Why Brazil will be a buy again
Do you remember that old chestnut about emerging markets? The theory was that their fast growing economies would suffer less in a stock market downturn than old-fashioned ones such as Britain and the US.
It certainly hasn't worked out that way. Indian, Russian and Chinese shares have plunged just as fast in the recent falls. And as they started dropping earlier than 'Anglo Saxon' stocks, they're all now officially in bear market territory.
But about the worst of the lot has been Brazil. Has it now become a busted flush?
Investors have dumped Brazilian shares in droves
Investors have "run screaming" from Brazilian stocks in the recent global sell-off, says Samantha Pearson on FT.com. This has reduced Brazil's Bovespa index to the worst performer in the Americas this year. What's more, it has plunged by the best part of 30% from its highs of last autumn.
So has the 'emerging markets are safer' theory just gone right out of the window? Or is there a deeper problem with Brazil?
In truth, it's a bit of both. Whenever there's a major global sell-off, emerging markets are still prone to be hit harder. That's because until they become economically self-sufficient, they'll always react to consumer demand in developed markets like the US.
That said, the Bovespa has already been on the slide for several months for some very Brazil-specific reasons. One is inflation - it's proving very hard to get rid of. In the month to mid-August, the country's cost of living topped 7% on higher food costs. And the problem certainly isn't going away.
"Inflationary pressures haven't ended", economist Thiago Curado at Sao Paulo consultants Tendencias tells the Wall Street Journal. The end of Brazil's harvest season often means food prices start climbing in August and September, says Curado, while the cost of meat tends to jump on strong demand during the year-end holidays. A potentially poor sugar cane harvest could make matters worse.
While the Brazilian central bank has lifted interest rates five times this year - to a painful 12.5% - that hasn't done the trick in curbing price rises. The authorities might hang fire on more rate rises for the moment, as fears are growing about global economic growth. We'll soon know, as the next central bank meeting is on 31 August.
But investors will still fear future rate hikes. They're bad for share prices, as they cut growth prospects and make bonds look a better bet than equities. Fixed-income markets have already "siphoned investors from riskier equities", says Luciana Lopez on Reuters.com.
In fact, allowing for inflation, Brazil now has the highest level of interest rates amongst major economies. This has driven the currency (the real) to historic highs. In turn this has made Brazil's exports more costly and less competitive.
Growth is slowing sharply, while bad debts are rising
At a time when global growth is slowing, exporters everywhere are being forced to fight hard for business. A rising currency and pricier goods are the last things that Brazil needs. Annual industrial production is now barely rising, and the latest business surveys suggest it will soon shrink. That's bad for share prices too.
Worse, Brazil has another developing problem. In the boom times, the economy was powered along in part by a massive expansion of consumer spending. That was funded by a surge in credit. But with interest rates now rising, bank lending is being cut back.
What's more, many Brazilians overdid their borrowing when rates were lower. Just servicing their debts is taking up around 18% of disposable incomes, says Neal Shearing of Capital Economics, who says "all the signs suggest Brazilian consumers are overstretched".
That's likely to lead to a surge in bank bad debts. This will slow economic growth even more sharply in the next few years as lenders have to close their lending windows.
Throw in some political wrangling among members of the new government, and all in all, it's a sombre story. So it wouldn't be a huge shock if investors were to steer clear of the Bovespa for a while yet.
In the short run, this probably makes sense. The country is also a major commodity producer. With the demand outlook for both the local and world economies looking poor, the Bovespa could still have some way to drop. And if the number of bad consumer debts really soars, there could be a nasty credit crunch.
Yet Brazil's long-term future is still rosy
But Brazil's news isn't all bad. Its national finances are in pretty good shape - good enough, in fact, to make most finance ministers around the world green with envy. In June, the government generated the largest primary surplus - tax revenues less spending excluding interest payments - on record. And the ratio of national debt (what the country owes) to GDP is below 40%
In fact, looking further out, I'll be keeping a weather eye on Brazil. Over the last 15 years, measured in sterling, the Bovespa has risen five-fold. That compares with just a 50% gain by the rest of the world's stock markets. And Brazil could yet make a spectacular comeback. The longer-term growth potential is still huge.
Last year, over half the world's oil discoveries were made in the country, making it the global leader in crude exploration. That will pay dividends in future years. When global commodity demand recovers, as a major exporter Brazil will be in the forefront.
It may seem hard to believe now, but only in January this year PricewaterhouseCoopers forecast that within 20 years time, Brazil's economy will be bigger than Germany's.
Further, the Bovespa has fallen so far that it now sells on below eight times earnings. OK, the index could yet get cheaper. But it will be worth buying into again at some point. If you want to get broad exposure to a Brazilian fight back, a fund like the JP Morgan Brazil Investment Trust (LSE: JPB) could be a good long term play. We will let you know when we think it's right.
This article is authored by MoneyWeek, the UKs best selling financial magazine. MoneyWeek offers intelligent, easy-to-read analysis of the financial news, with practical investment advice.
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