Factors That May Impede the Real's Continuing Rise

Brazil’s infrastructure improvement program, Programa de Aceleração do Crescimento (PAC), has plans to fund many projects including a high-speed train between Sao Paulo and Rio de Janeiro. The Brazilian stock market and the Brazilian Real appear to have caught a ride on this train as they outpace many other indices and currencies. Whereas, the Dow Jones and S&P 500 are returning to breakeven for the year, the Bovespa is up nearly 37% (and over 75% off its 52-week low) and the Real has rebounded over 12% against the Dollar (the second best performing currency in 2009). Last month, Dollar inflows exceeded outflows by $1.4 billion. This is a sharp contrast to last November when $7 billion fled Brazil.

Part of this relative strength derives from the growing conviction that Brazil is one of the best positioned markets in this crisis (an opinion put forth in my earlier articles as well). Brazil’s economy has two powerful engines: a growing internal market and a large base of natural resources. The recent wave of earnings reports has confirmed that the consumer base engine can continue to be strong despite weakness in the export-dependent natural resources engine. Last week, steelmaker Gerdau (GGB) announced a drop in revenues of 22% from a year earlier and mining company Companhia Vale Rio Doce (VALE) reported a 33% drop. Meanwhile, beverage manufacturer AmBev saw an 11% gain in revenues and Vivo (VIV), the cellular phone company, increased revenues by 9%.

Over the long-term the Bovespa and the Real should continue to strengthen against the Dollar, especially when inflationary forces take hold of the US economy and provide commodities with higher values. However, investors need not worry that the high-speed train has yet left the station. More weakening events are on the horizon that should provide new dips for interested investors to jump on this long-term opportunity. Here are some factors that could bring back some turbulence to the Brazilian Real’s rocketing performance:

Central Bank Action

During the last run of the Brazilian Real in 2007 and 2008, the Brazilian Central Bank (BCB) made some attempts to restrain the precipitous rise of the currency but was ultimately unable to rein it in. This past week, the BCB bought dollars in the foreign exchange market for the first time since last September. This time their efforts may be more successful as the factors below assist them in achieving their goal.

Return of Risk Aversion

Since the crisis landed on Brazil’s shores there has been a correlation between weakness in US markets and weakness of the Brazilian Real. The same fear and uncertainty which brought down US markets resulted in forced liquidation and a re-assessment of risk which dissuaded investors from emerging markets and caused a retreat to Dollar denominated assets. The current decrease in risk aversion which is raising US markets is the same sentiment behind the flow of funds to Brazil and other emerging markets.

This may be the first rally since the crisis began that is resulting in panic buying instead of an opportunity to unload bad positions. This panic buying may continue for some time as it has not yet reached a crescendo but its sustainability is unlikely. Though there is debate on whether the March lows will be retested, there is a general belief among analysts that more corrections are inevitable as further negative surprises await both the US and Brazilian markets. The forecast of Brazilian GDP for 2009 by private sector economists has fallen from a retraction of 0.3% to 0.39%. A return of fear will undoubtedly result in a retreat to the US dollar once again, though over time these retreats should be mitigated by the growing threat of inflation.

Election and Spending

As mentioned in my previous article, the upcoming election may dissuade some foreign investment until a clearer vision of future policy is revealed. At the end of April more uncertainty was added to the election as Dilma Rousseff, the likely candidate of President Lula’s party, announced that she is battling cancer. As the election approaches and Lula’s presidency ends, there are many who anticipate that he will conclude his mandate with a wave of increased spending. The aforementioned PAC infrastructure program, which kicked off in 2007, has recently been joined by new spending initiatives motivated by the crisis, including the low-income housing stimulus package and tax cuts on automobiles and construction material. An increase in inefficiently managed public spending could negatively impact the Real’s forward movement.

Regional Time Bomb

In a recent World Cup qualifying match, the Argentinean national team suffered a humiliating 6-1 loss to Bolivia, their worst result in over 60 years. The disaster on the soccer field may soon repeat itself in the country’s economy. Though the Brazilian economic landscape is far different than that of its neighbor’s, a powerful seismic event in Argentina will inevitably be felt by its major regional trading partner.

As the global crisis reached a nadir last year, Argentina appeared destined for a repeat performance of its debt-default earlier in the decade. President Christina Kirchner’s administration was able to avert disaster by selling bonds to national agencies, including the state pension which is now flush with cash following last October’s desperate measure of nationalizing the private pension fund.

This delay tactic should allow Argentina to cover its $20B in debt and service charges owed in 2009. The ability to cover 2010 debt is more questionable and beyond that the probability of default increases significantly. The current $150 billion of government debt exceeds the amount at stake in 2002, exports have been halved and foreign currency reserves are rapidly depleting. The situation is further aggravated by increased spending anticipated ahead of the mid-term June elections.

Argentina is following the US’s strategy of taking desperate measures to avoid disasters today without worrying about the consequences in a few years. This “pay it later” approach is likely to result in inflation for the US in a few years and debt default for Argentina.

A failure of one developing country tends to cause distrust of the entire emerging markets sector even though other developing countries do not share the same economic attributes as the failed economy. Hence, a debt default in Argentina would certainly have a psychological effect on foreign investment in other countries in the region including Brazil.

Investors should not fight the current positive trend, but, likewise, they should not succumb to the psychology of panic buying, keeping in mind that there are a number of factors waiting to throw a wrench into the current euphoria. These moments of weakness will provide good buying opportunities to benefit from Brazil’s long-term favorable story.

Disclosure: No Positions

Comments

[tc1:]

Thanks, Steve, for yet another insightful piece on Brazil's situation, and on how to see any likely upcoming dips and invest accordingly.

May 11 10:56 AM

[RiskReturnO...:]

Excellent article. The best analysis of Brazil that I've read on Seeking Alpha. Thanks for going beyond the superficial coverage on EWZ that's all over SA, probably written by those who've never worked in Brazil!!

Another Time Bomb to watch (hopefully not a 2009 event) is the growing consumer lending across all demographic groups (A to D). Having participated in much of Brazil's growth in banking following the 2002 recession, I'm concerned that the 25%+ growth in consumer lending year after year may have run its course. US-centric analysts will say that the total debt service burden is much lower compared to US, UK, and Europe, healthy margins as interest rates are much higher, etc, etc.

But, the real benchmark for emerging markets consumer lending is probably Mexico, Turkey, and South Africa. One can study the developments in those markets and see that once Brazil's GDP per capita reaches a certain level, growth rate slows, and consumer lending hits a wall. The level of lending among the lower income groups in Brazil is especially worrisome, as retailers, consumer finance companies, micro-finance organization, and banks have been very aggressive in offering all types of loan products for the past 7 years. (While it's not fair comparison, using American standards, its deep, deep subprime stuff, offering loans to people making $250 salary per month).

Once loan growth slows (say to 10% or 5% per year), the credit loss rate will shoot up, and create a credit crisis that's likely to draw Brazil into a recession (unless the natural resource sector is really booming). Just look at the consumer debt crisis that hit Turkey a few this this decade, South Africa the past few years, and Mexico right now. Keep an eye out for this Time Bomb. Monitor bank balance sheets and loan portfolio carefully (ITU, BBD).

May 11 11:43 AM

[EUARTE:]

I live in Brasil. Coming from USA I do not like pointing out bad things in Brasil. However, I must agree with the lending portion of the article. I have long wondered how these good people will ever be able to pay back their loans. The interest rates are criminal. These folks do not make a livable salary. They are marginal. Once they can not get more credit it is over. They will just walk away from their debt. Remember the old company store. This is worse.

May 12 11:42 AM