Navigating Brazil's choppy waters

For more than a decade, Brazil’s high-flying economy was the envy of Latin America and a darling of investors worldwide. 

“It was simple,” says Rob Philippa, founder of New Amsterdam Advisory Services, a back-office consultancy active in the country. “You’d buy a government bond and sprinkle in a few shares of [state-led oil giant] Petrobras and maybe some other companies, and you’d earn 15% risk-free.”

The strategy even held up in the 2008 economic crisis. Although the Brazilian economy shrunk along with that of the rest of the world, the benchmark Sistema Especial de Liquidação e Custodia (SELIC) interest rate peaked at 13.75% (see “Interest rates,” above) while inflation flirted with 7% (see “Inflation,” below) and Brazil became a net creditor nation for the first time in history. Interest rates and GDP growth both plunged in 2009 (see “Brazilian GDP,” below), but by 2010 Brazil seemed to have left the global slowdown behind. Its economy surged 7.5% that year, and the SELIC finished the year at 10.75%.

But the world caught up with Brazil last year, when economic growth slowed to 2.7% and the government began slashing interest rates — from a peak of 12.5% in July 2011 to 8% this past July. The latest cut came just before Petrobras posted its first quarterly loss in more than 13 years, and at press time the market is anticipating another cut to 7.5% by the end of this August. The most optimistic projections for GDP this year are 2%, and those are contingent on a strong second half. June’s GDP growth was just 0.2%, and that came after three consecutive down months.

The IBovespa stock index (see “Stock market,” below) flirted with 68,000 for most of March and then slid to below 55,000 in June as the country’s biggest exchange-traded fund (ETF), the MSCI Brazil Index Fund (EWZ), bled almost $1.5 billion in assets. By mid-July, EWZ was down 8.8% year-to-date (see “Brazilian ETFs,” below), and money was flowing out of Brazil and into other Latin American countries.

“It is evident that the investors seeking exposure to Latin America are looking at some of the economies with better growth prospects,” says Neena Mishra, an analyst with Zack’s Investment Research. “The Global X FTSE Colombia 20 ETF (GXG) has gained about $37 million in assets under management and is up 15.1% in 2012, and the iShares MSCI Chile Investable Market Index (ECH) has gained about $57 million in assets under management and is up 7.6% during the same time.”

That may be a function of who Brazil hangs with compared to Colombia or Peru — neither of which belong to Mercosur (Mercado Común del Sur), the old-school lefty alliance that ties Brazil to Argentina, Paraguay, Uruguay and Venezuela instead of to the Pacific Alliance, which includes not only Colombia and Peru, but Chile and Mexico, and has been more practical in its approach to reducing trade barriers.

Industrial malaise

The growth so far this year has come mostly from household consumption, which has fueled a retail boom and driven retail sales up 6%. The industrial sector, which is supposed to overtake commodities as the country’s growth engine, is down 2%.

The government has responded with a series of micro measures designed to support specific sectors. In May, for example, it slashed taxes on autos enough to drive the end price to consumers down more than 5% on average, and automakers are reporting brisk sales. 

“The tax break is supposed to expire on August 31, but the market is pricing in an extension,” says Flávio Serrano, a senior economist with Espirito Santo Investment Bank in São Paulo. “The trouble is that Guido Mantega, the finance minister, says it will not be extended.”

Many believe Mantega is holding off on the extension to pressure General Motors Co., which is reportedly planning massive layoffs at one of its plants. Mantega had said earlier that automakers had promised to hold off on layoffs in exchange for the tax break.

The credit expansion led to an increase in durable goods orders, but that has petered out as banks reeled in their risk. Non-durable goods, which are more related to income than to credit, have remained strong, and the results are showing in the market.

“In retail, those related to income are strong, while those related to credit are performing in a bad way,” Serrano says.

And this translates into continued sideways action in the IBovespa, but directional movement in certain sectors, says Mariano Silva, an independent trader based in São Paulo.

