After The World Cup, Nothing Can Save Brazil

By: Joseph Hogue of Street Authority

Shares of Brazilian companies listed on U.S. exchanges have made a remarkable comeback since March. The reasons given in the financial press would be comical if they were not so ridiculous.

For instance, one pundit says the World Cup, though well over budget and a spectacular failure for the home team, will mean faster economic growth in the second half of the year.

That's just a sample from a list that goes on and on... but nobody's acknowledging the economic reality that is poised to bring stocks down again.

Stocks Bounce -- But Not For Long
In November, I examined the country's deep fiscal problems and predicted lower economic growth on higher rates. Since then, analysts have downgraded estimated 2014 economic growth to just 1.2%, down from expectations well above 2% last year. In March, the country's debt was downgraded to BBB- (one level above junk) by Standard Poor's, and the government will likely miss budget targets this year.

Shortly after my article came out, Brazilian stocks plummeted, with the iShares MSCI Brazil Fund (NYSE: EWZ) falling 18% in just three months. Shares of Petrobras (NYSE: PBR), forecast to be the hardest-hit for its role as state-controlled piggy bank, fell almost 38% over the period.

While Rousseff's approval ratings have been dropping, investors are underestimating the power of her political base and the government's ability to manipulate the electorate with social programs. The government has boosted cash transfers to the poor and increased tax exemptions. Price controls have lowered electricity by 30% and bus fares by 20% over the past year.

With a recent poll giving her less than 40% of the vote, Rousseff will probably face a runoff vote after the primary election in October. The socialist president's falling popularity has cheered markets, but she is likely to keep her position.

The economic reality I wrote about in November has only gotten worse, and a Rousseff win will likely mean no turnaround from poor policy decisions. Increased social handouts have pushed inflation to 6.5%, at the upper limit of the central bank's range, and could have been as high as 8% without price controls. Price caps on electricity, fuel and transportation may be lifted after the elections and could cause inflation to jump.

This means the central bank will probably need to raise rates even more, past the current 11%, further choking off economic growth. Without a major rebound in commodity prices, the country is most likely in for at least a few years of economic disappointment. The outlook is so bad that the International Olympic Committee has developed a Plan B for the 2016 Summer Games: Should Brazil not be able to meet its obligations, the Games will be held in London.

Higher Prices, Worsening Outlook

Petrobras is the world's most indebted crude producer with $138 billion in debt, far outpacing its $99 billion market cap. The firm is planning to spend $221 billion in capital expenditures over the next five years. The company was the worst performer among the mega-cap oil companies over the past year, and shares trade at 10.6 times trailing earnings.

While the shares may seem cheap, the government is unlikely to allow fuel prices to increase. Doing so would add to an already high inflation rate and destroy what little positive public sentiment Rousseff still enjoys. Price controls on fuel mean the company must sell gasoline and diesel at discounts of 6% and 14% to international prices and have driven the company to a $42 billion operating loss since 2011.

According to iShares, the rebound in its MSCI Brazil Fund has taken the valuation to 20.9 times trailing earnings of the companies in the fund. That is above the 19.4 price multiple on the SP 500. The volatility of 28% in the Brazil fund over the past three years, compared with just 12% in the U.S. index. Even those bullish on the Brazilian market would have to agree that the risk-reward ratio for Brazilian equities is out of whack.

Shares could be volatile around the presidential election, scheduled for Oct. 5, and could rally higher if Rousseff wins less than the 50% needed to avoid a runoff. A Rousseff win -- and the ensuing economic repercussions -- could mean a tough 2015 for Brazilian stocks.

Risks to Consider: Shares of many of the domestic companies, most notably Petrobras, trade for steep discounts to international peers. There is always the possibility that shares rally on better economic growth or more fiscally responsible policies. While the upside is high, the downside risk appears to be much greater.

Action to Take -- Investors are still blinded to the economic reality as they hope for assets to bounce from low valuations. The markets have managed to rebound this year, but the real pain is yet to come. Avoid shares of domestic Brazilian companies or hedge your position by selling call options.

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