Some thoughts on the Brazilian Economy 

Part 2

For a while the Brazilian economy has been showing signs of contraction. These signs have not only derived from global economic contraction but also dubious domestic policies.

I don’t believe that excessive and unsustainable credit expansion to businesses and individual borrowers deriving from government interventions generate benefits. It may do so in the short term, but later on the costs will far outweigh the benefits.

Growth financed or deriving from accumulation of funds or Funds Saved is real growth; growth financed by the means of government interventions (money printing or interventions in Interest rate instruments) is not real and it doesn’t work.   It doesn’t take too much effort to verify this theory. By taking a close look at the current situation in Europe and The US.

Governments worldwide have been Cutting Taxes to stimulate growth. The only way to make the process work is to implement Tax cuts along with Cuts in government expenditures. Without cutting spending (tightening the belts in Economic Jargon) to avoid inflation, the recipe will not work; actually it will become recipe for disaster. The US and Europe have been cutting taxes and injecting capital through Bond repurchase programs and all kinds of stimulus packages. The results have been devastating!

We are following the same pattern in Brazil. Maybe I am not aware of current cuts and shifts in policy in Brazil, but as far as Results are concerned, the policies aren’t working. There were proposals for very strong cuts in Brazil and but so far, I don’t think that they materialized. If they did, we should start seeing signals of improvement around October or November. But with the latest economic data,  I doubt that the cuts were fully implemented: if they were we are not aware of it. I read about plans and cuts, but looking at the scale of cuts and spending, there is a long way to go before balance could be achieved.

 A very important detail that goes often unnoticed is that Spending last year was absurdly high during presidential elections. This year spending has increased quite significantly as well, so even some cuts were presented they will not outweigh expenditures and contractions will follow.

The same kind of policies that were implemented elsewhere – and failed – were being implemented in Brazil. As I mentioned before, the policies failed elsewhere therefore it would be a real surprise to see them working in Brazil.

To give readers an idea of how damaging the combination of lowering interest rates + accelerating money supply can be (to any economic power) here is a list to leave no doubts or room for speculation. Below, the European and US Debt to GDP ratios (data source: Eurostat):

Government debt at the end of the first quarter 2012 by Member State

The highest ratios of government debt to GDP at the end of the first quarter of 2012 were recorded in Greece (132.4%), Italy (123.3%), Portugal (111.7%) and Ireland (108.5%), and the lowest in Estonia (6.6%), Bulgaria (16.7%) and Luxembourg (20.9%).

Compared with the fourth quarter of 2011, twenty-one Member States registered an increase in their debt to GDP ratio at the end of the first quarter of 2012, and six a decrease. The highest increases in the ratio were recorded in Lithuania (+4.0 percentage points - pp), Portugal (+3.8 pp), Spain (+3.7 pp) and Belgium(+3.6 pp), and the largest decreases in Greece6 (-33.0 pp), Hungary (-1.8 pp) and Denmark (-1.5 pp). It should be noted that the change in debt ratio between two successive quarters can be influenced in some cases by seasonal patterns.

Analyzing the data, It is clear that the situation has been deteriorating since the last quarter of 2010. Europe has some serious problems, it is very clear, but the USA doesn’t enjoy a better outlook. Here are the figures for the USA:

In essence, all programs implemented to BOOST economies since the 2008/2009 crisis has done very little to solve the problem.  One could argue that the recent statistics have improved, but it only takes a glance to the figures above to realize that the reality lies far from that. 

Let's examine what has happened since President Obama has taken power. Please keep in mind the following: He promised Changes; Changes that would improve economic conditions and boost the economy:. He promised Tax cuts and stimuli. Here are the results of his Changes:

With that in Mind, I would like shift our focus to our domestic situation. the graph below displays the current situation in Brazil:

Brazil is not immune to problems. It is exposed as much as any other nation in the planet. By following the same kind of policies that have only damaged what once were stable economies, will not bring any improvements. On the contrary, they will lead us to the same road already traveled by those who implemented these policies.

The Copom Minutes released on July 11^th, have presented some interesting developments:

-          Mixed signs on the Employment sector. Situation is improving according to officials, but only once figures are compared to the March 6.2% Unemployment rate; April had 5.6% and May 5.4%. There is an interesting paragraph in this report, on page 3.  Here is the segment:

“In May 2012, 139.7 thousand formal jobs were created (compared to 252.1 thousand jobs created in May 2011). The slower growth of the economically active population in the recent period, compared to the occupied population, has contributed to the maintenance of low unemployment rates”

-          Among the industry use categories, according to data seasonally adjusted by the  IBGE,  capital goods  production  fell  by 1.8% in May and  the  production of durable consumer goods  decreased by 2.2%. The production of intermediate goods grew 0.2%, and the production of semi-durable and nondurable consumer goods fell by 2.1%. In the twelve months through May, there were decreases in the production of capital goods (-3.8%), durable consumer goods (-7.1%), intermediate goods (-1.1%), and semi-durable and non-durable consumer goods (-0.3%).

