Last July, I wrote an article detailing the attractive risk-reward opportunity that was Brazil. Back then, valuations were low and investor sentiment was even lower. Since the article was written, the iShares MSCI Brazil Capped ETF (EWZ) has rallied roughly 30%, making it one of the top single-country performers over the past twelve months.
While I still believe that Brazil will outperform over a long period of time (perhaps a decade), I expect increased turbulence and potential negative performance over the coming six to eighteen months as valuations correct and the Brazilian real faces headwinds.
Latin America is still one of my favorite regions, but investors in Brazil may achieve better results in neighboring countries due to their superior valuations and lower trade war exposure.
Relative Performance is Waning
My favorite way to analyze trends in single-country ETFs is by comparing them to a regional benchmark. In general, countries that outperform their region in one time period will underperform it in the next. As in all investment “rules,” this is not always true but can still be a strong guide for investment allocation.
(Source: Google Finance)
Note: Performance indexed to 1, so “2” indicates a 100% gain.
As you can see, Brazil outperformed its benchmark by a wide margin until the first six months of 2018, when it crashed significantly. After it crashed in July, I wrote the bullish article on Brazil, which was primarily based on the country being so oversold. Now that the performance spread is back at a high, I’ve become more bearish, as I expect either all Latin American to correct upward toward Brazil or Brazil to correct downward toward its neighbors.
To see this more clearly, here is a chart of the performance index of Brazil divided by the Latin America benchmark. This can be thought of as the performance of “Long Brazil Short Latin America” if re-balanced daily.
(Source: Google Finance)
Interestingly, Brazil outperformed its benchmark the most during the October 2018 crash in equities. This was due to the election of the current Brazilian president, Jair Bolsonaro. This may be a bit of an oversimplification, but Bolsonaro is to Brazil as Trump is to the United States. He has promised widespread economic reforms that investors believe will finally help Brazil out of its GDP growth rut. Thus, the performance of Brazilian equities was extremely strong following his victory.
Per usual, my view with world leaders who make “economic savior” promises is to buy the rumor and sell the news. Of course, economic reforms will likely come to pass, but the reality is governments probably have much less control over the long-run growth of an economy than many believe. Thus, it seems likely Brazil will see less outperformance over the following year than over the past one.
Financial Fundamentals Less Encouraging Than Before
Our Seeking Alpha Marketplace The Country Club subscribers have access to our “Dashboard,” which lets them see financial fundamentals for each country based on statistics from over 4,000 stocks. Here is the current chart of median P/E ratios by country:
The best countries are Russia, Turkey, Pakistan and Romania. At 17.5X, Brazil is not too overvalued, but I think that 15X would be more reasonable given my expected growth rate for its economy.
Here is a chart of year-over-year revenue growth by country:
Brazilian equities were, once again, not poor performers but also by no means strong. Argentina has a much lower median valuation and saw stronger top line growth last year. The same is also true in Russia, which is another BRIC country that is a commodity exporter.
Overall, fundamentally Brazil does appear stronger than Europe or the United States, but is still not strong enough to make up for the higher political and economic risk that comes with being an emerging market.
Real to see Trade War Weakness
The Brazillian real can usually be blamed for poor equity performance on behalf of foreign investors, as the currency is very volatile. Brazil exports the second-most soybeans globally, and thus, the equity returns to foreign investors are heavily dependent on the commodity through the real.
As you know, soybeans have been the primary Chinese retaliation strategy during the trade war. While the Chinese have been buying more Brazilian soybeans and less from the U.S., they have also pushed the price down considerably. This, combined with political uncertainty and a (rapidly) strengthening U.S dollar, has pushed the currency down considerably.
Here is a chart of EWZ vs. the BRL/USD and the Soybean ETF (SOYB):
(Source: Trading View)
As you can see, the currency sold off dramatically along with soybeans over the first six months of 2018. As the trade war has recently picked up steam again, I expect this trend to continue. I actually am not too bearish on soybeans; it seems that China may have played that card more than is useful, but it seems that the U.S. dollar will continue to strengthen.
The U.S dollar is the primary risk to all global investing today. Global external debt backed by dollars is at extreme highs. As the dollar continues to break higher, those countries who have loans that must be repaid in dollars suffer greatly. Brazil has an external debt-to-GDP of only around 35%, but the growing “dollar viscous feedback loop” may destabilize the real.
Further, government spending in Brazil poses a serious medium- to long-term risk to the currency. While the country’s government debt-to-GDP is lower than that of developed nations, it is very high for an emerging economy.
Here is the government debt-to-GDP in Brazil. Note the extreme growth since 2014:
(Source: Trading Economics)
Currently, this large increase has yet to negatively impact the Brazilian economy and currency, but it is a factor investors should keep an eye on. Whenever governments try to expand credit to manufacture high GDP growth, it does not end the way they expect. They get GDP growth, but debt expands at a faster rate and little progress is made.
The Bottom Line
Overall, Brazil is simply less enticing than it was a year ago. Over the next decade, as the commodity super-cycle returns and after trade war dust is settled, I think Brazil will make for a good investment. It is more isolated from global geopolitical tension and, as an emerging economy, has more GDP growth potential than most.
That said, investors will likely see superior performance in Chile and Mexico (article coming soon), as they have the same bullish factors at a lower valuation and lower currency risk.
I’ve closed my long position. I would not short Brazil, but I may look to USD/BRL as a way to take advantage of possible currency weakness over the next few months.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.