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Have Recent Market & Currency Gains In Brazil Just Increased The Risks?


  • Brazil’s economy contraction is slowing and the trend is turning positive.
  • The political situation is currently stable but trouble is always around the corner.
  • Fundamentals show potential but also risks as the price to book value is relatively high at 1.4.

Introduction

In April we wrote about Brazil and described it as a good risk reward opportunity as all the bad things had already happened. Brazil’s president Dilma Rousseff had just been impeached, the economy had declined by more than 5% and Brazil’s currency was at historical lows against the dollar.

As Brazil is a young country, rich with natural resources, the investing logic was that Brazil is oversold and undervalued from a longer term perspective. As predicted, the currency has strengthened and the Brazilian stock index has increased. This article is going to discuss the current situation, and take a look at fundamentals and economic factors, in order to see if this improvement is backed up by concrete facts or if it’s just a change in sentiment and Brazilian stocks are now riskier than they were three months ago.

Current Situation

The economic situation in Brazil hasn’t improved since April. While the economy did shrink, it only did so by 0.3% in Q1 2016 which is better than expected as the Brazilian Institute of Geography and Statistics predicted a 0.9% contraction. The economy is still contracting but is shifting in trend. The International Monetary Fund (IMF) forecasts a 3.3% contraction in 2016 and then finally small economic growth in 2017 based on business confidence bottoming out and higher commodity prices. The better than forecasted contraction in Q1 shows that Brazil is on a good path to reach growth in 2017. IMF warns that stronger growth is difficult to forecast as political uncertainties remain.

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Figure 1: Brazil’s GDP per quarter. Source: Trading Economics.

The economic shift in trend was immediately reflected in the stock market. The Brazilian stock index has increased by 10% since April and by 50% since the global stock bottom in January.

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Figure 2: BOVESPA index. Source: Google Finance.

But on top of the stock index increasing, international investors have also benefited from the stronger Brazilian Real (BRL). The Real has strengthened by 22% in relation to the dollar since January, and 10% since April.

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Figure 3: BRL per 1 USD last 12 months. Source: XE.

As the 10-year average is 2 BRL for $1, there is still plenty of space for currency gains from Brazilian investments.

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Figure 4: BRL per 1 USD last 10 years. Source: XE.

When Brazil returns to its normal economic growth rates the currency will return to normal levels, thus there is still a 50% potential gain. But for that gain to be realized a lot of things have to improve in Brazil, starting with its politics.

Brazil has an interim president at the moment, Michel Temer, who is trying to stabilize things by limiting government spending to the inflation rate and limit social benefits. Such moves are already priced into the market, but there is always the risk that a left-leaning party takes over as this is just an interim president which could affect prices to the downside. Elections are planned for 2018 but many invoke early elections, especially the impeached Dilma Rousseff who has called for a referendum for early elections.

Political risk is still the main risk for Brazil. With the markets 50% up, any new political turmoil might bring the markets down quickly.

Fundamentals

A look at fundamentals shows that Brazil is still amongst the lowest priced global markets. The cyclically adjusted price to earnings ratio, which looks at 10-year average earnings, is 8.5 but the current PE ratio is very high at 44.1 due to the economic crisis and high interest rates. The price to book value is also relatively high at 1.4, thus it does not give much downside protection.

figure 5 valuations
Figure 5: Fundamental valuation ratios in international equity markets. Source: Star Capital.

Conclusion

Despite Brazil’s political and structural issues, the country remains a promising one. With a population of 200 million, and with a GDP per capita at only $11,208, there is still plenty of room to grow in order to reach a developed level (for reference, the US’ GDP per capita is $53,041).

In the long term, there’s no reason that Brazil won’t eventually return to its previous growth levels of around 3% annually. In the short and medium term, Brazil still has many issues. Apart from the political issues previously discussed in this article, the country also has a constitution that has been amended 91 times in the last 30 years, indicating an instability that consequently makes it very difficult to plan long term investments.

Since we wrote in April, the economy has improved a bit, but it is still contracting. The mere fact that there haven’t been any political scandals recently is not enough to base an investment case. While Brazil looks cheap, a return to power by Dilma Rousseff or any further indication of early elections may increase its risk and send asset prices down.

Until real structural, economic and political developments are reached, higher asset prices and a stronger currency means more investing risk for foreign investors. Traders might want to grasp the opportunities created by the current stability and positive trend, but long term risk averse investors might want to wait for lower risk with cheaper prices.

 

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