“For now, it’s really about individual shares and sectoral ETFs,” he says. “This kind of uneven growth will be with us for a while, and it’s a government-led thing.” 

For clues, he and Serrano advise keeping an ear out for pronouncements by Mantega as well as Luciano Coutinho, chairman of Banco Nacional de Desenvolvimento Economico e Social (the Brazilian National Development Bank, or BNDES).

Waning interest

Most analysts — including Serrano — believe the government’s year-long interest-rate easing cycle is nearing an end.

“We see one or two more cuts, but that’s it,” Serrano says. “We feel the easing cycle is over, and rates will be heading up by the end of the year.”

Daniel Snowden, an emerging markets analyst at Informa Global Markets, agrees.“It will be hard for the Central Bank to justify further cuts beyond that, because inflation is starting to creep back up, so their hand will be forced.”

Inflationary pressures will rise along with a new increase in the minimum wage and record low unemployment (see “Unemployment” below), but primarily because inflation is built into the Brazilian economic system.

“The international environment is deflationary, but inflation in Brazil is 5.2%,” Serrano says. “That’s partly because many contracts are indexed to past inflation, which means past inflation always will impact current inflation.”

The Banco Central do Brasil has targeted an inflation rate of 4.5% with a 2% band, but currently is more focused on promoting growth, which it feels should be running above 4%.  

Serrano and Snowdon each believe inflation will reach 5.5% or even 6% in 2013 before dropping to 5.2% in 2014. 

“It will remain persistent above 5%, which is why we expect to see some tightening in next year,” he says. “We’re not looking for a return to 12%, but maybe an increase to 9%, but not much more.”

The real deal

For the real, this translates into sideways action as well, says Espirito Santo trader Claudio Margulies (see “Exchange rates,” below).

“Basically, Mantega and the Central Bank want a range between 1.90 and 2.10, and he’s gotten it,” he says.

The Bank has used interventions aggressively to get its way, as well as increasing, decreasing and at times even eliminating the so-called “IOF” tax on foreign exchange transactions.

“The tax has proven to be a good proxy for the Bank’s intentions,” Margulies says. “They always will raise it when the real is too high and then lower it when the real is too low.” 

To make up for faltering industrial production (see “Industrial production,” below) — and to create a more favorable environment for that growth to take place — President Dilma Rousseff is pushing for a major overhaul of the country’s rural infrastructure.

That could translate into strong growth for certain ETFs, but as always there are pitfalls ahead. Chief among them, ironically, could be a drop in the price of oil. That would hurt Petrobras while not necessarily helping the nation’s struggling industrial sector. One reason: Companies are obligated to buy domestic oil, billions of barrels of which are under the sea and only can be extracted at a cost of $100 per barrel, while U.S.-based oil from fracking operation can run $70 per barrel.

“As a foreigner living here, it strikes me how much people are worried about returning to the pre-Lula boom and bust cycle,” Philippa says, referring to the decades of turbulence before Luiz Inácio Lula da Silva took office in 2003. “For now, there’s no perceived danger of that, and the fact that the world took the transition from Lula to Rousseff in stride shows you how far they’ve come, but it’s always in the back of peoples’ minds.”

Through its partnership with Bolsa de Valores, Mercadorias & Futuros de São Paulo (BM&FBOVESPA), CME offers IBovespa stock index and real futures. American traders also can access Brazilian grain markets, but the costs are prohibitive. Traders also can gain exposure to Brazilian equities via American depository receipts and ETFs. 

BM&FBOVESPA also plans to deepen its partnership with CME, through which each exchange owns 5% of the other and the chief executives of each sit on the other’s board. The partnership already has led to the distribution of 135,000 Globex terminals in São Paulo, and additional cross-listing is expected by year-end.

Recent challenging economic times may have people forgetting just how far Brazil has come this century, but it is clear that Brazil’s economy is becoming a significant global player. Meanwhile, the country’s retail derivatives sector continues to increase, with the annual Expo Trader Brazil conference growing into a year-round training resource for brokers and customers.

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