Stagflation fears hurt confidence in Brazil

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Every new year comes with hope for a fresh start, but don't expect 2013 to be a breath of fresh air for the Brazilian stock market.

Once a Latin American powerhouse, Brazil's Bovespa stock index has fallen 11 per cent in the past two years, having ceded much of its regional influence to Mexico. The Portuguese-speaking country sits at a point of "stagflation": It shocked observers when it posted only 0.6-per-cent growth in the third quarter of 2012, while inflation sits close to 6 per cent.

While there are signs of a small economic turnaround in Brazil in 2013, the country no longer appears to be a bellwether for the world's emerging markets. Those looking to buy a stake in the BRIC country may want to hold out until Brazil proves it's got its swagger back.

January's Bank of America Merrill Lynch Global Research survey of emerging-markets fund managers provides a stark picture of investor confidence in Brazil: Only 21 per cent of surveyed portfolios were invested in the country, the lowest level since the monthly survey began.

"There is little optimism in Brazil," said Scott Piper, who manages Excel Funds Management Inc.'s Latin America Fund. Investors, he said, have been thrown off by the country's inability to meet growth expectations: Most forecasts for 2012 hovered near 4 per cent, but it looks like GDP growth will come in closer to 1.7 per cent for the year.

Stagflation – the combination of sluggish growth and high inflation – "is not good for equities," said Nomura Securities managing director Tony Volpon. A long-time proponent of Brazilian growth, he's recently turned his bullishness to Mexico instead. Brazil, he said, "has been one of the worst-performing equity markets in the past few years."

Last week Brazil held its benchmark interest rate to its historical low of 7.25 per cent. While the absence of further stimulus should indicate optimism for Brazil – the rate has fallen 5.25 percentage points since August, 2011 – it also signals the possibility that the interest rate could instead soon reverse course and begin to rise to combat the country's rising inflation.

Pierre Lapointe, head of global strategy and research at Montreal's Pavilion Global Markets, said in a report last week that he has shed his pessimistic view of Brazil and has turned mildly optimistic for 2013. But he also warned that "investors should brace" for the benchmark rate to rise, possibly within the year, which would affect Brazilian assets.

"The conditions are in place for a small economic rebound," Mr. Lapointe said in an interview. But when it comes to equities, "We're not saying it's our best bet for 2013 … we recognize there will be some catch-up with other emerging markets."

Adam Kutas, who manages Fidelity Investments Canada ULC's Latin America fund, has a "mixed picture" of Brazil's investment environment, as the country tries to rebound.

In the short term, Mr. Kutas sees the market moving back in Brazil's favour, but not enough to offset the risks that have been keeping investors away.

He sees the Brazilian market trading at 11 to 12 times earnings, with return on equity in the mid-teens. That kind of price-to-earnings ratio makes sense, he said, with such high inflation – pushing him to look for "ideas on the margin." He's looking for companies that are automating to reduce labour costs, including the manufacturing industry, as well as asset management.

Excel manager Mr. Piper said companies taking advantage of growing educational programs and infrastructure renewal are wise ideas for getting stronger returns in Brazil.

There are, of course, several things that could turn in the Brazilian market's favour this year. The rise in Chinese residential construction could boost demand for Brazil's raw materials, including iron ore.

And attempts last year by the federal government to deflect inflation with economic intervention should calm down in 2013, Mr. Piper said. Investors were frustrated by these interventions, which sometimes targeted certain industries in an ad-hoc fashion, he said. That made investors cautious for fear of investing in the wrong industry.

Canadian investors looking for a taste of Brazil without biting into the country's risk should consider looking more broadly, such as a Latin America or emerging markets fund.