Brazil Recession
Brazil was once among the most promising of the world's emerging markets. But the nation is starting to see darker days...

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It wasn’t long ago that Brazil was considered one of the most promising emerging markets in which to invest, enough to be included as the “B” in the “BRIC” group of nations.

And things were going swimmingly for South America’s largest nation covering nearly half the continent. That is, until the commodity cycle’s tide started rolling out toward the end of 2011.

brazil mapWith unemployment now on the rise and GDP on the decline, are Brazil’s glory days over? Or can you as an investor still make a profit from its still untapped potential?

More Than Just Resources

Contrary to what many might expect from its heavily forested and resource-rich landscape, Brazil’s recent rise as an emerging market powerhouse has not been solely tied to the commodity markets.

Though it is a major exporter of iron ore, soybeans, and coffee, as well as possessing the 13th largest crude oil reserves just ahead of Qatar (14th) and the U.S.A. (15th), Brazil’s largest sector is actually services, comprising 68% of GDP, compared to industry’s 26% and agriculture’s 5%.

Brazil’s diversification has been the key to its success since the outset of the new millennium. With a combined focus on commodities and the manufacture of products higher up the production chain, the nation has broadened its production base to include textiles, shoes, chemicals, cement, steel, aircraft, autos and auto parts, machinery and equipment, in addition to the raw resources of lumber, iron ore, and tin. This allows it to keep multiple layers of production within its borders and pocket the added value.

Its revenues, then, are beefier than you’d get from commodities alone. 2012’s GDP of $2.4 trillion puts Brazil in 8th place on the world scene, just behind Russia and just ahead of the United Kingdom.

And the emphasis on production has enabled it to steadily employ an ever growing workforce, driving down unemployment year after year from 12.3% in 2003 to an enviable 5.97% in 2011.

Too Hot for its Own Good

So hot was Brazil’s rise that funds from abroad poured in as they chased some of the best interest rates and currency appreciation in the world. As can be noted in the graph below, the Brazilian real (pronounced “rey-ahl”) doubled in value relative to the USD from early 2004 until the beginning of the global credit crisis in mid 2008.

Brazilian currency 7-30-13 small(click to enlarge)

But this was a case of being too successful for its own good. All that foreign investment – though beneficial in providing access to credit for continued economic expansion – delivered with it an unwelcomed upward lift to the nation’s currency’s value. Not only did a stronger real lower export revenues, it also forced the government to keep raising interest rates, which ultimately took a toll and slowed the economy.

By 2008, Brazil’s succumbed to the global crisis, with dwindling demand for its products from abroad and two back-to-back recessive quarters, plunging the value of the real by over 60% in just a few months.

Yet the nation was among the first to emerge from the crisis and with ever greater impetus than before, reaching a stellar 7.5% annual growth by 2010.

But once again, that same one-two punch that knocked Brazil down in 2008 struck again by the end of 2011. Slow global demand for its products and an expensive currency back at 2008 levels slowed growth to just 2.7% in 2011 and 1.3% in 2012.

To make matters worse, Brazil has to keep its interest rates up to combat a still troublesome inflation at 6.7%, which slows the economy even more. For the first time in over a decade, the unemployment rate has gone up from a recent low of 5.9% in 2012 to 6% this June, with projections for 6.5% unemployment by 2014.

Yet over the past few weeks, sentiment has been changing. We may just be at the lows of the global crisis and commodity prices right now. If so, the worst may be over for Brazil too, with analysts projecting Brazil’s GDP to rise by 2.28% by end of this year and by an even healthier 2.6% in 2014.

Investing Opportunities – The Carry-Trade

One of the oldest cross-border investment ideas is to capitalize on the disparity between your nation’s money and another nation’s. Known as a “carry trade”, the idea is to borrow money cheaply in your own country and purchase a foreign country’s higher-yielding bonds to collect a higher interest rate than you would at home. While the U.S. 10-year yield is at a cooler 2.58%, Brazil’s 10-year bond yields a scorching 10.81%!

Keep in mind, however, that interest rate changes can often work against the carry trade if the bond you sold rises in value and the bond you bought falls. You will also have to contend with exchange rates when you close your positions. If the Brazilian real falls in value while the USD rises, the currency exchange rate could completely negate your interest income.

As can be seen in the currency graph above, Brazil’s real appreciates when the rest of the world buys its wares. If Chinese demand recovers soon, and the rest of the world’s demand with it, Brazil’s economy could once again be lit on fire, and its real could once again climb versus the USD as it did from 2004-08 and 2009-11. In this scenario, a carry trade could serve you very well indeed.

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Investing Opportunities – The Broader Market

Another popular means of participating in a foreign country’s prospects is to buy stocks in its leading companies or even its broader stock market.

Brazil’s main stock market, BOVESPA, is the 8th largest stock exchange in the world, with a market capitalization of $1.22 trillion USD as of the end of 2011. There are several indices to choose from, including the IBRX50, which tracks the 50 most traded stocks on the BOVESPA, and the IBRX, which trades the top 100.

Brazilian stock market 7-30-13 small
(click to enlarge)
Source: Trading Economics

As the chart above shows, the BOVESPA can quickly turn with the global economy. Most notable are the 2008 credit crisis crash and the subsequent commodity run into 2011.

While the U.S. stock markets have outperformed the BOVESPA from 2011 to present, some consider Brazil’s stock market to be poised for a rally to new highs once the global recovery resumes.

If you are willing to invest and hold, you may just benefit from a beefy percentage gain when the global scene turns. A run from the current 45,000 back to its peak of 70,000 is a gain of over 55%, which took just two years the last time the BOVESPA managed it from 2006 to 2008.

Prepared for a Wait

Yet some economists are predicting it could be a while before Brazil’s gears starting turning at full steam again.

Barclays Capital economist Marcelo Salomon noted to Forbes that “a weak economic recovery should fail to [help] employment … and even if we see balanced risks to our second quarter GDP growth forecast, the balance of risks for growth in the second half remains tilted to the downside.” [This counters other analyst predictions calling for increasing GDP by year’s end and into 2014, as noted earlier.]

With global demand for Brazil’s products still down and its annual inflation still strong at 6.7%, the nation’s central bank can’t offer any stimulus the way the U.S. and other nations have been doing, for such easing measures would propel inflation even higher.

Brazil needs to find markets that other nations are not able to fully supply, crude oil and natural gas being two of them, especially given their high prices lately. Currently, Brazil’s crude oil production is ranked 12th in the world, just behind Kuwait and just ahead of Nigeria, though most of that is consumed internally.

While the government is continuing to diversify into the production of value-added advanced products, it will take time. Until the global marketplace recovers, investors in Brazil have to be prepared to stand by. But at least you get a healthy interest rate while you wait.

Joseph Cafariello


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Brazil Recession originally appeared in Wealth Daily. Wealth Daily, a free daily newsletter, offers practical investment analysis and contrarian stock market advice.
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