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By Joseph Hogue CFA

Brazilian stocks have been hit harder than other markets in Latin America, save for the obvious fallout in Argentina.

Image courtesy Evandro Miquelito: http://www.flickr.com/photos/emiquelito/

The Bovespa index is down 8.3% since the beginning of the year and 13.0% in the month of May. Only the loss in the Brazilian currency - falling by more than 15% from quarter highs, has overshadowed the weakness in Brazilian stocks. The pace of decline in the Brazilian real has caused the central bank to rethink its pace of rate cuts for fear that a depreciated currency will import inflation later in the year.

While the steepness of decline and the amount of stimulus being fed into the system may ultimately cause Brazilian stocks to rebound and outperform others in the region, the increasing level of policy and political risk threaten a systemic event and further long-term macroeconomic weakness. As the largest and most liquid market in Latin America, there may still be individual Brazilian stocks that merit attention but an underweight view is taken on the market overall.

Economy

The government has targeted growth of around 3.5% this year, above last year's growth of 2.7%, while most economists are looking for growth of around 3.1% or lower. The central bank has been aggressively cutting rates in an attempt to support growth and weaken the real.

Despite optimism that manufacturing would rebound after a series of rate cuts, recent data shows a still sluggish industrial sector. The Purchasing Managers' Index (PMI) for manufacturing remains below the 50.0 demarcation for growth, and a drop in forward-looking components like new orders suggests that a recovery is still further down the road. The services PMI has remained above 50.0 since 2009 and continues to show strength in consumer demand.

Domestic demand has held up fairly well with manufacturing being the culprit behind weakness. Other than Mexico, which has enjoyed strong industrial production growth due to a rebound in the United States, the one-sided nature of economic growth is a trend throughout much of the region. Retail sales and services have performed well given a strong domestic consumer and increasing credit growth but exports and industrial production have been very weak due to slowing growth in China and Europe.

The central bank last week suggested its pace of rate cuts would slow in the months ahead. The monetary authorities cut the benchmark SELIC by 50 basis points to 8.5%, a record low with a smaller decrease than at previous meetings. Though the pace of cuts may slow, low pricing pressures will most likely keep the rate lower into next year. Inflation currently sits around 5.1% but is expected to fall closer to the bank's target of 4.5% by year end.

The sluggishness of the economy to respond to rate cuts suggests that the government will need to resort more to fiscal stimulus to spur growth. Lending by the state development bank, BNDES, will most likely pick up through the second and third quarters.

Rate cuts and an artificially weak currency may help to boost exports in the short-term, but until the country can fix some of its long-standing anti-competitive problems it will continue to lag other emerging markets. Doing business in Brazil is such a problem that it has its own name. The 'Brazil cost' is a combination of bureaucracy, taxes, and infrastructure that makes the country one of the most difficult in the region behind Venezuela and Argentina. A monstrously complex tax code takes 2,600 hours a year for the average company, fourteen times the amount in the United States and the highest of 183 countries measured by the World Bank. While the government has made plans to privatize and update much of its overdue infrastructure problems, many investors are questioning whether the country can be ready for the 2014 World Cup or the 2016 Summer Olympics.

Brazil is expected to receive an increase of 500,000 airline passengers during the month-long World Cup in 2014, followed by an even larger inflow for the Summer Olympics in 2016. Investment in airports and other necessary infrastructure has not kept up with needs. Passenger traffic increased 118% between 2003 and 2011, more than any other in the world over the past decade. The last major privatization drive by the government was in the '90s when the government sold off some of the network of roads and utilities to increase private participation and investment.

Risks

Policy risk is increasingly becoming an issue in Brazil as the administration leans further towards intervening in the markets. As global economic uncertainty increases, the Brazilian government seems to fumble awkwardly with stimulus designed around populist intervention. This kind of market control has a habit of making things worse in the region, increasing capital flight and inflation.

The government has recently put pressure on state-owned lenders to lower rates for consumer credit. This is threatening profits for financials and may cause a credit bubble even as the default rate on consumer loans jumped to 7.6% in the first quarter.

Brazil has unveiled a series of uncoordinated stimulus measures over the last few months aimed at jump-starting an economy that has underperformed its BRIC and other emerging market peers. The most recent series is targeted largely to the auto industry which has grown increasingly uncompetitive due to high taxes and input costs.

