Brazil Corruption Tapes: This Market Dip Is A Good Entry Point

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Includes: BRAQ, BRAZ, BRF, BZQ, DBBR, EWZ, FBZ, UBR
by: Alan Longbon

Summary

Brazil crashes on new political scandal.

Massive government fiscal flows causing a stock market bull run.

With Temer out of the way the bull run can continue, at any rate Brazil is on sale today and Mr. Market beckons.

I covered the basics on Brazil in this article not long ago and would not normally return to it so soon however a market entry opportunity has presented itself.

"One of the country's largest newspapers reported on Wednesday evening that a secret recording exists of Temer approving a payment to Eduardo Cunha, the mastermind behind last year's impeachment of former president Dilma Rousseff. The tape was submitted to the Supreme Court by two senior executives from meat-packing giant JBS SA as part of a plea bargain deal, according to O Globo newspaper. The paper provided neither a transcript nor a recording."

(Source: Bloomberg)

The purpose of the review is to see if the local stock market is worth investing in via exchange traded funds (ETFs). These funds are available to all investors, even for non-residents or those not able to trade in the stock market of that country directly.

"Brazil crashes on new political scandal; Bovespa down more than 10%."

On days such as these stocks go on sale for reasons that have nothing to do with market fundamentals or valuation. This current event is pure emotion, panic and sentiment.

It is not as if the economy has suffered a real structural blow such as the wipe out of productive capacity or the loss of a major market or population center.

In this article, we update the figure on our last report and examine the strength and consistency of sectoral fiscal flows into the private sector that causes the valuation of financial assets in the private sector to rise or fall.

Details of the methodology employed to analyze these opportunities are available in the sectoral analysis section found later in this article.

The magic formula for success is:

P = G + X

And you can read more about that below.

Which countries stock market are doing well and why?

The first port of call is the ETF page at Seeking Alpha and a look at country ETFs and how they are performing.

The chart below shows the relative positions and performance of the countries at the top of the SA country ETF list.

The iShares MSCI Brazil Capped ETF (NYSEARCA:EWZ) is now second from the top of the list and is up 45 % in 12 months. Brazil is going really well.

We will start with the private sector.

The Private Sector

The chart below shows the historical development of the stock market.

The chart indicates that after January 2016 there was a significant change of trend and the stock market is on the way to making new all time new highs which is very bullish. Something changed, read on to find out what it was.

The private sector can to some extend fund itself through private debt. The chart below shows total loans to the private sector.

The chart shows that after peaking in 2016 private credit creation has begun to fall. This is not a good trend.

The chart below shows household debt service as a share of disposable income as a proxy for debt to income and shows that this is flat after some deleveraging in 2011/12.

There is not a lot of information of private debt levels in Brazil. In 2015 Domestic credit to private sector (% of GDP World Bank 2015) was 67.5%.

All available indicators point to relatively low private debt levels in Brazil.

House prices in the private sector are stable as the chart below shows. No sign of a housing bubble here. For the moment growth is in stocks, though real estate will most likely follow.

Overall the private sector is contracting as demonstrated in the GDP chart below.

GDP is now where it was ten years ago. The money supply is increasing as shown in the chart below.

Falling GDP and a rising or stable money supply mean inflation and this held true until 2016 whereupon the trend changed and inflation began to fall to more "reasonable" levels. The contraction of private credit creation might explain this.

One sees from the charts below that the private sector is not at full employment capacity.


12% unemployment of workers and a 77% capacity utilization points to there being more factors of production that could be employed to meet aggregate demand. Before real inflation can occur these two measures must be far lower.

The growth of the private sector is underpinned in total by the number of consumers in it. The population chart below shows a healthy growth rate providing an expanding pool of consumers with which to expand the private sector. More people to buy and sell from, the core of capitalism and business.

In summary, falling credit creation is "unprinting money" out of the private sector. The population is growing as is the stock market. However, GDP is falling.

The next sector to look at is the external sector.

The external sector

The current account chart below shows that overall the external sector is draining the private sector of about -60B USD per year or -1.3% of GDP.

Important for international trade is the currency exchange rate

Exporting countries need a stable to lower exchange rate to remain competitive on a world stage. The exchange rate looks to be weakening again which is good for exports and dampens the demand for imports and causes the current account position to improve.

Weakening exchange rate is also a reflection of weakening asset backing such as a fall in GDP and under employment of land, labor and capital.

Of special mention in Brazil is the impact of volatile political events, like the one happening right now, that can send the currency lower than would be justified by fundamentals.

The Government Sector

The chart below shows how much money the government is adding or draining from the private sector.

The chart shows that the government has been adding a lot of money to the private sector since 2015 which explains to some extent the upward move of the stock exchange since that time. Approximately 60000 BRL Million per month is injected into the private sector by government. This is 20B USD per month or 240B USD per year. No doubt this stimulus is meant to counter falling GDP and bring Brazil back onto a growth trajectory.

Big fiscal flows arriving in the private sector lift the value of all private financial assets in the sector, including stocks and bonds. Given the liquidity of the stock and bond markets, the change is seen here first.

The big deficit spend up is largely due to former President Dilma Rousseff.

Incumbent President Temer's planned narrower deficits will not help the private sector and will reduce the size of income flows into the private sector. That he is now under siege with a tapes scandal is a time of opportunity and may see a reversal of the current destructive policy settings and restore fiscal flows back to the private sector.

