BRIC Countries: Brazil

The following is a guest post from Marotta Asset Management. I'd be interested in hearing everyone's thoughts on BRIC investments and especially Brazil opportunities.

In 2003, the Goldman Sachs Global Economics Department predicted the economic and geopolitical influence of Brazil, Russia, India and China (the BRIC countries) would become increasingly visible in the developed world and even dominate it by 2050. These countries have averaged a total return on investment in their stock markets of 38.28% over the past five years, up 5.02% over the past year.

It pays to look outside the United States for investment options. Every portfolio should be crafted to have the optimum amount of noncorrelated assets in order to lower volatility and increase returns. Understanding BRIC countries helps investors and their advisors determine what percentages best meet those goals.

According to the original investment thesis, these emerging market countries have the preconditions needed in an emerging market to encourage sustainable successful development. Their economic strengths should be able to overcome their economic or political weaknesses.

The term "BRIC" has become synonymous with "emerging markets" in investors' minds. But when the acronym was coined, the BRIC countries were perceived as distinct entities. They have never represented more than 30% of the Emerging Markets Index. The three largest countries, representing more than 40% of the index, are South Korea, Taiwan and South Africa.

Over the past five years, the BRIC subset has beaten the Emerging Markets Index annually by a whopping 11.07%. And the index is down 4.36% over the last year, whereas the BRIC index is up 5.02%.

Brazil, the biggest BRIC country, is credited for most of this performance. It has the fifth largest landmass and the fifth largest population in the world. Brazil also has the best five-year return. As of the end of July, the MSCI Brazil Index showed a five-year annualized return of 53.91%, and it is up 32.05% over the past year.

But these returns came with a price. An editorial last month criticized President Lula for "loving investment grade [securities rating] over the welfare of his people." The Brazilian central bank has set the interest rate at 13%, although inflation is only expected to run at about 5%. This has kept Brazil's currency strong. Contrast the Brazil's strong currency policy with the U.S. current interest rates of 2% while inflation is running an actual 5% to 10%. As a result of the difference in monetary policy, the Brazilian real (R$) has appreciated 222% (16% annualized) against the dollar since January 2003. Brazil's conservative monetary policy has helped it lower government debt to 41% of gross domestic product compared with the U.S. debt currently at 70%.

Brazil has potential, but a lack of economic freedom still holds the country back. Graft and corruption are rampant at every level of government. Injustice is commonplace. Who people know determines the amount of bureaucratic regulation they have to suffer. "For my friends, everything. For strangers, nothing. For my enemies, the law." This common Brazilian adage is a sobering reminder of the mindset there.

Starting a business in Brazil takes 152 days, more than three times the world average. Obtaining a business license is difficult. Just going bankrupt takes four years. Such an environment is difficult for most Americans to comprehend.

The resulting extreme inequity between the haves and the have-nots in Brazil motivates the latter group to seek relief politically. More than 30% of the population live below the poverty line and identify with the socialist and communist political parties.

But as political activists press for more laws, opportunities increasingly open up for unequal application by corrupt officials. This blocks the development of commerce. A professional class of intermediaries is required to facilitate introductions and grease governmental red tape. Substituting personal relationships for the rule of law also creates instability, so entrepreneurs hesitate to take risks. As a result, a well-intentioned socialism actually helps perpetuate the opportunity for abuse and inequality.

One area where Brazil has excelled is making headway toward energy independence. The 1973 oil crisis hit the economy particularly hard. During the recession that followed, Brazilians learned the hard way about the importance of energy. Today, Brazil's extensive system of rivers generates about 90% of its hydroelectric power. The country has also developed a large sugar industry to provide ethanol for domestic use and as an export. In the last few years, Brazil has begun drilling for offshore oil and natural gas. So it may become an oil-exporting country.

The United States imposes a $0.54 cents a gallon tariff on Brazilian ethanol made from sugarcane to protect the ethanol made from U.S. corn, currently at $2.90 a gallon. Ethanol made from Brazilian sugarcane at $1.40 a gallon would be less than half the price. But the tariff pushes Brazil to sell to other markets that do not impose a tariff.

Oddly enough, Brazil itself discourages imports through a wide range of nontariff barriers. As the world economy falters, somehow a majority of people in different countries believe they are the losers in free trade, one of the most simple and easy ways to enrich the world.

Today the winds of trade wars are blowing cold everywhere. Politicians need foreigners to blame for domestic economic troubles. Even our own mantra has become "fair trade, not free trade." But the word "fair" is left vague. This is a political advantage; after all, no one favors unfairness. The unintended harm of trade restrictions are difficult to connect to the cause and take years to unfold.

President Clinton should be praised for moving the United States toward free trade. In the fall of 1991 while running for president, he overruled his campaign's internal debate. "Clinton looked up over his spectacles and said, 'I want all of you to understand something: I'm not going to run as an isolationist, and I'm not going to run as a protectionist,'" recalls political theorist William Galston.