Appearances of political pressure between the central bank and the government have raised questions of central bank independence and weakened the country's economic stability. While the central bank maintains its independence, officials have gone on the record with rhetoric very similar to that of the government. Additionally, despite inflationary pressures towards the higher end of its target range, the bank has lowered rates to historic lows and is likely to ease further through the year.

Besides the risks specific to Brazil, it also faces similar risks to other commodity exporters and emerging markets. As of June, stimulus measures in China have yet to stabilize growth and demand is seen falling further over the next few years. The European credit crisis is creating an environment increasingly uncertain and may have started to affect the recovery in the United States. While the crisis should subside in the second half of the year, sovereign debt profiles in developed markets will still be a problem for years to come.

Investment options

Policy and political risks are major drivers in Latin American equities. One of the most important strategic decisions to be made is that of decreasing allocation in markets before policy risks create a financial collapse similar to those in Argentina and Venezuela over the last decade. While many investors prefer to hang on and benefit from the high returns commensurate with high levels of volatility, longer-term investors are better off moving allocations to market-friendly countries.

As the largest and most liquid market in Latin America, individual Brazilian stocks may still merit attention. Retailers and consumer services like TIM Participacoes (TSU) and Net Servicos de Comunicacao (NETC) should do well as the government intervenes to support domestic demand and currency manipulation makes import products relatively expensive.

Gerdau (GGB) produces and sells steel products in the country and could see an uptick as projects increase ahead of international events in the next few years. The company offers crude steel products used to manufacture wire rods, rebar, as well as long rolled products. The shares trade for about 13.3 times trailing earnings and pay a dividend of 1.4% per share.

The EG Shares Brazil Infrastructure (BRXX) remains a possible diversified bet on Brazilian stocks in infrastructure. The fund holds a diversified mix of sectors including: utilities (37.7%), industrials (25.1%), telecommunications (14.5%), basic materials (12.2%), and financials (8.1%). The fund charges management expenses of 0.85% and pays a dividend of 4.1% per share.

The iShares S&P Latin America 40 (ILF) is the most heavily-traded ETF for LatAm exposure with about two million shares traded daily. Despite its claim of providing exposure across Latin America, it is heavily concentrated in Brazilian stocks (54.2%) and Mexican stocks (26.9%) with marginal exposure to Chile (11.0%), Peru (4.8%), and Colombia (2.3). Investors may use the fund to maintain some exposure to Brazilian stocks while mitigating risk with exposure to faster growing and more stable markets in the region.

American Depository Receipts of Brazilian stocks include:

Company Name

Symbol

Sector

OI SA

OIBR

Communications

TELEFONICA BRASIL SA

VIV

Communications

TIM PARTICIPACOES SA

TSU

Communications

GAFISA S.A.

GFA

Consumer Durables

BRF - BRASIL FOODS SA

BRFS

Consumer Non-Durables

CIA DE BEBIDAS DAS AMERICAS

ABV

Consumer Non-Durables

NET SERVICOS DE COMUNICACAO SA

NETC

Consumer Services

EMBRAER SA

ERJ

Electronic Technology

PETROBRAS - PETROLEO BRASILEIRO SA

PBR

Energy Minerals

ULTRAPAR PARTICIPACOES SA[

UGP

Energy Minerals

BANCO BRADESCO SA

BBD

Finance

BANCO SANTANDER BRASIL SA

BSBR

Finance

ITAU UNIBANCO HOLDING SA

ITUB

Finance

CIA SIDERURGICA NACIONAL SA

SID

Non-Energy Minerals

GERDAU SA

GGB

Non-Energy Minerals

VALE SA

VALE

Non-Energy Minerals

BRASKEM SA[

BAK

Process Industries

FIBRIA CELULOSE SA

FBR

Process Industries

CIA BRASILEIRA DE DISTRIBUICAO GRUPO PAO DE ACUCAR

CBD

Retail Trade

GOL LINHAS AEREAS INTELIGENTES SA[

GOL

Transportation

TAM SA

TAM

Transportation

CENTRAIS ELETRICAS BRASILEIRAS SA

EBR

Utilities

CIA DE SANEAMENTO BASICO DO ESTADO DE SAO PAULO

SBS

Utilities

CIA ENERGETICA DE MINAS GERAIS

CIG

Utilities

CIA PARANAENSE DE ENERGIA

ELP

Utilities

CPFL ENERGIA SA

CPL

Utilities

Source: How To Play Brazil In 2012