Surfing the Tsunami: Brazilian Markets and the Global Crisis
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Brazilians often point out proudly how blessed their land is. “Brazil has no natural disasters: no earthquakes, no tornadoes, no volcanoes, no hurricanes,” they say. Some add, chuckling lightly, “Our disasters are all man-made!”
The financial crisis engulfing the globe has arrived recently on Brazil’s shores. Brazil is no stranger to financial and political stress; indeed, over the last thirty years, the country has endured debt crises, extended hyperinflation, currency crashes, seven currency changes, economic recession, unemployment, the transition from military to civilian government, presidential resignation to avoid impeachment, banking failures, and, more recently, a period of rapid domestic and export growth that breaks with traditional experience. The consistent theme throughout these challenging years has been Brazil’s resilience: both economic and social.
The traditional investor response to emerging crises in Brazil has been to get out as quickly as possible. For foreign investors, that has meant reducing exposure and liquidation, typically sending the currency downward, triggering inflation and often recession through capital starvation. For Brazilians, it has often meant trying to send assets abroad and battening down the hatches for an economic storm. But Brazil is in a markedly different place today than it was even five years ago. The global crisis will no doubt hurt Brazil, but investors are likely to be rewarded for hanging on in difficult times.
Like many emerging markets, Brazil’s financial and currency markets have recently taken some hits, and the country will certainly feel some pain going forward. However, in a relative sense, Brazil’s economy appears set to weather this storm better than in the past. It is also in a better position than many other global markets.
When the global financial crisis arrived, it struck at Brazilian equities first, then moved to the currency markets, and has since pushed up interest rates and increased uncertainty, threatening to slow economic growth in the near future. As of this writing, Brazilian equities continue to fall, as do equities across the world.
Figure 1 compares Brazil’s equity index with other major indexes over the last 10 years. In late May 2008, Brazil’s Bovespa equity index rose to its highest weekly close. Brazilian equities had performed spectacularly up to May, looking particularly attractive compared to China’s SSE index, which had by then dropped almost 40% from its October 2007 high, and India’s SENSEX, down about 20% since January 2008.
Figure 1: Performance of Bovespa and Other Major Equity Indexes, January 9, 1998, through November 7, 2008. Source: Bloomberg weekly returns data, November 12, 2008.
Brazilian and Russian equities hit their peaks almost simultaneously in May, strongly suggesting that the subsequent collapses in both markets were closely connected to the deflating of commodity prices. Crude oil reached its high value in early July 2008, as commodity prices in general began to collapse and unwind. As of late November 2008, the Bovespa had fallen about 50% from its May high (Russia’s RTSI is down nearly 70% as of this writing).
Brazil’s (and Russia’s) equities may have benefited and then suffered from portfolio investors loading up on commodities and commodity exporting markets, since these were practically the only positively performing asset classes in the first half of 2008, and likely attracted money chasing returns. When the commodity boom exhausted itself in the face of large-scale asset deflation and uncertain future demand in developed countries, these investments pulled out, pushing prices steadily downward.
The initial effect of the equity slide was noticeable, but not entirely unexpected. Brazilian equities had been one of the last standing performing assets, and investors should have expected that some part of the global crisis would eventually filter back to the Brazilian economy. Although the June–September decline was steady and marked, it was only after September 2008 that the equities collapse became dramatic, with some weekly drops as high as 13%–14%, and one as high as 22%. This time, the wild swings in equity values were strongly correlated to markets around the globe.
The most likely explanation is that rapid deleveraging of global portfolios in response to losses elsewhere prompted forced sales of positions in all markets—including Brazil—and Brazil lacked the liquidity to absorb the sudden rush for the exits. The equities collapse does not appear to reflect a sudden reevaluation of the prospects of Brazilian companies, although there may well be feedback effects for companies that require new (and now more expensive) capital to function and grow.
Unlike the earlier, more moderate decline in equity that had been taking place since June, the equity battering in September interacted strongly with Brazil’s currency markets. Figure 2 shows the Brazilian real steadily strengthening against the US dollar since late 2002. In fact, the real continued to rise even after the Bovespa index turned downward. The real’s weekly close peaked at US$0.641 (R$1.56/USD) on August 1, 2008 (two months after the equities peak), and began to weaken thereafter. This initial weakening was less likely to have been caused by a rush out of Brazilian assets or deterioration of Brazil’s current accounts than by a general strengthening of the dollar versus other world currencies. The real actually strengthened against the euro during this period, suggesting it was dollar strength, rather than weakness in the real, that dominated the price trend.
In September, however, the real began to drop precipitously. By early November, it had fallen 25%–30% from its previous high versus the dollar. The fastest declines in the real coincided precisely with the worst weeks of the financial crisis in the US (measured by changes in the S&P 500), and probably reflected both mass selling of Brazilian assets, weakening the real, and a worldwide rush to US Treasuries, strengthening the dollar. Even before the crash in the S&P 500, however, a 16% decline in the real from its highs, combined with a 12% decline in the Bovespa, had probably prompted many skittish investors to position themselves for the exits.
