Brazil Slips Into Recession, But This Is Not Bad News

Includes: EWZ, PBR
by: Alpha World


Brazil has slipped into a technical recession, further hurting the chances of President Dilma Rousseff's re-election in October.

Rousseff has been blamed for mismanaging the Brazilian economy since she took charge in October 2010.

Recent polls suggest that centrist candidate Marina Silva will beat Rousseff in a second-round run-off.

A change of government will provide a boost to the IBOVESPA, which has already gained more than 20% in the run-up to the election.

Investors can play the Brazilian election with the iShares MSCI Brazil Capped ETF, which is already up more than 21% so far this year.

The Brazilian economy has slipped into a technical recession, with growth contracting for two quarters in a row. The report, which came out last Friday, though, did not have a negative impact on the IBOVESPA. In fact, the benchmark index rose 1.38% to finish at 62,134.21.

The IBOVESPA's rise despite disappointing GDP data doesn't come as a surprise. Bad news on the economic front deals a blow to Brazilian President Dilma Rousseff's prospects of getting re-elected in October's presidential elections. Indeed, the rising prospect of Rousseff losing the elections has boosted the IBOVESPA this year, which is now up more than 20%. Many investors believe that Rousseff has mismanaged the Brazilian economy ever since she took charge in October 2010. Indeed, investors are hoping for a change in the upcoming election, and in recent weeks, the possibility of a change has become stronger. If the economic data continues to disappoint ahead of the elections, it will further dampen Rousseff's chances of getting re-elected.

Brazil Slips into Technical Recession

Brazil last week slipped into a technical recession, as the economy contracted for two successive quarters. The IBGE, Brazil's national statistics agency, reported on Friday that the country's GDP declined 0.6% in the second quarter of 2014. The first quarter GDP figure was, meanwhile, revised downwards from a growth of 0.2% to a contraction of 0.2%.

Economists surveyed by Bloomberg were expecting the Brazilian economy to contract by 0.4% in the second quarter. Investment, which has been a major worry for Brazil, was down 5.3% in the second quarter. The agriculture sector expanded 0.2%, while private consumption was up 0.3%, according to the IBGE. The weaker-than-expected GDP data led to many economists slashing their outlook for the full-year GDP growth.

Weak GDP Data Raises Prospects of Change of Government

Although Brazil's second-quarter GDP was worse than expected, the IBOVESPA finished sharply higher on Friday. That shouldn't come as a surprise, as weak economic data hurts Rousseff's re-election bid in the presidential election, which is scheduled to take place in October.

The IBOVESPA has, in fact, posted gains of more than 20% so far this year. While some of the gains can be attributed to the soccer World Cup, which was hosted by the country, the rise in the index is mainly due to the fact that investors are expecting a change in government.

Rousseff's handling of the economy since she took charge in 2010 has been severely criticized by investors and analysts. According to Reuters, between 2003 and 2010, Brazil's economy grew at an average 4%. However, growth has averaged less than 2% in the last four years under Rousseff. Meanwhile, high inflation forced the Brazilian central bank to raise benchmark interest rates by 375 basis points to 11% in the year through April. While the central bank is not likely to raise rates further, a rate cut is also not likely anytime soon. High interest rates have further dampened Brazil's growth outlook. The weak state of the economy is being blamed on Rousseff's economic policies, which have hurt investors' confidence. Since Rousseff has been in charge, the IBOVESPA has fallen more than 9%, compared to a decline of more than 3% for the MSCI Emerging Market Index. In the same period, the S&P 500 has gained nearly 60%.

It is not just the economy. Rousseff has also been blamed for Brazilian oil giant Petrobras' (NYSE:PBR) woes. Petrobras' shares are down more than 42% since November 1, 2010, and the company has the highest debt among major integrated oil and gas companies. The company's production has been declining, even as it continues to spend heavily. Petrobras' problems stem from the fact that the company has been forced to subsidize petroleum products to support the Brazilian economy. However, the company's failure to boost production has meant that it has had to import more to meet domestic demand for refined products. Petrobras has to pay the market rate for imported oil. But the company has not been allowed to increase the price of refined products significantly in recent years. This has hurt the Brazilian oil giant's bottom line and led to an increase in net debt.

Until a few months ago, Rousseff was seen as the favorite to win October's elections, despite the Brazilian economy's underperformance. However, recent polls suggest that there could be a change of government in October. Aceio Neves, who leads the opposition PSDB party and is seen as pro-business, has been the main challenger to Rousseff. In the last two weeks, though, environmentalist Marina Silva of the centrist PSB party has raced ahead in polls. Silva has been in the reckoning only for the last two weeks, after PSB's presidential candidate Eduardo Campos died in a plane crash. Latest polls show that Silva is gaining momentum. Polls indicate that Silva will beat Rousseff in the event of a second-round run-off. More bad news on the economic front in the run-up to the elections will further boost Silva's prospects.

Additionally, Silva is being seen as pro-business. According to The Economist, a 250-page document released by Silva highlighting the government's program includes some sensible economic policies. If Silva is chosen as president and is able to implement these policies, the Brazilian economy could be back on track. Not surprisingly, Silva's lead in polls is being seen positively by investors. In fact, the performance of the Brazilian market in the run-up to the election is not very different from the one seen in another emerging market, India.

Like Brazil, India's economy faltered after 2010, with the much of blame going to the center-left Congress Party, which was in charge for 10 years until May 2014. The Indian election, held in April and May, saw the opposition BJP voted into power with a massive mandate. The BJP is seen as pro-business, and investors were hoping that its election would kick-start the economy. In the run-up to the Indian elections, the BSE Sensex, India's benchmark index, rallied as the BJP gained momentum. The rally has continued even after the election, as the BJP won handsomely. Coincidentally, India also released its GDP data for the June quarter on Friday. The Indian economy grew at its fastest pace in more than two years.

The IBOVESPA is likely to see a similar rally in the run-up to the Brazilian election, especially if Silva expands her lead in polls. And if she is elected as president, then one can expect a sustained rally.

Play the Brazilian Election with this ETF

In the run-up to the election and in the event of a new government, investors can consider the iShares MSCI Brazil Capped ETF (NYSEARCA:EWZ). The index provides exposure to a range of sectors. It tracks some 76 stocks listed on the Brazilian stock exchange. The ETF has already gained more than 21% so far this year. More importantly, if Silva continues to maintain her lead until the election, there could be further gains.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.