Bottom Fishing In Brazil

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Includes: EWZ, LEMB
by: Evans Osemwegie

Summary

Brazil's downturn has been over exaggerated by international investors.

The fundamentals of the economy remain sound.

The current President is best equipped to lead the nation through the crisis.

I have been watching the situation in Brazil unfold over the last few months and I have come up with two conclusions that may be counter intuitive to current market sentiments but both of which are correct from an economic perspective.

First Conclusion

Firstly, Brazil is not Argentina. In Argentina, there was a lot of ideological policy decisions made by the Kirchner administration which in hindsight were mistakes and the ultimate result of this was that they were shut out of the global capital markets.

Mr. Macri was voted in under a democratic election to take the country in a different direction, he was given a mandate by the Argentinean people on the strength of his record in Buenos Aires and his economic plan for the nation.

Since then, he has succeeded in doing some of what he said he will do, Argentina has restructured her debt and is now once again participating in the global capital markets with more internal reforms to come.

Brazil on the other hand does not share those characteristics, it is a much more diverse economy than Argentina and despite the recent downgrade, it still has access to the capital markets albeit at a much higher cost.

For me, the main concern for Brazil like many other large emerging economies is to diversify their economies whereby they move from simply commodity exporters to exporters of higher value finished products.

In order for them to do this successfully, they must shift from simply consumption spending to investment spending by investing in infrastructure, housing and manufacturing.

These are reforms that I know are already under way in Brazil, the impending Olympics games has provided the perfect opportunity for huge swathes of Brazil infrastructure to be upgraded.

So, with all of the foregoing in mind, I remain strongly bullish on Brazil particularly with the current President in charge for the remainder of her term.

International investors and economic commentators have a bad habit of generalization and jumping to conclusion and thus making matters worse for governments and nations around the world. The tendency has been to group Brazil, Argentina and Latin America including Venezuela under the same economic banner.

This is erroneous because there are significant differences between the economies and an economy like Brazil needs to be given the benefit of the doubt and allowed to transition in the midst of the global commodities downturn.

Allied to this is an admonition to investors to look beyond and beneath credit ratings, the downgrading of Brazil's credit ratings to junk status was really very counterproductive especially when the country has not defaulted nor is it likely to default on its debt.

Nevertheless, I believe that this will be a positive for Brazil because as a result of the higher cost of borrowing, it will force both the public and private sector to rein in spending and instead focus on internal reforms in areas like the pensions systems, current labour market laws, Brazil's trade policy, education policy and so on.

As a result, I believe that we will see the debt to GDP fall to about 55% by the end of 2016 thus making the current ratio the high watermark for their debt to GDP.

With regards to the Brazilian real, as the overall level of debt and inflation stabilizes and gradually begins to fall, we will see a gradual strengthening of the currency particularly against the dollar.

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This rise can be even more dramatic if we see significant increases in the price of commodities particularly oil by the end of 2016.

Assuming the real strengthens by the end of the year and inflation continues to fall, it will allow the Central Bank of Brazil to cut interest rates thus making real denominated bonds very attractive from a valuation perspective especially if it is bought now.

I will recommend ETFs like LEMB and EWZ. They are currently very cheap compared to where they are likely to be within the next 12 to 24 months.

Second Conclusion

My second conclusion is that Ms. Rousseff remains to best person to lead Brazil through this season. In order to determine whether the current economic woes in Brazil are because of policy mistakes by the current administration or are as a result of global economic conditions of which Brazil is a victim.

My opinion is that it is the latter and that the current Vice President Mr. Temer and various other conspirators are guilty of brazen opportunism. They have used the current situation in Brazil to seek to oust the current President and destabilize the country.

As I have said before, Brazil is not Argentina where Macri came in as an outsider and was democratically elected. In this case, Mr. Temer was and is an integral part of the current administration.

This should highlight to global investors and commentators to be cautious in their embrace of a regime change in Brazil.

Brazil's economy is generally on an upwards trajectory but it is never easy to govern a strong emerging market economy particularly as a result of constantly shifting investor sentiment.

A leader of an economy like Brazil will regularly find themselves between a rock and a hard place because on the one hand, they need foreign investments and in order to attract this, they have to spend in order to stimulate economic growth and also increase exports of raw commodities.

On the other hand, in order to develop the economy in a sustainable manner, the government needs to invest in sectors like manufacturing, infrastructure, education and so on.

These investments do not provide a quick pay off in economic growth terms and in such times, economic growth may shrink and as soon as this begins to happen, investors will start pulling out their investments from that economy and thus precipitating an economic crisis.

This is the case for all emerging market economies, the leaders know what needs to be done for the long term but in order to achieve that, they understand they will have to be punished by the global capital markets in the short term.

This is currently the case with China, as long as they were expanding their credit base, manufacturing for the world and growing at 7% per year, investors were very happy but the minute they begin to reorient their economy and switch from an export based economy to a more domestic consumption led economic model, they are punished for the normalization of their economic growth rates.

This is the case with Brazil, I am very confident that Brazil will come out of this crisis stronger in the short, medium and long term and the patient investors will be handsomely rewarded.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.