furthermore many top companies are under partial government ownership.

However, precisely because of Brazil's lack of interior infrastructure, I am quite bullish on the Brazilian construction and housing sectors.

On the whole, Brazil is remarkably stable for a resource rich, emerging market nation. There are certainly drawbacks, but I am very positive in terms of investing long in Brazil.

Apr 24 02:11 PM