My Comments: Many are waiting for the penny to drop indicating a new global recession and collapse of the stock markets. Is this it?
Oct. 19, 2015 by Ian Bezek
- Brazil’s economic “Superman” may have resigned Friday, according to conflicting media reports.
- Brazilian shares and currency fell sharply after Friday’s market close.
His departure would bring close parallels to Argentina’s collapse in 2001.
Investors should avoid or short sell Brazil as the country comes closer to catastrophe.
- It’s just about over for Brazil. The signs are clearly in place that the country is in the midst of a historic implosion.
- Brazil is following almost precisely the same script that Argentina did between 1999 and 2001. The outcome there was a 75% devaluation of the Argentine currency, the total dissolution of the government, and a black hole of losses for foreign investors.
It’s almost eerie how close these two tales are playing out. Friday brought Brazil’s “The savior throws in the towel” moment as conflicting media reports suggest the nation’s respected economic minister may have resigned. Brazil’s stocks (NYSEARCA:EWZ) and currency knifed lower in Friday’s after hours session.
First, let’s remember what happened in Argentina so we can see what’s in store for Brazil.
Up until the 1990s, Argentina’s economy was a chronic basket case, wracked by constant hyperinflation and repeated total failures of the country’s currency and budget.
All this changed in 1991, when Domingo Cavallo was appointed Minister of the Economy. He immediately and boldly pegged the Argentine currency to the dollar 1 to 1, and prevented the government from floating more currency than it had dollars in reserve.
This sharp break with the past revived the economy, which took off at lightspeed, growing more than 50% over the ensuing 8 year period. Cavallo was widely credited with saving the economy. He exited the government in 1996 following political in-fighting.
All continued well for Argentina until 1998, when various emerging market crises in Brazil, Russia and Southeast Asia started to weigh heavily. Argentina remained firm with its ironclad 1:1 peg to the dollar, newly elected president Fernando de la Rúa campaigned specifically on maintaining the peg despite mounting international instability.
During this time, the Brazilian currency devalued sharply, as did other Latin American currencies and various European monies. As such, Argentina was tied to the increasingly overvalued US dollar. Argentina had increasing difficulty competing with its peers. Brazil, in particular wa, as its leading trading partner garned a huge advantage from the currency devaluation.
By early 2001, the Argentine economy was in year 3 of a bitter recession, and questions were mounting as to whether it could service its debts. Then Argentine-President de la Rúa, after watching various economic ministers resign eventually felt compelled to ask Cavallo to be his economic minister. This was a shocking move, since Cavallo had run against de la Rúa for the presidency in 1999.
But desperate times call for desperate measures, and it was widely viewed that only Cavallo, as the economy’s “savior” had the ability to convince the IMF and foreign investors that Argentine was able to make it through the crisis.
Take this article from March 2001 in Fortune:
Argentineans are probably feeling a sense of déjà vu right now after Argentine President Fernando de la Rua’s bold and possibly threatening move of appointing Domingo Cavallo as Argentina’s economy minister for the second time in a decade.
Domingo Cavallo stepped in as Argentina’s third economy minister in the last three weeks, taking over from Ricardo Lopez Murphy, who served a controversial two weeks before resigning Monday after outraged opposition to his ambitious cost-cutting plans.
Cavallo served as economy minister in 1991 and guided the economy out of a period of hyperinflation and spiraling currency devaluation, becoming a Wall Street darling in the process. Rua’s move is being viewed by most as the return of the savior of Argentina’s economy […]
The one thing that has been lacking in Rua’s administration is political credibility. Rua was hanging by the skin of his teeth, and selecting Cavallo was an act of desperation but a good move. (emphasis added) But it wouldn’t end up being enough. Cavallo, despite being the “savior” was unable to fix Argentina’s core problems. Its currency was dramatically overvalued, further budget cuts were simply shrinking the economy and thus never closing the fiscal hole, and investor sentiment soured again after a quarter-long uptick following Cavallo’s return.
Following the September 11th attacks and increasing global economic tensions, the IMF cut Argentina loose, denying further loans. Argentina devalued the Peso 75%, the government collapsed, the capital was paralyzed by riots for months, and finally a new socialist government took over and made the country an international investing pariah – where it remains stuck even today, 13 years later.
Brazil’s Similar Trajectory
Brazil, seeing neighboring Argentina’s success in the early 1990s, tried a dollar peg to revive their economy starting in 1994. However the upturn didn’t really gain traction until 2003. Luiz Inácio Lula da Silva was elected president, and despite campaigning on a leftist platform, ended up handling the economy more moderately than expected.
His market-friendly policies, among them picking a former Bankboston CEO (now part of Bank of America) to run the central bank, drew investor interest. The country was upgraded to investment grade, commodity exports boomed catching the Chinese wave perfectly. Millions of Brazilians were lifted out of poverty and the country’s investments boomed.
After working at the ECB, Levy in 2003 was appointed Treasury Secretary by President Lula. Levy, a University of Chicago trained economist, had all the fiscal hawk credentials and orthodox economic views that make foreign investors swoon.
Under Levy’s leadership, Brazil secured the all-important investment grade credit rating and ushered in Brazil’s investment boom. Levy left the government in 2010 and went into wealth management at Bradesco (NYSE:BBD).
Fast forward to 2014 and the Brazilian economy finds itself on the ropes. The government is now headed not by the charismatic Lula but his incompetent and ever more socialist successor Rousseff.
Brazil’s economy overheated around 2007 as the Chinese boom stimulated overinvestment in Brazil. The Brazilian Real rose too sharply, making the country’s goods uncompetitive, again repeating Argentina’s sad experience.
