Brazil as a Hedge in the New Economic Paradigm

The consensus among many investment advisors is that the economic paradigm that will define the next decade will be characterized by inflation, currency devaluation, commodity appreciation and slow real growth. Marc Faber accuses the Federal Reserve and other central banks of reckless money printing, Jim Rogers emphasizes that the dollar is a flawed currency, and Michael Pento warns that the U.S. economy has all the elements of a banana republic.

Most citizens of the developed world derive their salaries from and have their primary residences in their home countries. They are therefore heavily exposed to weaknesses in their local currencies and economies and must seriously consider the benefits of investing beyond their borders. A review of the key trends of the new economic paradigm suggests that Brazil offers a valid hedge to potential instability in the developed world:

• Stagnant Growth in Real Terms: Consumption represents 70% of the U.S. economy and reduced access to credit will continue to curtail the U.S. consumer’s spending habits. Wall Street may enjoy stock market rallies fueled by low interest rates, but Main Street is unlikely to find a catalyst for growth in real terms. By contrast, Brazil has a growing internal market with a diversified economy. Unlike other developing countries, Brazil is not heavily dependent on exports nor are its exports concentrated in a single industry. Although Brazil is viewed primarily as a commodities producer, commodities represent less than 30% of the Brazilian economy.
• U.S. Inflation and Dollar Weakness: Increasing public debt, low interest rates and a rise in the money supply create a threat of inflation in the U.S. and a weak dollar. Deterred by fears of repeating the 1937 recession, Ben Bernanke has indicated that no change in the Fed’s position is forthcoming. Meanwhile, Brazil’s difficult past with inflation has created a hawkish central bank which maintains relatively high interest rates. Though rates have been cut to a historic low of 8.75%, analysts and traders expect rate hikes in 2010. Such action would not cause panic and cessation of investment as would occur in the U.S. since Brazilians are not conditioned to expect uninterrupted low interest rates. Brazil is also a net creditor and has a debt to GDP ratio around 40% as compared to above 60% in the U.S. A look at key statistics of these two major countries of the western hemisphere supports the idea that today’s U.S. is appearing more like yesterday’s Brazil, and vice-versa.
• Rising Commodity Prices: An imbalance between supply and demand is leading to higher commodity prices which could exacerbate inflationary pressure in the developed world. The crisis resulted in the suspension of new projects which will be greatly needed in a few years when demand from the developing world increases. As an important commodity producer, Brazil should benefit while developed countries suffer from the consequences of rising prices.
• Demographic Shift: The developing world now accounts for 80% of GDP growth as a share of the world total (compared to approximately 40% ten years ago). Persons over the age of 65 make up over 20% of the population of developed countries (and this is expected to rise to a third of the population by 2050). The ageing population will dampen growth in developed countries and weigh heavily on fiscal deficits. In the developing world, persons over 65 make up less than 10% of the population and Brazil’s over-60 population by 2025 is still expected to be below 15%.
• Alternative Energy and Carbon Credits: Environmental concerns and the slowing discovery of new oil fields is increasing interest in alternative energy. Some investors, including George Soros, have argued that this area may produce the next wave of innovation that can reinvigorate the economy. Moreover, cap and trade systems are spurring investment in carbon offset projects. The developed world is playing catch-up in the area of alternative energy while Brazil has a fully integrated ethanol program and is a popular location of many carbon offset projects.

In the new economic paradigm, investors should allocate a larger share to emerging markets than in the past. Among developing countries, those with large internal markets offer the best hedge since they can decouple more successfully than those that are primarily export driven.

Of the few candidates with large internal markets, Brazil offers unique features such as a democratic system, low exposure to international conflicts, a mature free market economy and a history of private property rights.

Brazil has reached this position of stability by slaying the demons that have traditionally haunted it including dictatorship, inflation, high interest rates, and excessive debt denominated in foreign currencies. The fact that these ailments are less than a generation old and still fresh in the country’s collective memory have actually immunized Brazil against the current epidemic.

