Description

 Consensus knows Brazil is in trouble but the extent of the trouble is not priced in yet, mostly because the market doesn't understand the intricacies of its economy and the present situation's direness. Brazilian stocks are still expensive by DM valuation standards, not to mention by EM valuation standards! I recommend a short position, priced in USD of course. It should take another 6-12 months for the market to price in what is commonly referred to as 'depression', as opposed to 'recession'. Consensus simply sees Brazil as part of the “EM and commodities complex”, which, because of U.S. dollar dynamics, will weaken further. Let's dive into Brazil:

Here's the recipe:

Take Canada, a country sensitive to commodities/China. Add even more sensitivity to commodities/China. Add more inequality and crime. Add an unwillingness to invest coupled with an equal but opposite ultra-willingness to provide citizens with a very large social safety net. Add corruption. Add persistent inflation (9% and growing). And now, add a German-like fear of that same inflation, which leads to prioritizing high interest rates. That's Brazil. So if Canada's about to go through the worse recession since at least the early 90's, imagine what Brazil is about to go through...

Historical Background

In the early 80's Brazil's economy was slowing and the country prioritized debt repayment, which led to austerity and economic decline. Foreign debt was taken care of but domestic debt grew and this eventually led to a cycle of expanding inflation, government deficit, price controls and a disorganized public sector. Then came hyperinflation and more craziness, including many failed reform plans. Eventually in 1994 they put in place a credible plan. The real was introduced as pegged to the USD, which eliminated inflation and brought foreign interest in investing in the country. In 1997-1998 Brazil only suffered a bit and allowed its currency to float as part of the solution (it adjusted downward somewhat), leading to strengthened international confidence.

Finally Brazil had a chance to rise in a stable, diversified way. Unfortunately that's when China and commodities came along. Brazil was tempted by this new situation to rely on commodities for growth while keeping legacy elements in its economy intact. The larger the China/commodity bubble grew, the greater the temptation to keep this “Legacy Brazil” as opposed to moving on. As a matter of fact, “Legacy Brazil” kept growing. The profits from commodities were used to increase the social safety net even more, and for consumer loans and other short term 'wealth effect' spending. How does “Legacy Brazil” look like? It is very bureaucratic. There's free health care and university education and the country's minimum wage applies to a third of workers. There is also lots of easy-to-access income support for the poor.

More importantly, Brazil's growth rate wasn't even in the EM ballpark in the 21^st century. Brazil, as a third-world country, is supposedly a fast-growing EM. But in reality it is in no way comparable to, say, China. China has spent a lot of effort on rapidly growing its exports pre-2008 and then on an investment boom post-2008. It has managed to get this rapid growth through financial repression, with a plan to pass on more of the gains to its citizens at some future time. It has moved forward aggressively. There are of course issues with that approach but that was the chosen path and it led to growth. Brazil is the opposite. Scared of repeating past mistakes and wanting to build a middle class fast, they chose to grow at a lower rate while providing their citizens with a very large and generous safety net backed by a huge bureaucratic government that charges high taxes. Since the early 1980s, Brazilian growth has oscillated around an average of 2.5 percent a year. And in the 2000's they grew only half as fast as China, India, and Russia. Investment was 20% of GDP in recent years vs 50% for China. And infrastructure is bad. Electricity is expensive and an AP analysis revealed dangerously high levels of viruses and bacteria in Olympic venues. Roads are very old and hard to travel on for trucks. Essentially, Brazil has behaved like a developed economy, focused on stability and and sinking into deeper and deeper welfare system, as if its economy is already strong, mature and diversified. It missed a perfect chance to grow. Also, because it has had a policy of keeping its currency strong, it has been relatively expensive, which hampered its ability to export in non-commodity sectors. Speaking of which, trade barriers in non-commodity industries have also been an issue. Brazil is very protectionist. Trade as a percentage of GDP is just 20%, the lowest among all EMs. In 2009, China surpassed the United States as Brazil's leading trade partner.

Now Brazil is stuck. The speculative financial flows are going the other way and the economy doesn't have anything backing up the natural resources industry and “Legacy Brazil” is still in place. This isn't the first time they face a dramatic situation like this; Brazil has a history of politicians wanting their country to become a great power quickly and moving too fast to accomplish that goal. Outsiders have gotten caught in these optimistic episodes. Then things go down. This is yet another iteration. So where will the country end up?