This type of dynamic that is very negative for overall economic recovery. Erosion and contraction on almost every manufacturing segment.

-          Contraction on the export sector, with the trend continuing and accelerating since January 2011. From May 2011 and May 2012, The trade balance surplus on a twelve-month accumulated basis decreased from US$27.5 billion in May to US$23.9 billion in June. Again, here, the same problem. Exports underperforming and import demand, a bit better from early this year, but also into very low levels.  When both sector are experience erosion, there is nothing much to be said. We are entering a period of considerable economic contraction.

      

       Brazil is regarded as an export nation; a  key supplier of important raw materials. With its exports dropping at current pace, It would be surprising to see a rapid turn and improvements on the near term. They government may not want to admit, but the other term for moderation is CONTRACTION. With economies globally undergoing hardship, we should reassess the situation.

In general, the minute doesn't present very good outlook for the domestic economy. It only reinforces what the recent data has already proven. Our economic growth is slowing consistently and at fast pace.

The most interesting paragraph on the entire document is the number 12. Here I copied and pasted the paragraph:

“12. Global economy faces a period of above-than-usual uncertainty, with high risk aversion, and prospects of low growth, which have intensified since the last Copom meeting. In this sense, data suggest some cooling of the activity in the United States (US), in a scenario of risks associated to the fiscal outlook and to the deepening of the European crisis. Heightened risks to global financial stability remain due to the still high level of political uncertainty and to the difficulties of implementing the recently announced measures.  High rates of unemployment for a long period, coupled with  the need for  fiscal adjustments, the limited scope for countercyclical policy actions and  the  political uncertainty are translated into projections of low growth  for mature economies.

Global Unemployment rates June 2012

 The composite leading indicator released by the Organization for Economic Cooperation and Development (OECD), referring to June, indicates activity below trend in the Euro Area and in the main emerging economies, besides moderation of activity in Japan and in the US.  In the same sense, the disaggregated indicators of the Purchasing Managers Index (PMI) for June suggest moderation in global activity, mainly in manufacturing activity. 

Regarding monetary policy, advanced economies persist with strongly accommodative stances - the European Central Bank (ECB) reduced the interest rate to the lowest historical level, and the Bank of England resumed measures of quantitative easing. Core inflation measures have remained at moderate levels in the US, in the Euro Area and in Japan. In emerging economies, in general,  the  monetary policy bias is expansionist, which combines, in some cases,  with  additional countercyclical policies. In particular, China promoted, in June and July, two consecutive cuts in the reference interest rates for deposits and loans.”

Below, some figures from the leading global economies for June 2012

Global Inflation Rates 

Global Debt as per July 2012

 Moving on, we should address Inflation. Here is the last official figure released:

-          Brazil's broadest inflation index, the IGP-M, rose 1.34 percent in July, up from a 0.66 percent increase in June, the Getulio Vargas Foundation research group said on Monday. 
The index was expected to increase 1.23 percent, according to the median forecast of 13 economists polled by Reuters. 

-          Consumer price inflation rose to 0.25% in July on higher food price inflation and the fading impact of the IPI tax cuts on auto prices (this more than offset the seasonal decline in apparel prices). In yoy terms, IGP-M inflation accelerated to 6.7% more than double the 3.2% March print. 

Conclusion: We are facing Inflationary pressures.

At this point, we must ask ourselves a question: What makes economies “really grow and improve”?   

Real growth is achieved when there is real increase in funds saved. Funds saved or increase in the POOL of deferred funds ready to be invested has increased or accumulated. Here I would like to stress that artifial creation of funds does not serve that purpose.

Central bank intervention does not replace real savings.  Lowering interest rates and expanding liquidity has the opposite effect. When modeling an investment opportunity, if interest rates are artificially low, entrepreneurs are led to believe the income they will receive in the future is sufficient to cover their near term investment costs. Therefore, investments that would not make sense with a higher i.e. 10% cost of funds become feasible with a prevailing interest rate of i.e. 5%.

I believe that the principles of the Austrian Economic School provide some  great insights and very clear explanations to the events we are witnessing around the world today. Here some excerpts from definitions  extracted from Ludwig Von Mises books and Wikipedia:

The Austrian theory of the business cycle (or "ABCT") varies significantly from mainstream theories and is generally rejected by mainstream economists. In contrast to most mainstream theories on business cycles, Austrians focus on the credit cycle as the primary cause of most business cycles. The theory was created by Hayek, by integrating Böhm-Bawerk's theory of capital and interest with Ludwig Von Mises's arguments concerning how an expansion of the money supply or government manipulation of interest rates contributed to malinvestment.

