Should You Buy Into Brazil Despite Huge Trade Deficit?

Unfortunately, bad news is still coming from Latin America. Brazil, South America's largest economy, accumulated its worst foreign-trade deficit in 21 years. The deficit figure, which reached $6.1 billion for the first quarter, is almost 18% larger than one year ago.

Looking more closely at the data, the drop in exports is mainly in the semi-manufactured products category, where exports fell 19.6%. Exports of manufactures dropped 15.3%, but the "basic products" category that is composed mainly of commodities grew 9.5%.

What and where
The biggest and second-biggest markets for Brazil are China and the U.S., where exports grew 22.8% and 11.8%, respectively. However, exports to Argentina, Brazil's third-biggest market, dropped almost 11%. That explains the growth in commodities exports and the decrease in manufacture sales, where Argentina is a key market.

The impact
Brazil and Argentina are members of the Mercosur trade agreement. This became a huge destination for Brazilian manufactures, especially vehicles and auto parts. Now, Argentina is going through a period of currency devaluation and restrictions on foreign trade, which have drastically reduced its imports. Brazil seems to be feeling some of that pressure.

Two Brazilian assets
Not everything can be blamed on commerce with Argentina. If you consider Vale (NYSE: VALE  ) , the world's largest producer of iron ore, China is the company's biggest market. In fact, China is the biggest market worldwide, having demanded 64.3% of seaborne iron ore last year. The country accounts for 40.5% of Vale's net operating revenue.

However, there are fears that China's infrastructure- and construction-led growth model is exhausted. Some believe  the country will eventually shift to a consumer-driven growth model. This would mean a sharp slowdown in iron ore demand. Be on the lookout for these developments, as Vale is the most iron-ore-dependent of the major diversified miners.

If you add the preferred stock and the common stock, Vale is the biggest component inside Brazil's iShares MSCI Brazil (NYSEMKT: EWZ  ) ETF, accounting for roughly 8.8% of the fund's $4.3 billion in assets.

This ETF, which tracks the MSCI Brazil 25/50 Index, has been quite volatile over the past few years. This owes partly to its unhedged exposure to the Brazilian currency, the real. In fact, over the past 10 years, the fund's annualized standard deviation of returns was 32%, while the S&P 500's was roughly 15%.

Should you buy?
For Vale, and a great deal of the ETF, what matters most is how China will combat its mild slowdown. Recently, China outlined a $24 billion stimulus package that includes railway spending and a tax relief to support the economy. The Chinese are increasing their efforts to create jobs, and this is good for Brazil. The country's announcement to build more than 4,100 miles of new rail lines and boost construction in order to meet its 7.5% growth target for this year suggests that for now there will be no change in China's infrastructure-led growth model.

We still do not know the full extent of these measures and their implications. When it comes to railways and construction, though, iron ore and steel demand will clearly see a boost.

Final thoughts
The major risks for Vale and Brazilian assets do not necessarily come from Argentina and China. With a fiscal deficit and a foreign-trade deficit, Brazil has its own internal problems. Both of these problems are sustained by an increasing issuing of debt.

When there are signs of a deteriorating fiscal situation, the selling pressure on the real begins and foreign funds flow out of Brazilian assets, exacerbating these trends. To a certain extent, we have seen this in the past two months. Maybe it's just a small correction, but if you are planning to buy Brazil's primary ETF, pay attention to these variables.

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