Latin America

Brazil’s wake up call for investors

Temer

Just before going to bed last night I flicked on the local news here in Buenos Aires. That was the first I heard about the latest political scandal in Brazil. The Brazilian president was reportedly caught approving a bribe to buy someone’s silence. Brazilian stocks and the local currency crashed this morning. Another impeachment could be on the cards. This is a wake up call for investors in Brazil.

Washington may be a swamp, but Brasilia – Brazil’s capital – is a cesspit of coddling and corruption. Brazilian members of congress make fat salaries in a country full of dirt poor people. Add in gold-plated pensions, generous allowances for expenses and travel, and other perks and they make somewhere between US$300,000 and US$400,000 a year.

Given how much the politicians extract from the teats of state, you’d think they would feel little need for corruption. But you’d be wrong. Hundreds of politicians have been caught up in an ever-expanding corruption investigation that got started in March 2014.

The original scandal is known as “lava jato”, literally meaning “jet wash” but usually translated as “car wash” in English. It involved vast amounts of bribes paid to people inside Petroleo Brasileiro (NYSE:PBR), the state controlled oil company also known as Petrobras. They were for construction projects awarded at inflated prices. But the whole things just keeps getting bigger and bigger.

In the latest round of indictments in March this year cases concerning 83 politicians, including the previous two presidents, were referred to the supreme court. A further 211 cases were referred to lower courts.

We’re not talking about small potatoes here either. You know, the gift of a car or some foreign travel. Edward Cunha, formerly the president of the Chamber of Deputies (equivalent to the speaker of the lower house of Congress) was found guilty in March of taking over US$35 million in bribes. He was banged up for 15 years.

Cunha isn’t alone in taking such vast sums. But he is at the centre of the latest development. The accused chairman of a construction company, JBS, is busy plea bargaining. And he’s dropped current Brazilian president Michel Temer right in the doo doo.

Apparently the JBS chairman recorded a discussion with Temer where the latter approved and encouraged the payment of bribes to buy Cunha’s silence. A Brazilian newspaper reported that the tapes have been submitted to the Supreme Court in evidence.

Of course Temer’s office has denied it all. But the political opposition is trying to get an impeachment process underway, and there are protests on the streets. Temer was already deeply unpopular. He only got the job after the last Brazilian president, Dilma Rousseff, was impeached last year. This could (or should) be the last straw.

The upshot is that it’s a reminder that practically the entire Brazilian political class is deeply corrupt – even more than most other places – and it reaches right to the top. So many politicians of all stripes are already in jail, or could end up there, that there may not be anyone left to run the country (or steal the money) any more.

Which is a pity for investors, who had pinned their hopes on Temer’s government. It’s been trying to push through some major reforms to public pensions and such like. But there’s unlikely to be any swift progress given the new revelations.

The BOVESPA index of Brazilian shares crashed over 10% at the market open today. That kicked in a halt to trading for 30 minutes under exchange rules. The Brazilian real, the local currency, also lost 7.4%.

The iShares MSCI Brazil Capped ETF (NYSE:EWZ), which is priced in US dollars, was down a whopping 16.3%. Which, if you think about it, isn’t far off the realms of “Black Monday” back on 19th October 1987, when the Dow Jones Industrial Average plunged 22.6%. And it could have been more if the market breaker mechanism hadn’t kicked in.

Brazilian stocks were one of the stand out global winners since they bottomed out at the end of 2015. In fact the EWZ ETF went from US$20.68 on 31st December 2016 to US$40.42 by 16th May 2017 (two days ago). That was a gain of 95% in under 17 months (plus dividends).

Quite a bit of that came from a recovery in the currency, the Brazilian real (BRL). USD/BRL went from 3.96 at the start of 2016 to 3.10 on 16th May, which is a gain of almost 28% for the real against the US dollar. In turn that was partly driven by a general recovery in commodity prices, Brazil being a big commodity exporting country.

Notwithstanding the boom in Brazilian stocks since the start of 2016 I’ve maintained a suspicious stance. In fact on 20th April last year I wrote “Avoid Brazil and buy Colombia”.

So far I’ve been wrong, I admit. The Global X MSCI Colombia ETF (NYSE:GXG), currently priced at US$9.80, is up just 1.7% since then. Whereas EWZ, even after today’s fall and priced at US$33.15, is up 16%.

Brazil charged ahead of Colombia since April 2016

But I’m sticking with my call. Here are some of the reasons:

  • Colombia is a country that’s generally improving after it’s long history of violence. Brazil is a country in the midst of a long, drawn out political crisis that’s hitting the entire political class.
  • Colombia’s economy grew 2% in 2016 and 3.1% in 2015. Brazil’s economy shrank 3.6% in 2016 and 3.8% in 2015.
  • Colombia’s unemployment rate is 9.7%, which is quite high. But Brazil’s is 13.7%, and more than double the 6.2% in December 2013.
  • Colombia’s government debt-to-GDP ratio is 47%, whereas Brazil’s is 70%. Also Colombian interest rates are lower.
  • Colombian stocks are cheaper than Brazilian stocks (see below)

This morning I was chatting with a long time friend of mine from England. We shared a house with some other friends at university, and he’s recently moved to Buenos Aires. There’s no way that we’d have guessed 25 years ago that we’d both end up in South America, let alone living in the same city. Life is full of surprises…

My friend lived in Brazil for a long time in the past, mainly in the 1990s and early 2000s. He has a Brazilian wife and has just returned from a weekend in Sao Paolo visiting her family. He’s an ex-banker and has also worked in New York and London. (Incidentally, he now keeps himself busy putting together real estate construction deals in Colombia.)

Anyway, it’s fair to say my friend knows a lot about Brazil and about finance. We were chatting this morning and he told me how it’s possible in Brazil for individuals to make as much as 10% real (above-inflation) return on bonds and simple bank savings products. In fact 10 year Brazilian local currency government bonds yield 10%, which is nearly 6% above current inflation, and short rates are even higher.

In an ultra-low (or negative) yield world, those are real yields to die for, albeit in Brazilian currency. In fact a real yield of 6% is almost as much as investors made on US stocks over the past century. (And probably much more than they can expect to make over the coming decade or more…see here for more.)

In other words, if an ordinary Brazilian can make 6% or more real yield from bonds or bank deposits, why on earth would they risk buying Brazilian stocks? And if it’s not worth the locals buying Brazilian stocks, then why should foreigners get involved?

Let me put it another way. If you can make 10% a year nominal interest on Brazilian government bonds you should want at least 14% a year to invest in Brazilian stocks (once you add around 4% “equity risk premium”).

At that kind of required return – and without getting into number crunching – you’d expect a single digit P/E ratio and most likely a price-to-book ratio (P/B) below 1. You know, like the S&P 500 back in the late 1970s and early 1980s, when interest rate were high.

But you don’t get that today. The P/E of the MSCI Brazil index is currently almost 15 and the P/B is around 1.5 (these are estimates after today’s falls).

The latest crisis in Brazil is a reminder that the country has some serious economic and political issues to resolve. These are structural and fundamental, and won’t get sorted out overnight. The stock market got ahead of itself over the past year and investors were complacent.

But crises often spell opportunity. As the dust settles in coming weeks and months there could be some interesting bargains to be found in the rubble of the Brazilian market. For now though, Brazil is once more in the limelight, and not in a good way.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.

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