Fiscal Situation

In 2014, the Brazilian economy grew by 0.1%—the worst performance since 2009. Consensus forecasts for this year are between -1% and -2%

Debt/GDP is over 60%, current account deficit about 5%. And the social safety net is a huge burden. Again, from this point of view Brazil looks like an over-indebted developed country, except it has a 3rd world economy to fall back on. Its CDS prices are the 8th worse in the world.

But unlike in 2008, the lower growth is now accompanied by persistent inflation (over 9% presently) and rates are being hiked as per Brazilian tradition. Recently rates were hiked to 14.25%. This was the sixth consecutive 50bp hike since the initial 25bp in October . The policy statement indicated they will remain at the current level for a prolonged period of time, perhaps in an attempt to influence inflation expectations. This will probably not last – it's a typical stagflation scenario and will worsen. Also the twin deficits are both worse than 2008.

The international community has responded to Brazil's troubles by pointing in the direction of reform and austerity. Policymakers' credibility is not good, so together with inflation, that's two big reasons to expect continued rate hikes. Potential changes include spending less on its welfare state, streamlining it by simplifying the tax code, broadening the tax base, and modernizing the inefficient pension and social security systems. But these changes are not taking place easily. President Rousseff’s popularity is at a record low 8% because of already-instituted austerity measures and there is talk of impeachment. This is all mixed in with corruption scandals and also another scandal: the sharp increase in lending by state banks for questionable purposes. This, along with the fiscal situation in general, has led the rating agencies to evaluate Brazil at either one or two notches above junk with a negative outlook. Any further political instability or inability to reform will probably bring them into junk.

One reporter recently went to visit Luis Belluzzo, who is Rousseff’s one-time economics professor and also a close friend and adviser of former president Lula. Belluzzo said: "I'm going to be 73 years old, and I've been through many periods in Brazil's history, but I've never seen one so grave”.

Banks

In 2014, the Brazilian banks’ loan portfolio saw an increase of 11.9% YoY. These are similar numbers to China and India, but in a slower-growing economy. Household loans constitute 47% of total credit - they grew 14% YoY in 2014 and 10.4% in Q2 2015. Corporate lending grew 10.11% YoY in 2014 and 8.2% in Q2. So in loans, the party continues despite the recession and banks are 25% of the EWZ ETF.

In 2014, NPLs were 2.85%. In the first half of 2015 they were 2.90%. We know that in 2000 it was 8.3% so if Brazil is going through the worse recession in decades, surely these bank stocks will suffer much more.

Valuation

So to summarize, Brazil stocks are screwed whether the country goes into much higher inflation or into a world of very high interest rates. Most likely they will go into stagflation. Their GDP is going to shrink way more than the -2% currently assumed. They will fall into junk territory and have more political turmoil. World demand for commodities is not rebounding anytime soon. And even if it wants to turn around completely, it'll take Brazil a long time to do it because of structural impediments. In the meantime, the population will be hurt badly. The domestic economy as well as trade are both screwed and the social safety net is getting into a risky area, which can only lead to further problems. Capital will flow out. An economy such as this trades at single digit multiples of earnings. The banks, no doubt, will suffer a lot and deserve to trade at sub-1.0x of the current book value, which surely is overstating reality. Eyeballing stocks in Brazil, they seem to be trading at a low-teens TTM P/E while bank stocks specifically are close to 1.5x book. Half of that level would make more sense.

Another way to look at it is when we realize this downturn is deeper than 2008. Their stock market took off during 2003-2008, when it grew 400%. Then in 2008-2009 only half of those gains were purged. 2009-2011 saw a rebound to the highs and 2011-2015 so far saw a trickling down back tot he lows of 2009. Only if we return to 2004 levels would we be undoing all of the bubbly rise. Both of these methods lead me to estimate a fair value of about half, or $13 a share for the ETF.

Catalyst

- On Tuesday, Brazil's Trade Minister said China's decision to devalue the yuan could hurt the country's manufacturing exports, so that's one. The Yuan could slide much further.

- Higher USD and capital flight leads to higher rates and lower Real. Brazilian banks and the Real have both sharply declined together in 1998, 2002 and 2008. So that's a catalyst for bank stocks especially.

- More deleveraging in the EM/commodities arena. Yes, a lot of it has taken place already but it's not over.

- Rating agency downgrades, worsening financial/trade position vs. rest of the world.

- Political turmoil