CBJ: BRIC Countries: Brazil

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 percent over the past five years, up 5.02 percent over the past year.

It pays to look outside the United States for in-vestment 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 inves-tors and their advisors determine what percent-ages best meet those goals.

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

The term “BRIC” has be-come synonymous with “emerging markets” in investors’ minds. But when the acronym was coined, the BRIC countries were perceived as distinct enti-ties. They have never rep-resented more than 30 percent of the Emerging Markets Index. The three largest countries, repre-senting more than 40 per-cent 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 whop-ping 11.07 percent. And the index is down 4.36 percent over the last year, whereas the BRIC index is up 5.02 percent.

Brazil, the biggest BRIC country, is credited for most of this performance. It has the fifth largest land mass and the fifth largest popu-lation 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 percent, and it is up 32.05 percent over the past year.

But these returns came with a price. An editorial last month criticized Presi-dent Lula for “loving in-vestment grade [securities rating] over the welfare of his people.“ The Brazilian central bank has set the interest rate at 13 percent, although inflation is only expected to run at about 5 percent. This has kept Brazil’s currency strong.

Contrast Brazil’s strong currency policy with the U.S. current interest rates of 2 percent while inflation is running an actual 5 percent to 10 percent. As a result of the difference in monetary policy, the Brazil-ian real (R$) has appreci-ated 222 percent (16 per-cent annualized) against the dollar since January 2003. Brazil’s conservative monetary policy has helped it lower government debt to 41 percent of gross domestic product compared with the U.S. debt currently at 70 percent.

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 sober-ing reminder of the mindset there.

Starting a business in Brazil takes 152 days, more than three times the world average. Obtaining a busi-ness license is difficult. Just going bankrupt takes four years. Such an envi-ronment 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 percent of the population lives below the poverty line and identifies with the socialist and communist political parties.

But as political activists press for more laws, oppor-tunities increasingly open up for unequal application by corrupt officials. This blocks the development of commerce. A professional class of intermediaries is required to facilitate intro-ductions and grease gov-ernmental red tape. Substi-tuting personal relation-ships 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 percent 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 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 sugar-cane 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.

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 percent of the 53.91 percent 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.