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Editor’s note: We have added a new stock to the Portfolio, Brazilian lender Banco Bradesco (NYSE: BBD), which enters the Long-Term Holdings Portfolio as the fourth-ranked stock. A complete analysis of Banco Bradesco can be found in this issue’s Stock Spotlight. To maintain our Portfolio’s balance we have sold Chinese property developer Renhe Commercial Holdings (Hong Kong: 1387). We recommend that subscribers sell Renhe Commercial Holdings.

 

The Brazilian market followed emerging markets downhill in 2011 and posted a poor performance for the year. The benchmark Bovespa index lost 18 percent last year in local currency terms. However, in dollar terms the Bovespa lost a whopping 27 percent as the Brazilian real depreciated significantly against US dollar in the second half of the year.

As a result, the Bovespa currently trades at a relatively low valuation and expectations for earnings growth are muted. The Brazilian index trades at less than 10 times earnings and about 1.3 times book value while offering a 4 percent dividend yield.

That being said, the real has been strengthening lately, which should be a boon for US-based investors despite the effect it may have on Brazilian exports. Note that less than a decade ago, the real traded at four to one dollar. Currently the exchange rate is about 1.78 real to one dollar.

Source: Bloomberg

Investors expected too much from the Brazilian economy and market last year following a strong 2010. Now that expectations have become more realistic, the relative strength of Brazil’s economy makes allocating some funds to this market a smart move.

The Brazilian economy has been run in a characteristically sober fashion for the past 10 years, especially when compared to its Latin American peers. Brazil was a no-show at the credit-expansion and easy-money party of the past decade.

As the chart below indicates, Brazil’s net public debt as a percentage to gross domestic product (GDP) peaked at about 63 percent in 2003, and reached a low of about 35 percent in 2008. Currently the figure stands at about 37 percent of GDP and should continue to fall to 2008 levels this year.

Brazil took advantage of the recent commodity boom to accumulate vast amounts of foreign reserves. Brazil now holds about USD352 billion in foreign reserves in its coffers, funds that can be used to support the economy amid periods of high capital outflows. These foreign reserves can also be deployed as needed to pay down debt.

Source: Bloomberg

The EU sovereign-debt crisis continues to threaten the global economy. But Latin America exports relatively small amounts of goods and services to Europe. As you can see in the chart below, the US was Latin America’s largest trading partner in 2010 and Europe accounted for about 13 percent of all exports from Latin America.

In Latin America, Chile has the highest exposure to Europe at more than 6 percent of GDP, while Brazil’s exports to Europe amounted to about 2 percent of GDP. That being said, the EU gobbles up about 21 percent of Brazilian exports, while exports to Asia represent 30 percent of the total.

Latin America’s reliance on commodity exports can be a millstone around the region’s neck should the global economy experience a severe slowdown in growth. Commodities represent about 40 percent of the region’s exports; processed food and ores account for the lion’s share at about 16 percent and 12 percent, respectively. 

Nevertheless, Latin American economies performed decently during the global financial crisis. Most important, the global collapse in economic activity didn’t wreak havoc on the region’s economies, as had been the case in previous downturns. 

Source: World Trade Organization

The Brazilian economy shares many of the same positive traits found in other major emerging markets. For starters, Brazil’s interest rates are nowhere close to zero, which gives it the flexibility to adjust its monetary policy with the prevailing economic winds. Brazil and Chile are the only Latin American economies that have room to cut interest rates and enact fiscal stimulus measures if their economies take a turn for the worse.

Brazil’s benchmark rate (selic) stands at about 11 percent and could decline to 10 percent if the country’s central bank attempts to support the domestic economy amid an uncertain global economic environment. As the charts below depicts, the Central Bank of Brazil began a cycle of easing monetary policy last summer and has cut the selic rate by 1.5 percentage points to the 11 percent.

Source: Bloomberg

Brazil does not face an imminent deflationary cycle as the country boasts strong employment and credit growth. Although inflation is manageable, it remains a red flag.  

Unemployment of 6 percent is close to historical lows and represents a sharp reduction from the unemployment rate of 13 percent in 2003. Meanwhile, the country’s minimum wage for workers and retirees was recently boosted by 14 percent to USD350 per month. By contrast, the country’s official poverty line is demarcated at a monthly wage of about USD40.  

Rising wages help boost consumption, but they also contribute to inflation and we believe that inflation will remain a minor issue for Brazil’s economy. Inflation recently came in at about 5.8 percent, higher than the official target of 4.5 percent, but a far cry from the 2003 high of 17 percent. We believe inflation will remain above 5 percent in 2012, especially given strong credit growth in Brazil.  

Credit as percentage of GDP in Brazil has almost doubled to 48 percent from 25 percent eight years ago, a trend that’s help fuel the country’s decade of economic expansion. Although household debt levels have risen, they remain relatively low at an estimated 32 percent of disposable household income.

Household debt could become a problem, especially as interest rates remain high. But if Brazil’s unemployment level remains this low, households should be able to pay down debt relatively quickly; the average term of consumer credit remains shorter than three years and debts generally do not linger for a long time.

Source: Bloomberg

In contrast to other emerging markets, the investment case for Brazil isn’t based on explosive GDP growth and gangbuster earnings growth. We expect Brazil’s economy will continue to grow steadily, particularly when compared to developed economies. Given Brazil’s strong fundamentals, economic growth could surprise to the upside when the global economy finally finds its footing.

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