The shock to equity prices and the outflow of investment have prompted a rise in Brazilian interest rates, partly because higher yields are needed to convince capital to stay, and partly because lower equity prices increase fears of credit events. At the October 13, 2008, Brazil Economic Conference in Washington, DC, Luiz Fernando Figueiredo of Mauá Investments reported real interest rates in Brazil rising over 165 basis points to 9.65% in September alone, up from an average of about 7.5% over the first half of 2008. Of all the shocks to the Brazilian system, interest rate rises are the most likely to have a lasting effect on Brazil’s economy, as they may constrain short-term liquidity, restrict consumer spending, and—in combination with lower equity prices—raise the costs of capital for economic expansion.
Despite rough financial markets, the Brazilian economy and public finances look relatively healthy on their fundamentals, particularly when compared with core developed countries. While Brazil will almost certainly experience an economic slowdown along with the rest of the world, it is less likely to experience economic contraction or a prolonged slowdown, and it may well emerge from the crisis in a relatively strong competitive position, resuming growth that may be modest in comparison to recent rates in China and India, but that is sustainable.
A key source of strength for Brazil is its highly diversified economy. Within the BRIC (Brazil, Russia, India, and China) dynamic, Brazil is often categorized as a raw materials exporter that supplies China, India, and others with raw materials for infrastructure and manufacturing. While it is true that trade with China has expanded dramatically and that commodity exports contributed significantly to recent GDP growth, Brazil’s exports are substantially diversified, as shown in Figures 3 and 4. Not only are Brazilian exports diversified across raw materials (including agricultural commodities, metals, and energy), light industry, and industrialized products (Embraer, for example), but Brazilian exports are also highly diversified by export destination.
This diversification means that Brazilian exports cannot really avoid the impact of a global economic slowdown, but they are likely to absorb that impact without crippling exposure to concentrated, Brazil-specific risk. Two additional considerations are important: first, the recent decline in the real is likely to improve the competitiveness of Brazilian exports; second, Chinese demand for Brazilian commodities is unlikely to fall in proportion to the US consumer sector, since infrastructure spending in China should continue whether or not Chinese export growth declines.
Brazil’s position is strengthened by the presence of large foreign reserves accumulated over recent years, valued at close to US$200B (see Figure 5), three-quarters of which have accumulated in the last two to three years. This puts the central bank in a strong position to defend the currency if necessary, to provide liquidity, and to ensure that the government need not print money to finance public spending in a slowdown. This reduces the risk of a return to hyperinflation, a perennial fear in any Brazilian crisis. Moreover, Brazilian public debts are virtually all denominated in the local currency, a departure from past crisis points in which exchange rate problems quickly became fiscal and inflationary disasters.
According to data from the Economist Intelligence Unit (accessed November 18, 2008), Brazilian domestic demand accounts for between 97% and 99% of GDP. Even if higher interest rates curb domestic spending (as is probable), the correlation between economic performance and the performance of the export sector will still not be excessive. Imports will become more expensive but, as noted above, exports will become more competitive with a weaker real.
One major concern is that while public finances are now denominated in local currency, a large number of companies in the private sector have liabilities denominated in dollars. When interest rates from dollar-based lenders were low and the real was continuously strengthening, Brazilian firms found dollar-denominated debt extremely attractive. However, not only have dollar-denominated interest rates risen in the credit crunch, but the exchange rate collapse has suddenly increased dollar-denominated debts by 30%–50%, compared to the real. The increased debt and interest burden is a serious handicap to firms with dollar-denominated debt, and is probably the most important implication of the crisis for individual Brazilian companies.
From a long-term perspective, Brazil must reduce the tax burden on industries and streamline regulatory processes to minimize the degree to which licensing and permitting impede business start-ups and expansions. If these goals could be achieved, Brazil’s GDP growth rates might come closer to China’s and India’s precrisis growth rates. These issues predate the financial crisis, but resolving them is essential to Brazil’s long-term economic and financial health.
In times of financial turmoil, ensuring that asset allocation is consistent with risk tolerance and liquidity needs is essential. It is difficult to say just how deeply the global economic slowdown will affect Brazil and other markets, but many indicators suggest that Brazil is in a more secure position than many other countries, and should be able to navigate today’s challenges more successfully than in the past. This optimistic forecast is based not only on Brazil’s economic fundamentals, but also on the quantitative snapshots offered in Table 1 and Figure 6. To the extent that any equity exposure makes sense in the current environment, Brazil should certainly be a part of it. Brazil could also form the long leg of an emerging markets pairs trade in order to capitalize on its relatively strong position. The main caution at the firm level should be to examine carefully the effect of the exchange rate on a firm’s dollar-denominated liabilities.
—Bruce P. Chadwick, PhD, CFA (firstname.lastname@example.org) , is principal at Chadwick Consulting, an independent consulting firm specializing in quantitative, emerging market, and SRI research and strategy.