A key sign of an investing bubble was spotted, in that Brazil’s productivity rate almost didn’t move during the boom. Unemployment fell as sharply as it did simply because the economy was so inefficient that it had to hire excess workers to complete even basic tasks.
The overstimulated economy allowed Brazilian companies to take on too much debt, much of it denominated in dollars. Once the Real went from undervalued to overvalued, the uncompetitive nature of the economy was exposed and the growth miracle suddenly went into reverse. The falling commodity market has now moved the situation from dour to dire.
In Venezuela, the dung didn’t hit the fan until the enigmatic Chavez was replaced by the thoroughly ordinary and deficient Maduro. Similarly, the Brazilian economy immediately headed south once President Lula gave way to Dilma Rousseff. The economy was already in recession by the time Rousseff felt compelled to beg for Levy, the renowned free-market austerity hawk to fix the mess.
Like with Cavallo in March 2001, another unpopular president was forced to appoint an intellectual opponent viewed by markets as a “savior” to try to head off crisis.
When Ms. Rousseff, a leftist former guerrilla who has favored a strong state hand in the economy, announced last year that a free-market “Chicago boy” would run her finance team starting Jan. 1, it was widely viewed as a shotgun marriage. But with Brazil’s economy and public accounts deteriorating fast after years of heavy government spending, the president was under pressure to change course.
Mr. Levy, whose background includes stints with the International Monetary Fund, the European Central Bank and the asset-management arm of Brazilian banking giant Bradesco, was seen as a market-friendly face to reassure investors and mollify jittery credit agencies. He had political experience as well, having earned high marks as treasury secretary under former President Luiz Inácio Lula da Silva and as a budget-cutting finance secretary in Rio de Janeiro state.
News of his appointment initially boosted markets and Brazil’s currency strengthened, a phenomenon local media dubbed the “Levy effect.” One glowing profile late last year compared the new finance minister to Superman. (emphasis added)
10 months after Caballo was appointed in March 2001, Argentina totally collapsed.
10 months after Levy was appointed last winter, Levy is now on the brink of being kicked out and the Brazilian economy is facing an Argentine-like cliff. Levy was particularly brought in to save the country’s credit rating from going to junk and reassuring nervous investors.
He failed on all counts. Brazil has been cut to junk, investors are bailing, the Real just hit all-time lows, and now the only market friendly face in an otherwise corrupt anti-capitalist and wildly unpopular government is about to leave the government.
With Rousseff taking heat from her own supporters for allowing a tax-hiking budget-cutting “Chicago boy” to handle the economy, it’s unlikely the next finance minister will be nearly as investor-friendly.
Rousseff’s own approval rating is under 10%. The country’s institutions are completely discredited following massive corruption scandals. The country’s former crown jewel, Petrobras (NYSE:PBR), is rapidly heading toward bankruptcy.
It’s hard to see many outcomes here much different from Argentina in 2001. The government called in the economic “savior” or “superman” to save the day. They failed. Then the sitting government is booted from power and the currency is devalued sharply.
Needless to say, there’s no “buy-the-dip” opportunity here. Brazil’s Debt-to-GDP ratio has mushroomed to 65%, well above the threshold that often gets emerging market nations into trouble. The economic recession is deepening with GDP shrinkage accelerating.
The country, for the first time in ages can’t even manage a primary surplus (that is, your budget before interest payments). CDS spreads are exploding. The country’s exports for hard dollars, such as iron ore are collapsing in value thanks to the global slowdown.
Even if you thought the country was about to turn, its stocks aren’t cheap. This is no Greek sale. The median Brazilian stock trades at a – considering the situation – surprisingly high 14 PE ratio.
Brazil: The Investment Takeaway
For aggressive investors, Brazil is a perfect short sale, which can be played by shorting the Real, shorting individual stocks heading lower such as Petrobras or Vale (NYSE:VALE). I’m personally heavily short the country’s main ETF, EWZ.
A more sophisticated investor might try shorting Banco Santander Brasil (NYSE:BSBR) and buying the parent Santander (NYSE:SAN) since they’re both down around 40% over the past year and may diverge at some point.
For investors wanting to buy the dip in Latin America, Brazil is simply the wrong country. Better alternatives include Peru (NYSEARCA:EPU) with its 20% Debt/GDP rating and moderately growing economy. Mexico (NYSEARCA:EWW), also investment grade, is more insulated from regional troubles as its economy becomes ever-more tied to exporting goods to the US rather than South America in the post-NAFTA world.
For the closest Brazilian proxy, try Colombia (NYSEARCA:GXG) which remains the region’s fastest growing major economy. Despite being investment grade, having a market-friendly government, and continuing to grow GDP at more than 3% a year, investors have lumped Colombia into the same boat as Brazil pricing both commodity-exporting nations similarly.
Colombia does face, like Brazil, a massive slump in its exports and its currency has sharply devalued. Unlike Brazil, it remains comfortably in investment grade territory with a much more reasonable 40% Debt/GDP reading.
The economy is largely insular and never overly relied, like Brazil, on FDI to boom in the first place. And Colombia just announced a long-awaited peace deal with the FARC terrorists that (finally!) takes geopolitical risk off the country’s table.
Both Colombia and Brazil are down 47% over the past 12 months in dollar terms. The single largest position in my portfolio is long Colombia and short Brazil and I fully expect this will be my home run investment of 2016.
The possible resignation of Brazil’s economic “superman” will usher in the next chaotic break lower in Brazilian equities as the grand finale – a fiery bankruptcy/devaluation/government collapse – looms larger and larger.