The Market Isn’t Excited About Brazil Yet. Here’s Why You Should Be.

July 14, 2017

The Market Isn’t Excited About Brazil Yet. Here’s Why You Should Be.

  • The Brazilian economy is at a turning point. Inflation is down, exports are up, and growth is projected to be at 2%.
  • As currencies follow the economy, the stronger real will add a tailwind to your returns.
  • Don’t invest blindly in an ETF. Buying a few stocks will lower your risk and increase your returns.

Introduction

I have written about Brazil a few times here at Investiv Daily, and have primarily described the potential of the country. This article isn’t about potential because the situation has started to turn, so it’s time to really take advantage of the new trend.

Investing In Brazil: Position Yourself For An Economic Turnaround & Currency Gains

Investing in Brazil has one major catalyst for foreign investors, a currency turnaround.

The Brazilian currency has been battered by bad political news, eight quarters of economic contraction, and low commodity prices, but things have started to change recently.


Figure 1: Quarterly Brazilian economic activity just turned positive. Source: Trading Economics.

Economic growth will bring much needed relief to businesses and the population which should significantly improve market fundamentals. However, the fundamentals for the country as a whole haven’t really been that bad in the past two years as the balance of trade was consistently positive.


Figure 2: The balance of trade indicates the potential Brazil has and the strength of the currency. Source: Trading Economics.

A strong balance of trade is essential for a stronger currency, while a stronger currency leads to additional benefits for foreign investors.

On top of the above, reforms set in place by the new president, Michel Temer, have significantly lowered inflation, a very important factor for foreign investors as inflation negatively influences currency movements.


Figure 3: Brazilian inflation is back to normal levels. Source: Trading Economics.

Even the World Bank and the International Monetary Fund have become more bullish on Brazil and expect growth of around 2% for the foreseeable future. This is excellent when compared to economic declines of 3.8% in 2015, and 3.4% in 2016.


Figure 4: Brazil’s economic forecast. Source: Knoema.

What’s important for us as investors isn’t Brazil really delivering on its potential, but the global financial world perceiving Brazil as likely to deliver. A turn to a positive investment sentiment toward Brazil would bring it close to where it was a few years ago, in regards to valuations and currency values.

Investors willing to take the plunge now will reap large rewards as the “few years ago” level gives an upside not to be found in domestic markets. Due to the fact that Brazil is turning slowly toward recovery with inflation slowing down, foreign investment increasing, and GDP eventually turning to growth, we can expect it to reach a positive global investment sentiment in the next few years.

Such a situation would first impact the Brazilian currency which has been oversold in the last two years due to the recession and weakened because the dollar got stronger.


Figure 5: R$ per 1 USD. Source: Bloomberg.

When things normalize in Brazil, the currency could soon return to levels before the recession started from the current R$3.38 per $1 USD. A return to a level of R$2.5 per $1 would immediately give you a 36% return. On top of that, the dollar is currently strong from an historical perspective, so it might be a good time to think about global diversification as the strong dollar makes the U.S. less globally competitive and everything is much cheaper around the world for you. Thus, now is the time to act on international diversification.


Figure 6: The U.S. dollar index is in a long term declining trend with short term cycles – currently strong (data since 1975). Source: FRED.

How To Invest

It’s important to take a helicopter view at what a market offers. The economics are positive but not for every company, and valuations and dividends are very variegate.


Figure 7: Brazilian stocks with updated P/E ratios and dividend yields. Source: Author’s data.

If we take a closer look at the list above, we can see that some companies like AmBev, Cemig, CPFL Energia, Embraer, Telefonica Brasil, TIM Participacoes, and Ultrapar are relatively fairly priced in a global comparison. However, there are some companies that have extremely low P/E ratios: Electrobras, Copel, Sebesp, Vale, and some banks.

Given that the economy is recovering and economic projections are stable, it might be a good time to invest in Brazil.

A look at what has happened with the Brazilian ETF will give some technical indications of potential future returns.

The iShares MSCI Brazil Capped ETF (NYSEARCA: EWZ) is still 77% below its 2007 peak and 60% below its 2010 peak.


Figure 8: iShares Brazilian ETF – EWZ. Source: iShares.

The problem—or opportunity, depending on how you see it—lies in the fact that the market hasn’t yet warmed to Brazil. Sooner or later it will, and if you can find investments in the above list that reward you while you wait for the market to put Brazil in a sweet spot again, you can expect excellent returns somewhere down the line.

Conclusion

International diversification is an essential component of a well-balanced portfolio. However, what the vast majority does incorrectly is that they invest abroad only when those markets are very trendy with the usual result being that they buy high and then sell low in panic. What Brazil currently offers is a positive economic trend where the global investment community hasn’t yet warmed up on it, thus giving an excellent entry point for the smart investor.

You can choose to invest in an ETF and own a little bit of everything with an overweight exposure to banks and an expensive consumer staple company.


Figure 9: iShares top 10 portfolio holdings. Source: iShares.

The other option is to individually analyze each company listed in figure 7 above, and find those companies that are mis-priced.

There has been a lot going on in the utilities sector in the last few years, so that is a sector to take a look at and if you prefer small caps with real estate exposure in Brazil, then BrasilAgro and Gafisa could be interesting picks.