Austrians Economists generally argue that inherently damaging and ineffective central bank policies, including unsustainable expansion of bank credit through fractional reserve banking, are the predominant cause of most business cycles, as they tend to set artificial interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles", and artificially low savings.

Many entrepreneurs can make the same mistake at the same time (i.e. many believe investment funds are really available for long term projects when in fact the pool of available funds has come from credit creation - not real savings out of the existing money supply) because the debasement of the means of exchange is universal, . As they are all competing for the same pool of capital and market share, some entrepreneurs begin to borrow simply to avoid being "overrun" by other entrepreneurs who may take advantage of the lower interest rates to invest in more up-to-date capital infrastructure. A tendency towards over-investment and speculative borrowing in this "artificial" low interest rate environment is therefore almost inevitable.

This new money then percolates downward from the business borrowers to the factors of production: to the landowners and capital owners who sold assets to the newly indebted entrepreneurs, and then to the other factors of production in wages, rent, and interest. Austrians conclude that, since time preferences have not changed, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. In other words, depositors will tend to remove cash from the banking system and spend it (not save it), banks will then ask their borrowers for payment and interest rates and credit conditions will deteriorate.

 Austrian Economists, contrary to Keynesian School economists, argue that a boom taking place under these circumstances is actually a period of wasteful malinvestment, a "false boom" where the particular kinds of investments undertaken during the period of fiat money expansion are revealed to lead nowhere but to insolvency and unsustainability. It is the time when errors are made, when speculative borrowing has driven up prices for assets and capital to unsustainable levels, due to low interest rates "artificially" increasing the money supply and triggering an unsustainable injection of fiat money "funds" available for investment into the system, thereby tampering with the complex pricing mechanism of the free market.

"Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. According to Mises's work, the artificial stimulus caused by bank-created credit causes a generalized speculative investment bubble, not justified by the long-term structure of the market.

Mises further argues that a "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates.^[41][42] Mises conjectured that the "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires.

Here, I rest my case. I don’t know what readers think, but it sounds very familiar to recent events that have taken place and could further unfold worldwide. And please correct me if I am wrong, but it seems that we are heading towards this direction in Brazil.

I will shift the gear from theory to facts.

Instead of spending time further analyzing economic data and theory, I think that is far more important to try to grasp how the situation is by means of evaluating the performances of leading companies from different sectors and industries. Companies create jobs and employ people, generate revenues and therefore have a direct impact on domestic growth.

Considering the overall economic analysis, I would like to address the possible impact and consequences of the current economic  trends to companies listed in Brazilian Stock Exchange.

Year to Date Performance: 3.60%

Other Emerging Markets Year to Date Performances

Hong Kong:  9.95%

Singapore:    15.34%

Phillipines:     20.90%

Taiwan:         2.06%

Thailand:       16.80%

Europe

France 13.30%

Spain:  (-17.00%)

Sweden: .9.70%

Netherlands: 6.68%

Let’s take a look how the leading companies are performing and use that as a proxy for the crowds. Putting it in a simple way, If the best equipped and most well capitalized companies underperform, the chances that average companies will outperform (deliver better results) becomes limited. It can happen, but, probability is low. I believe that there are exceptions to the rule but in general when the most important enterprises struggle and face challenges ahead, the probability that the challenges will extend to all other businesses is high.

As the data below shows, Brazilian companies are not performing well in 2012 nor historically:

                                                             1 month returns    Year to date       1 Year             3 Years  

Vale	-3.74%	-9.05%	-23.04%	2.33%
S&P 500 Total Return	3.65%	12.93%	28.11%	47.70%
Rio Tinto	6.82%	4.69%	-13.63%	-68.07%
BHP Billiton	8.04%	-0.19%	-9.82%	16.31%

Petrobras - Petroleo Brasileiro	14.20%	-10.17%	-16.68%	-43.94%
S&P 500 Total Return	3.65%	12.93%	28.11%	47.70%
Helmerich & Payne	12.31%	-16.12%	-11.09%	42.24%
Petrobras - Petrleo Brasileiro	12.70%	-9.17%	-11.67%	-34.76%

BRF-Brasil Foods	2.21%	-23.96%	-16.83%	-1.46%
S&P 500 Total Return	3.65%	12.93%	28.11%	47.70%
Pilgrim's Pride Corporation	-21.69%	-16.93%	44.56%	-1.54%
Adecoagro	9.84%	29.63%	16.90%	0.00%

Itau Unibanco	18.94%	-7.56%	2.22%	2.57%
S&P 500 Total Return	3.65%	12.93%	28.11%	47.70%
Banco Bradesco	10.45%	0.74%	1.90%	62.20%
Banco de Chile	0.74%	7.50%	11.41%	112.4%

What generates growth for enterprises:  Sales, New Projects and VERY Strong Cash Flow!  In short, as Investopedia so well defines, here is what makes companies grow:

“ Companies that generate Revenues at faster pace than the Economy, Any firm whose business generates significant positive cash flows or earnings, which increase at significantly faster rates than the overall economy. A growth company tends to have very profitable reinvestment opportunities for its own retained earnings. Thus, it typically pays little to no dividends to stockholders, opting instead to plow most or all of its profits back into its expanding business.”

