Is Brazil the next bubble?

Is Brazil a one-way bet and should you be advising clients to pile into Brazilian equities? asks Joanna Faith

Investor appetite for Brazil continued to intensify last year. The country’s healthy growth figures, strong investor appetite for exposure to emerging markets, weak GDP numbers in developed economies and Europe’s sovereign debt crisis, all contributed to Brazil’s increased appeal.

Meanwhile, the launch of the Allianz RCM Brazil fund, which the group claimed was the first British-domiciled, actively-managed Brazil Oeic, also added to the noise.

But is the country a one-way bet and should you be advising clients to pile into Brazilian equities? From a macro perspective, the answer is yes. Economic growth remains robust with GDP growth projected at 7.5% for 2010 and 4.5% in 2011, with Brazil expanding faster than most markets in Latin America.

Co-manager of the AllianzGI fund, Carlos de Leon, expects corporate earnings to be strong in Q4 and projects earnings per share growth at 22% for 2011.

He says high potential investment themes include consumer demand, infrastructure, education, housing, private healthcare, energy, mining and agriculture and believes the country offers the best opportunities in Latin America.

“We think the authorities have done the right thing, calming investor concerns about inflation and fiscal policy,” he says.

However, while the case for Brazilian equities may appear solid, there are risks, which according to Alan Nesbit, deputy head of global emerging markets at First State, investors are all too willing to ignore.

Nesbit, who has been a keen supporter of Brazil for two decades, says today he is more worried than ever before: “Everybody including my gardener has investments in Brazil. Although people see the positives, no one is asking questions about risk,” he says.

He cites the sheer number of non-dedicated investors with investments in Brazil including global, commodity and property managers as another concern.

He does not, however, devalue the country’s positives. “It has unlimited resources which broadly are resources China needs. The ability to produce more commodities is there. Brazil is one of the few places that still has abundant land to grow crops, more sugar and do more farming. There have also been oil discoveries.”

Yet he fears in the short term, a stock market bubble could be brewing. “If you worry about China, you should worry about Brazil,” he says. “It is overvalued. The Brazilian stock market has never been more expensive. Too many people own it who shouldn’t.”

Another worry is Brazil’s overvalued currency. Interest rates in Brazil are higher than in many other Latin American economies resulting in a lot of inward investment.

Nick Robinson, head of Brazilian equities at Aberdeen, says foreign inflows are strengthening the real against a number of currencies particularly the dollar, which means the export sector is struggling.

He believes the authorities are trying to decide what to do. “Inflation is becoming an issue – it crept above 5% which is nudging towards the top end of their targets – but raising rates again is going to make life even tougher for the manufacturing sectors if the real continues to strengthen.”

Nesbit says people investing in Brazil may not necessarily be aware they are taking quite a big currency risk.

The input of the government in the workings of large Brazilian corporations is also a worry few investors take into consideration.

The BNDES, a government agency which was set up to support strategically important industries in Brazil, still has a big influence on businesses. It was successful in the past in keeping big companies such as Vale and Petrobras going when they could not get funding from international markets.

According to Nesbit, the BNDES has been on a wild lending spree and has its “tentacles” in every Brazilian corporation. “These companies should be big enough to go to market and issue debt but they aren’t,” he says.

He believes the state’s intervention in these companies should alarm investors. “If you are investing in companies where you feel the benefits of those companies’ activities are not all coming back to the shareholders you should worry. You do not want to see companies wasting money, spending money unnecessarily and money disappearing into the pockets of the government.”

Meanwhile, Robinson is concerned about the effect developed markets may have on Brazil. “There is still the potential for a double dip recession, and as much as emerging countries have decoupled to a certain extent from the developed world, they are still very much tied to the global economy,” he says.

He adds if the global economy gets weaker this year it could impact Brazil which remains an important exporter of commodities. His message for investors is be cautious.

Despite the negatives, Nesbit says over the long term Brazil is still a compelling story and will be a great investment over the next 20 years. In the short-term, however, he is not so positive, saying in the next year the market could go down.

Meera Patel, Senior analyst at Hargreaves Lansdown says:

"If you want to go down a broader route, you should use the Allianz BRIC fund.

However, we have recently added the First State Latin America fund to our Wealth 150 list and we think it is an interesting play: its track record speaks for itself.

First State is never going to be a manager that will deliver top of the table returns in a strong bull market, but in a sideways or falling market it protects more than its peers. Longer term their results are exceptional.”

Click here to see a Q&A with Sebastian Luparia, portfolio manager of the J.P. Morgan Brazil fund.