The government is running a spending deficit and expanding the economy and money supply. This is good news.

The table below shows tax rates.

(Source: Trading Economics)

The rates of taxation are relatively high, and wage earners and business are paying a 19% consumption tax on all they buy. On top of that is a 39.8% social security tax, this is money that cannot be spent now and is as good as lost to the economy. Unusual that the corporate rate is lower than the personal rate, I expect Temer will change that as soon as he can.

All these taxes merely serve to dampen aggregate demand. One only need dampen demand in times of extreme demand that has outrun the productive capacity of the economy to meet it. The information in this report shows there is excess capacity in both the labor market and capacity utilization.

Value added taxes are complicated to administer and stifle small business with form filling and account keeping more able to be done by larger firms.

The government is the sovereign issuer of its currency unit; as the source of all money in the economy it does not need to obtain funding from the private sector via taxation or borrowing. This sort of economic thinking shows that the government is acting as if the gold standard still exists and that its spending needs to be squared off against a fixed quantity of gold; this has not been the case since 1971. Taking money from the private sector is for the currency sovereign like returning seawater to the sea.

Brazil has the self-imposed tradition of issuing a government bond to match deficit spending. This means that there is a "national debt" to point to. It also means that a large portion of private sector assets are held in the form of low-yield government bonds whereas they could be invested in productive capital. This is a misallocation of resources.

This paints a picture of a government that is not aware of its currency creation powers and driven by a now redundant gold standard budgeting mentality and is unaware of its role as the provider of the medium of exchange. This is not uncommon.

The next section explains the accounting theory behind this analysis.

Sectoral Analysis Methodology

Each nation state is composed of three essential components:

  1. The private sector
  2. The government sector
  3. The external sector

The private sector comprises the people, business and community, and most importantly, the stock market. For the stock market to move upwards, this sector needs to be growing. This sector by itself is an engine for growth and innovation, however, only it needs income from one or both of the other two sectors to grow.

The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine and can put in as much as its target inflation rate allows. It is not financially constrained, for a sovereign government with a freely floating exchange rate any financial constraint such as a matching bond issue is a self-imposed constraint. A debt ceiling is also a self-imposed constraint as is a fiscal brake.

The external sector is trade with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.

For the stock market in the private sector to prosper and keep moving upwards, income is required to be put into the flow. Otherwise, the sector can only circulate existing funds, or is being drained of funds and is in decline.

The ideal situation is that the private sector has a net inflow of funds and is constantly growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.

This relationship can be expressed by the following formula:

Private Sector = Government Sector + External Sector

For the best investing outcome one looks for countries where the government sector and external sector are both in plus and trending upwards.

Applying the numbers, summary and recommendation

When we take our inputs and place them in our formula, we can calculate the following sectoral flow result based as a percentage of GDP.

Private Sector Credit Creation

[P]

External Sector

[X]

Government Sector

[G]

TOTAL

[P]+[X]+[G]

Yearly

-1.6 %

-1.3 %

8.9 %

6 %

(Source: Trading Economics and Author calculations based on same)

The government sector alone has been doing all the heavy lifting. Both other sectors are negative and draining the private sector of funds. No matter where the income flow comes from, 6% of GDP is strong in any terms. Brazil has a large GDP and 6% flows are also large in absolute terms.

The good thing about government fiscal flows is that they are advertised a year in advance in the government budget so that one can plan accordingly should they change. No other sector offers this benefit as they are market driven and fickle.

The falling exchange rate may fix the external balance to at least neutral and add another 1.3% to the total inflow of funds. Political uncertainty will do this even in the face of good fundamentals that might have made the currency stronger.

While the political elites play intrigue games of thrones millions of Brazilians are still working, making and buying and selling things in their economy and generally being productive.

The key though to Brazil's amazing stock market performance have been extraordinary fiscal flows from the government which goes to show how important they are and that the private sector's surplus is the government's deficit. President Temer was in the process of reversing these flows and playing the game of austerity to pander to bondholders and ratings agencies that Europe has shown does not work. With Temer out of the way fiscal flows can continue inflating the private sector and causing the stock market to go up.

At present the Brazilian stock market is going onsale due to political intrigue and presents a good entry point.

An investor that believes that Brazil's good fortunes will continue can look at the following ETFs:

  • iShares MSCI Brazil Capped ETF
  • First Trust Brazil AlphaDEX Fund (NASDAQ:FBZ)
  • VanEck Vectors Brazil Small-Cap ETF (NYSEARCA:BRF)
  • Direxion Daily Brazil Bull 3x Shares ETF BRZU)
  • iShares MSCI Brazil Small-Cap ETF
  • Ultra MSCI Brazil ETF (NYSEARCA:UBR)
  • Global X Brazil Consumer ETF (NYSEARCA:BRAQ)
  • Global X Brazil Mid Cap ETF (NYSEARCA:BRAZ)
  • Deutsche X-trackers MSCI Brazil Hedged Equity ETF (NYSEARCA:DBBR)

Investors who believe that Temer will stay and continue cutting and burning according to his neo-liberal playbook leading to less government expenditure are advised to consider the following ETF.

  • ULTRASHORT MSCI BRAZIL CAPPED ETF (NYSEARCA:BZQ)

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.