As I have written many times here, I am a big fan of international investing. I especially like Asian and Latin American markets because of the impressive growth stories as well as political policies that have been put in place lowering taxes and incentivizing entrepreneurs. Throw in to the mix young populations, a growing middle class and an abundance of natural resources, and you have a potentially profitable long-term investment. If I have to choose a favorite in these markets, I would pick Brazil (EWZ).
While the Bovespa was one on the strongest global markets over the last decade, in recent months it’s been hammered. Both the EWZ and the BRF (Market Vectors Brazil Small-Cap ETF) are down 30% since April.
With investors able to get 10-11% on investment grade Brazilian Real bonds due to heightened inflation, it makes the short-term prospects a bit choppy. Why bother with stocks when you can grab double digit returns in the safety of a bond? I think that if we see a bit more downside in the Brazilian market, you will then see a move into stocks, as the long-term potential will be too juicy to pass up.
I recently had the fortune to interview Seth Zalkin, co-founder and managing partner at Astor Group, a global investment banking advisory firm that does a lot of work in Brazil. Zalkin is an expert in the Brazilian economy and really gives a thorough look at the market. Here are some excerpts from the interview:
Q: Can you give an overall picture of the Brazilian economy?
A: Notwithstanding the Bovespa’s recent volatility and concerns about inflation, Brazil’s fundamentals and its long-term outlook both remain strong. The job market is growing and that is supporting a significant transition from a low-wage country to a country with a voracious middle class.
Over the next 18 months, growth should stay strong and the actual GDP should remain above potential output at somewhere around 4.0% this year and slightly higher in 2012. Although the Bovespa is likely to outperform developed exchanges over the long-term, the broad-based uptrend experienced in the last couple of years is unlikely to return.
While Brazil faces a number of fiscal challenges, and its infrastructure demands urgent attention, the country is like a winding mountain road – danger exists around every corner, but with a stable political climate it is slowly getting to its long-awaited destination.
Q: How are inflation worries playing into the story?
A: Brazil's persistent inflation concerns continued in July as the 12-month inflation rate reached its highest level in six years. But concerns about global economic growth and expectations for a retreat in prices later this year will prevent the central bank from raising interest rates when it next meets on August 31 as it had recently been expected to do.
While Brazil’s central bank targets inflation of 4.5 percent, plus or minus two percentage points, consumer prices rose 6.9 percent in the 12 months through July, the fastest pace since 2005. Inflation is expected to peak and then start to trend down by the end of the year. While interest rate hikes and other measures implemented earlier this year may not be enough to bring inflation down to its target in the next year, the stumbling global economy may provide a helping hand. A decrease in the commodity market, lower fuel prices and weakening global demand are all likely to relieve inflationary pressure and even give room for policy makers to cut interest rates if the economy continues to decelerate.
If inflation resists these external factors and continues to spiral out of control, the government will be forced to raise interest rates yet again and risk choking off any significant economic growth.
Q: Do you see a strong ‘Brazilian Real’ continuing?
A: A confluence of events, largely driven by the global economic slowdown, is likely to cause the Brazilian real to stabilize or even weaken over the short and intermediate term.
While Brazil’s high interest rates get most of the blame, it is the country’s fundamentals more than anything else that have driven the appreciation of the real. Gains in commodity prices, increased foreign investment and the indirect impact on interest rates arising from increased government spending have all put pressure on the real. The global slowdown is likely to arrest each of these factors.
- Commodity prices tumbled 4.8 percent this month, according to the Standard & Poor’s GSCI Index, and a weakening global economy will continue to slow demand for raw materials.
- As exhibited by the robust recent redemptions from the Bovespa, foreigners are less likely to invest in emerging markets such as Brazil as their own economies suffer.
- President Dilma Rousseff has signaled that she will oppose any measures to increase expenditures this year, and discretionary spending in Brazil has slowed.
The softening of the real will be welcome news as its appreciation has had a substantial impact on the country’s balance of trade and on the ability of Brazilian manufacturer’s to compete both in their domestic and foreign markets. Brazil’s trade deficit doubled last year to $71bn, and Asian manufacturers have had a considerable effect on Brazil’s industrial base. The government has adopted 28 anti-dumping measures against China, yet China’s annual exports to Brazil have jumped from $5bn to $26bn in five years. With a weaker real, this trend is likely to weaken.
Q: Are you worried that a lot of the foreign investment is/was Hot Money and could leave quickly, if inflation perks up?
A: While a portion of the investment funds entering Brazil have moved in and out of the market, the amount of hot money has been vastly overstated. Central bank data shows that foreign direct investment and higher commodity prices have had a much more substantial impact than investment in Brazil’s bond market. About $42 billion flowed into Brazil between January and April this year, but only $7 billion of foreign investment was made for fixed income products during that period - about 14% less than during the same period last year.
