Everything that can go wrong, seemingly is going wrong in South America’s former powerhouse economy. The government is engulfed in a scandal that’s hammering the country’s biggest company, threatening capital expenditures and investment economy-wide. Mainstay commodity exports are experiencing severe price and demand declines. Inflation is high, and the central bank is tightening, which is dampening growth; the consumer sector, formerly an engine of growth, is hurting badly and heavily indebted. The country is being ravaged by drought, and the electorate is angry. A contrarian might ask: “When will there be an opportunity to invest?” We say, not yet -- and for the bold, there still may be an opportunity to short the Brazilian market and currency.
Murphy’s Law is playing out in spades in Brazil -- everything that can go wrong seems to be going wrong at the same time. And it shows in the country’s stock market; the most liquid U.S. ETF giving exposure to the Brazilian market is down nearly 45 percent from its recent high at the beginning of September (Brazil’s currency has fallen 23 percent since the beginning of the year).
So what are the woes afflicting Brazil?
First, the acute problem that’s front and center in the news: the bribery and kickback scandal engulfing the ruling Workers’ Party. Prosecutors allege that nearly $1 billion was diverted from state oil company Petroleo (NYSE:PBR) over a period of several years in the mid-2000s, and 34 sitting politicians are being investigated. Brazil’s current President, Dilma Roussef, was chairman during much of this period. She’s not being investigated, but mass demonstrations are calling for her impeachment.
The implications of this impending political disaster are legion. First, PBR is a titan of the Brazilian economy; it accounted for 12 percent of Brazilian fixed capital investment in 2013, and that capex is already slated to decline dramatically, both because of the current environment in the global oil market, and because PBR’s debt has been downgraded to junk status. A 20 percent decline in capex by PBR, analysts believe, would cut almost a percent off Brazil’s GDP growth. The effects may continue to ripple out from PBR to the construction firms and others with whom it contracts, who are also likely to see debt downgrades.
Second, Brazil is front and center in the collapse of global commodity prices that has accompanied the strengthening of the US Dollar Index over the last months. Brazil’s past decade of growth depended heavily on Chinese demand for two commodities in particular, soybeans and iron ore. The slackening of that demand is being driven by several powerful macro forces: increased Chinese capacity, the appreciation of the U.S. Dollar, and the ongoing transformation of the Chinese economy. Analysts have long commented on this trend -- but converging indicators (including the flatlining of global carbon emissions mentioned above) suggest that it is finally and decisively underway. Bad news for commodity exporters -- especially Brazil.
Third, both of the problems mentioned above are happening in a context of economic weakening. With inflation running at 7.14 percent by the most recent readings, the central bank has raised rates to 12.75 percent, a six-year high, and rates are expected to climb further this year. This tightening will likely depress GDP growth, which will lead to higher unemployment and depressed tax revenues. Combined with Brazil’s other woes -- including especially the PBR troubles discussed above -- these conditions may well induce foreign capital to flee, resulting in a feedback loop of lower growth and worsening performance.
iShares Brazil Index (ARCA:EWZ)
Source: Google (NASDAQ:GOOGL) Finance
Fourth, the central bank’s austerity and the concomitant growth slowdown will hurt the Brazilian consumer. The Brazilian consumer, though, was one of the engines of the country’s growth during the decade that followed its devaluation of the Real in 1999 and IMF intervention to stabilize the economy in 2002. 50 percent of GDP growth during that time came from private consumption -- so a downturn will also derail that component of the dissolving “Brazilian miracle.”
Fifth, the public disapproval of Roussef, after an election victory last year that was the narrowest in modern Brazilian history, may well rise to a point of social unrest. Recent demonstrations have massed hundreds of thousands of protesters. And it doesn’t help that a long-running and severe drought is putting pressure on agricultural production and on urban water supplies in some of Brazil’s biggest cities.
We like to look for contrarian ideas, and we like the theme of mean reversion -- so as we survey what looks like the unfolding “perfect storm” in Brazil, we immediately wonder when it will be time to buy.
The only answer we can give is, “Not yet.” Dilma Roussef could be implicated in the scandal and impeached, or she could resign under intense pressure from her party and its partners. Even though the composition of the National Assembly will not change until the next elections in four years, her party’s coalition could collapse as a result of such a political earthquake, and lead to a shift in power (some coalition partners are already making very unhappy noises about the level of corruption the scandal has revealed). Should that occur, we would watch the political process very closely and see what new leadership might emerge that could work to put Brazil on a better path. Of course, Brazilian markets could rally strongly on such an event.
Even should that occur, however, the longer-term structural problems afflicting Brazil seem overwhelming. It would take a real uptick in global GDP growth, perhaps sparked by accelerating growth in India, to create the external demand that would mark a fundamental shift in Brazil’s economic fortunes.
Investment implications: Brazil looks like a disaster, with fundamental economic problems exacerbated by a huge corruption scandal, a punishing drought, a looming recession, a collapse in commodity prices, and an angry electorate. However, absent an uptick in global growth, or the fall of the country’s ruling coalition, we see no reason to view Brazilian markets as attractive, in spite of their steep recent decline. Watchful waiting is still the wisest course of action. Investors with significant risk appetite could still short Brazil at this juncture, with the knowledge that unexpected political developments could result in a market rally.