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%.
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.
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.
James Catlin owns shares of Companhia Vale Ads. The Motley Fool recommends Petroleo Brasileiro S.A. (ADR). The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.