Today, Republican presidential nominee John McCain is the heir to the Clinton administration's economic principles. He says, "Every time the United States has become protectionist we've paid a very heavy price. Free trade has been the engine of our economy." His position won't help him any in the upcoming election.

During the Clinton years, a majority of Americans viewed free trade positively. But after the Democrats lost control of Congress in 1996, fear became a political tool. Job loss to foreign workers is an easy target. Specific anecdotal experiences trump clear economic studies. As a result, unions and environmentalists, opponents of free trade, heavily contributed to the Democrats winning a majority in Congress in 2006. Today, 68% of those surveyed in a Fortune magazine poll believe that America's trading partners benefit more than Americans from free trade.

In Brazil, political sentiments appear to be no different, except that we play the role of greedy foreigners. This occurs despite the fact that much of the country's historical growth has been export driven.

Emerging market countries are volatile. Brazil is no exception. A military dictatorship ruled the country from 1964 until 1985; the constitution was rewritten in 1988. A decade later, Brazil experienced a currency meltdown. Then in 2002, Brazil received a record International Monetary Fund bailout it repaid in 2005, earlier than required. Since that time, the real has appreciated tremendously against the U.S. dollar. It is responsible for 16% of the 53.91% annualized real return in the past five years.

Generally BRIC countries don't move in sync with the U.S. markets. The EAFE Foreign Index has a five-year correlation of 0.81 with the S&P 500. The emerging markets correlation is only 0.72, and Brazil's correlation is only 0.58.

We don't recommend that BRIC countries comprise a major portion of your portfolio, but they should be represented. Although any unstable investment can endanger the chances of meeting your financial goals, a small allocation to a volatile investment can enhance them, especially if that investment doesn't move in sync with your other investments.

Comments

[Andie]

Earlier this year I looked into a BRIC fund, but passed on it. I don't know much about Brazil, but have been keeping up with Russia since the mid-1990s. I thought in the short term, 3-5 years, investing in Russia would probably been fine. However, I was completely not confident that long term investing in Russia would work because the government cannot be trusted to resist its autocratic tendencies. Because of this longer term perspective, I passed on the BRIC fund. Now in light of recent developments with Russia, it is unclear that I could stomach the risks involved with investing over the next 3-5 years.

Having a riskier part of one's portfolio is a good thing, but sometimes knowing too much can make things difficult.

[Matt at Steadfast Finances]

Brazil has certainly done well for me in the past, but with commodity prices going lower, it's finally dragged many of Brazil's high fliers back to earth. Companies like Vale (RIO), Sadia (SDA) and Petrobras (PBR) were big holdings of mine in 2007 and held them until mid 2008, but had to ditch them due to rising negative sentiment against the commodity sector by in large. Sentiment dictates everything these days.

Petrobras (PBR) would still be my favorite pick if you had to buy today. They're sitting on billions in untapped oil reserves and have secured contracts with several deep water drillers for something like 5 to 10 years out. Although, with any developing nation, basic service and quality of life plays are also excellent choices. Wireless telecom and banking sector picks would be my second choices, followed up by the housing market.

You could simply buy the Brazilian ETF index (EWZ) if you just wanted exposure to the Brazilian broad market.

The China ETF index (FXI) is also looking fairly attractive at these levels. I'm looking at the FXI for a quick rebound after the Olympics when things get back to work as usual.

[Joe]

The best way to invest is to diversify across all markets. That includes the "BRIC" area, as well as all of the rest of the world. Don't focus on any given area - buy the market through mutual funds that cover the world.

[WiseMoneyMatters]

One thing to consider when investing in foreign markets is taxes. Taxes can be higher when dealing with foreign investments.

[cmadler]

I'm just curious why Taiwan and South Korea are still considered "emerging" markets?

[Jim]

Decent article. Its not as grossly biased as previous articles by Marotta.

I'm curious, by what measure is Brazil the biggest BRIC country? Its population and economy are smaller than Chinas or Indias.

When you discuss the impact of free trade you claim economic studies say it benefits us. But you provide no reference or basis for that. If you are going to say that unions and hippies are fear mongering and that the facts prove otherwise then state the facts to support it. I'm not doubting there are such studies, I'm just saying you should point to them to support your argument. Most people see the 'anectdotal' evidence of outsourced jobs and shut down manufacturing plants and don't readily believe someone who says studies prove them wrong.

Jim

[Jenny]

A very good article with some great information. But why the plug for McCain in the middle? It is random and has nothing to do with the topic.

[FMF]

Jenny --

That's a plug? I see it as neutral for McCain at best.

[Jenny]

FMF: He says "President Clinton should be praised", and in the next paragraph states that "John McCain is the heir to the Clinton administration's economic principles." Considering that, from what I know of the candidates' platforms, Obama and McCain don't differ significantly on this particular issue, yeah, I'd call that a plug.

Full disclosure, I disagree with each candidate on at least one important issue issue and I'm not sure who I will vote for yet...I just get annoyed around this time of year when politics gets forced into every conversation. Seems to happen repeatedly with MAM's posts.

[Victoria]

if you bother to look at the map, Brazil is definitely not the biggest BRIC country:))