BRIC markets were once viewed as risky investments but in today’s environment it would be risky not to participate in those developing countries with large and stable internal markets. There will be fluctuations in the economies and currencies of the developing world and any pull back should be used to gain more exposure.

Jim Rogers frequently suggests that in order to prepare children for the 21^st century they should be learning Mandarin. Portuguese is easier for most Americans and Europeans and may well offer as much opportunity.

Comments

[User 465503:]

so, based on these factors, which stocks/ETF/funds would you recommend for BRIC ?

Sep 24 10:59 AM

[mbkelly75:]

I would avoid Russian Stocks. They may have some good stocks but the Russian Government is too heavy-handed in doing things like closing the entire stock martket down for very little reason at all. Last year - they closed their market down something like 1/3 of the year. They are too unpredictable for me.
I would look at other countries besides the BIC though or as well as the BIC. Commodities are going up and some of the commodity-based currencies are doing very well (Australian Dollar, Norwegian Krone, and the Canadian Loonie are examples). I would look at stocks that pay a dividend in those currencies to take advantage of this also. There is a LOT of good choices out there for this purpose.

Sep 24 11:30 AM

[Brian O'Fla...:]

nice post, Steve, thanks

Sep 24 02:15 PM

[Alan Young:]

Brazil is a very strong investment destination (along with much of Asia), for all the reasons mentioned. The easiest way in, IMO, is with the smallcap ETF, BRF--not the large cap EWZ, which is overly biased toward commodities.

Sep 24 02:51 PM

[THofler:]

Hey Alan,
What do you think about being long both EWZ & BRF? I consider EWZ to be part of my commodities holdings.

Sep 24 09:06 PM

[Jana:]

Steve, Thank you. Excellent Report ! Facts, Analysis,Realism.

Sep 25 12:26 AM

[utilitus:]

Good thinking & writing- thanks.

Sep 25 06:25 AM

[Ifradique:]

I am a Brazilian Citizen, and live in Brazil. I am a witness of the changes in the economic environment in the last 10 years..I also work in a leading investing firm in Brazil.

I would suggest investors to take a close look at OGXP3 (ticker Symbol)... Which is the only listed OIL private company in the Brazilian stock-market.

Sep 25 05:47 PM

[Benjamin Re...:]

I agree with this post. It's simple, the real will strengthen against the dollar, and Brazilian Equities will outperform equites in the OECD over the next decade. The tide is rising in Brazil as it becomes a huge consumer market as well as a major exporter. Brazil reminds me of the United States in 1982.

Sep 26 12:56 PM

[Mad Hedge F...:]

nyt Hoping to beat the rush, I ordered my Rosetta Stone Portuguese language program last week, fully expecting Rio de Janeiro to win the 2016 Olympics bid. Pick pockets of the favellas of Latin America’s largest city were ebullient. A cheer even went up on the floor of Chicago’s CME, now that the denizens of the Windy City are dodging a monster tax bill. Of course, Obama was in a no win situation, with mud on his face for his failed pitch, and blamed for defeat if he didn’t go. There was never any doubt that the home of the string bikini and the banana thong was going to win. In order to justify the gargantuan cost of the modern games, the International Olympic Committee long ago turned this into an emerging market development program. The great news for investors is that corresponding emerging stock markets have a history of tenfold returns going into the games. Look at South Korea and China. Only the 2004 Athens games were a bust, the home of the Olympics building a games that were far more than it could afford. I have long been a fan of the country that is doing everything right, with a perfect demographic pyramid and a liberal pro business government fueled by resource and energy exports. I managed to catch a 270% leap for my subscribers in the ETF (EWZ) this year. I wouldn’t’ rush out tomorrow and buy on the news, as an impending global stock market selloff is likely to pull it down with everything else. But it definitely should be at the top of your “buy on dips” list.

Oct 04 05:30 AM