The current economic landscape promises more challenges than rewards on the short run. Certainly, the current valuations of certain Brazilian companies could lead us to believe that right now they present great investment opportunities.  I wouldn’t Jump conclusions so fast.

One should evaluate carefully the situation before making decisions. In  economic scenarios such as the one we experience today, normally attract the so called Value Investors. Once assets prices are depressed or selling at discount, they are the very first to hunt for opportunities. A good proxy for evaluation is too look at their valuation in historical terms, dividend yields, Book Values and discounting future projected cash flows to assess their competitiveness. When such metrics seem quite interesting to Investors, there are good probabilities of Stock Accumulation and price appreciation. I am using this metrics as examples. I am not implying that all value investors use the same metrics and procedures int their evaluations. There are several types of investors and funds using different kinds of metrics, system and methods in their portfolio selection.

I don’t think that Brazilian companies provide the best risk to reward ratios for the International investors right now. The so called Sophisticated investor (also called Smart Money)can find higher returns with lower risks elsewhere. There are enough companies and other asset classes  providing far more interesting returns and with lower riskfor their capital.

Among  international companies listed in the US exchanges, called A.D.R (American Depositary receipts) there are companies competing with Brazilian firms directly with better prospects and higher returns. It may sound strange but at this particular stage, even in markets such as Spain and Italy, there are better opportunities to invest (risks to reward) than those offered by companies listed in Brazil’s Bovespa.

Looking a bit deeper into Emerging markets, several companies listed in the exchanges of Thailand, Philippines, Singapore and Hong Kong as well as some in Turkish and Russian companies provide better outlook. Next to it, raw materials and Agricultural commodities provide far better risk to reward, Liquidity and outlooks as assets to invest at this stage.

International fund managers can allocate funds into international markets with a considerable degree of freedom.  In the US markets they can utilize the ETF instruments , they have access to diversified natural resources in Commodities and futures markets and many firms often have branches overseas, allowing them to directly operate into foreign exchanges. Having their capital at home provides extra flexibilit..

At this juncture, I believe that international investors are being somewhat careful regarding investments in Brazil. There are concerns and the concerns are valid.

Brazil is in evidence; not only by being a large and important economy but also as the organizer of very important events namely the 2014 world Cup and the 2016 Olympics.  One could argue that such attention would attract international capital.  To an extent it may be true, but given current economic conditions, there are considerable variables in play. Among such variables, we could highlight management efficiency and financial/budgetary controls.

Media coverage of these events is driving constant attention to us. Government Officials take that as positive; being currently overseas and reading as well as listening to media coverage from different countries, the message is a bit different. There are clearly mixed feelings.

There are concerns regarding the transparency and the ability to deliver. They don’t doubt that the events will take place and they will be beautiful; the doubts come exist concerning timeline, cost efficiency and possible consequences of LAST MINUTE  capital injections that may be required in case of delays.

In one hand we have our president cutting budgets, trying to reassure the world that tough policies are being implemented. In essence cuts should be welcomed; however. when one closely analyze where the 32 billion Real cuts are being enforced, we notice that they are targeting city ministries. If so, these cuts may very well impact the cities organizing the event and compromise the ability to set up the proper infra-structure required for upcoming events.

The delays in construction and completion of Sport Venues are constantly being addressed and the question remaining is the following: How much last minute funds (Emergency Funds) will have to be released to guarantee the completion of sport venues? Along with the question comes the misappropriation of funds! The possibility of abuse by contractors and government officials alike has often addressed in the media.

As very good studies and researches have proven, organizing such events have costs and profitability is not always significant. In recent history, we have seen that costs tend to be far above estimated and during recessionary periods, the damages far outweigh benefits. Some firms profit, the sponsors, but countries and cities are often left with debts.  Therefore, one of the keys to success in such events is controlling costs; That is not one of our strengths. Just look at the situation of World Cup venues and we are already are getting a test of what is about to happen;  the developments are far from smooth.

All in all, the outlook for our economic growth and development is in question. What was regarded as great achievements – Hosting the World Cup and Olympics – may end up being detrimental financially. Sponsors and private firms may profit, but the country and the cities may have to carry the burdens.

Only time will tell what the future will bring, but , there are enough question marks around to make Brazilians concerned.