Much of the slowdown of hot money is a result of the government’s successful decision last year to triple the tax it charges foreigners to invest in local bonds as a way to curb speculation. Since much of the capital entering Brazil now is more committed, and since foreign investors face a 6% tax if they choose to withdraw capital and later redeploy it, hot money has become a much less significant factor than it was in the past.
Q: What political/economic policies have been put in place to continue strong growth?
A: The most likely response to a softening economy is for the central bank to reverse course and begin to lower interest rates. This would be a positive sign for stocks and for local companies’ ability to access capital.
While President Rousseff is unlikely to accelerate state investment, lending by BNDES has proven very effective, and it can be expected to have a similar performance in the future. Additionally, the government has implemented a policy of relaxing its antitrust restrictions in order to enable local companies to compete on a world scale. Lastly, the government has considered lowering taxes for small businesses as a way to spur economic growth.
Q: What sectors seem to have the most upside?
A: Most investors entering Brazil first look to the infrastructure and energy sectors. Both of these sectors should continue to be strong. Despite the global slowdown, Brazil will continue to invest in a number of large projects in anticipation of the Olympics and the World Cup, and this should provide lift to the infrastructure sector at least through 2016. Energy may experience some short-term depreciation as a result of the global economy, but the long-term trends are also very favorable.
Getting the most popular categories out of the way, consumer-related sectors (consumer services, consumer goods, education and healthcare) are all prime sectors for continued expansion as the middle class purchasing power continues to increase and the young demographic ages and buys more goods and services. Other sectors that service this consumer growth such as logistics and insurance can also be expected to outperform over the short and long-terms.
Q: How susceptible is Brazil to a slowdown in Chinese economy?
A: While Brazil is a relatively closed economy interms of exports as a percentage of GDP, Chinese demand for its commodities has had a huge impact. With its voracious appetite for commodities, China has now become Brazil's main trading partner, surpassing the United States. Lower import volumes from China would substantially alter Brazilian growth, fiscal and inflationary outlook.
Moreover, Brazil's dependence on commodities is likely to have a negative impact on industrial production in the future. Brazil has already put some protectionist measures in place and if the manufacturing industry continues to suffer this response will only accelerate. The commodity boom has drawn too much foreign money, and it has driven up the value of the real to a level that hurts other industries.
A significant correction in commodity prices could have an enormous impact on the economy’s terms of trade. Brazil’sincreasing lack of export diversification and dependence on commodity prices is also a threat to Brazil’s growth trajectory since the commodity sector provides fewer positive externalities to economic development than the manufacturing and other sectors.
Q: How do you think the Olympics and World cup will impact the economy?
A:The World Cup and Olympics will bring significant economic and structural benefits to Brazil and will also advance the country’s planning and infrastructure network. Increased investment in airports, the power grid, railways, roads and other transportation, hotels, telecommunications, and environmental projects will all have a long-term impact on the Brazil economy that will transcend the direct impact of the actual events.
While studies have shown the economic impact of hosting similar events have been overstated, the Brazil experience stands to be different as it is starting from such a position of need. Other than the moneys allocated to build the stadiums, other investments such as a better transportation system or power grid will benefit Brazilians for many years to come. Some of these projects such as airport upgrades are desperately needed because of Brazil’s rapid economic expansion.
Moreover tourism is likely to enjoy significant and long-lasting effects. Future visitors will benefit from an increase in up to 50,000 new hotel rooms in Rio that will replace much of its antiquated inventory, and the development of Rio’s historic port area is likely to create a vibrant new entertainment district and generate positive benefits to the greater downtown area.
Another area that is expected to have a significant long-term benefit is the more aggressive police action that was long overdue. The pacification program that has been implemented in many of Rio de Janeiro’s favelas has already caused a sharp decrease in crime and increased the security and peace of mind among local residents.
Q: What risks do you see that can derail the story?
Despite the overwhelmingly positive macroeconomic conditions, Brazil is hobbled by a shortage of skilled labor, an inefficient tax system, a level of bureaucracy that places it among the most difficult places in the world to do business and a lack of government transparency. While steps are being made to remedy each of these issues, it is unclear if the political will is available to make such substantial changes.
While Brazil emerged from the last global crises in an enviable position, there can be no guarantee that it will have the same result this time around. Factors that could hurt the Brazilian economy include a substantial deterioration of international trade, a decrease in foreign investment and the collapse of commodity prices. Moreover, Brazil could be hit hard because of its dependence on external financing and its current account deficit.
Disclosure: I am long EWZ. I have clients who own the EWZ