Why Brazil Continues to Stumble

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Let's face it, times are tough in Brazil right now. Commodity prices remain challenged, speculation that stagflation is taking hold has hurt financials, credit downgrades loom, and political unrest appears to be on the rise.

As a result, the Brazilian market has suffered a beating. Taking a closer look at the components of the iShares MSCI Brazil Index ETF  (NYSEMKT: EWZ  ) , the largest Brazilian ETF, could give a bit of insight as to what the future holds.

State of Brazilian energy
When you add up common and preferred holdings, Petroleo Brasileiro  (NYSE: PBR  )  is the largest holding at 9.48%. To understand why Petrobras continues to stumble it helps to understand the macroeconomic environment Brazil finds itself in currently and how the government is involved.

At the end of January, Brazil's inflation rate was 5.59%, well above the government's desired target of 4.5%. As a result of this prolonged inflation seen through 2013, the Brazilian economy has seen eight consecutive rate increases. The latest increase in the funds rate to 10.75%  seems to have done little to stop this trend but threatens to put a damper on lackluster GDP growth. This latest move marks a 50% increase in rates over just a 9-month period. 

The Brazilian government holds a 54% common voting stake in Petrobras. It is widely known that oil and energy price fluctuations create huge distortions regarding inflation. It is also well known that the Brazilian government uses Petrobras (through mandated diesel and gasoline prices for example) as inflation control. As noted above, Brazil's inflation rate is now well beyond the government's target rate, so look for government restrictions on pricing to continue and perhaps increase. Since domestic sales make up the majority of Petrobras' profits, it stands to reason that further government action will drastically impact an already-shrinking bottom line.

But this policy regarding Petrobras and energy price manipulation could be misguided. According to Darwin Dib, chief economist at São Paulo's LAPB asset management, "Brazil's inflation is the result of a supply shock caused by currency devaluation. The central bank has to use the old textbook solution." That old solution of course is raising rates.

Behind the veil
The next largest holding is Vale (NYSE: VALE  ) , a mining and metals company. I can't argue that this is a well run company or that it maintains a great balance sheet. On top of this, commodity prices seem to be lacking any catalyst for a turnaround.

For those thinking that a yield of 6.57% might help you ride through the tough times, think again. Earnings are projected to drop off a cliff in FY 2014, down almost 17% compared to FY 2013 numbers. FY 2015 isn't looking much better with analysts forecasting continuing decreasing earnings to the tune of 6.4%.

Get real
A mixture of financials compose approximately 25% of the iShares MSCI Brazil Index ETF. Those will come under increasing pressure as inflation takes its toll on real (vs. nominal) loan returns. Look for credit contractions on the part of banks to avoid that risk. This will further hurt growth. The financial sector will find itself trapped between increasingly volatile currency, low growth, and political uncertainty -- all the ingredients needed for stagflation. The Brazilian domestic banking sector is going to be the least desirable investment during this turmoil. There is no quick or easy way out from this hot mess.

Bottom line
Approximately 45% of this ETF's composition was just discussed and shown to be a highly questionable investment at this time. Adverse government involvement, commodity price pressure, and potential stagflation are all going to weigh on the iShares MSCI Brazil Index ETF for some time to come. Until these issues are resolved, it would be wise to avoid this position.

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Read/Post Comments (4) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 19, 2014, at 8:33 PM, BrianSanders wrote:

    Biased and not very useful. Complete herd mentality.

  • Report this Comment On March 19, 2014, at 8:51 PM, allrightallready wrote:

    James Catlin:

    Who are you trying to "help" with this article?

    If VALE earnings "fall off a cliff" in 2014 and you have the correct percentage "collapse, VALE will still earn $2.06 per share!!!!!!!!!!

    "Worse yet," if VALE earnings "fall" another 6.4% in 2015, VALE will still post earnings of approx. $1.92!!!

    Oh no! Not a earnings of $2.00 per year on a stock selling at $12.74. Oh no. Someone save us.

    WORST OF ALL, one minute after your article posted, VALE CEO was quoted by Bloomberg News as saying "I think people again are going to fail in their projections."

    So, all you guys pull numbers from "who knows where" and throw a wet blanket on a stock selling at a P/E around 6 with a 5%+ projected dividend.

    My question: Why? What are you trying to accomplish? Are you trying to "save" someone from buying a cheap stock with a good dividend or "shake some shares loose?"

  • Report this Comment On March 20, 2014, at 4:47 AM, Interventizio wrote:

    How is describing the dire situation in Brasil "herd mentality"? If you are a contrarian investor, you're welcome, but don't criticize this article just because of its telling things as they are.

  • Report this Comment On March 24, 2014, at 5:31 PM, Lulupoopsalot wrote:

    First of all...thank you all for taking the time to comment no matter your position.

    To address the issue of herd mentality brought up by Brian Sanders. I seem to recall the herd being bearish on Brazil for quite some time, just as I have been (see my previous articles on EWZ). Have they been wrong? No. Money often follows where the herd leads. So I am not really sure why following herd mentality is bad unless you have very good reason to adopt a contrarian position. Which if you do have good reason please enlighten us all.

    Next, to alrightalready's question, though I actually suspect Brian Sanders and alrightalready are the same person based on the fact that they sometimes comment on the same article together right after each other. Found them both bashing another writer in January of 2014 who also wrote about Vale in a bearish tone. FYI, Vale is down 14% since then so investors would have been wise to pay attention to the author rather than comments.

    Anyway, you want to know what I am trying to accomplish? I do not want people sucked into a position where the foreseeable future holds declining earnings with no turnaround in sight. I write this article to "help" people like you. I have done the same for coal and gold miners over the last two years that are also trading at low PE's and threatening to suck in value players. Quite successfully I might add. You cite PE as a value indicator, but provide no idea when the trend of declining earnings will end. So if Vale's earnings continue to decline, how much of a safety net is that PE? Not much. Tell me why Vale should turn around. Tell me where increasing earnings will come from that will move the stock higher. Tell me why the macro environment will change in gold, copper, or anything else in which they deal. Till you explain that I'll stay bearish, thank you.

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James Catlin

James Catlin has degrees in both Political Science and Economics. He is the owner of a small orchid nursery and manager of a private portfolio that includes stocks and investment real estate.

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