Could Brazil Be the Next Japan and India?

Japan India Brazil

In recent years the world has experienced two elections in large countries that ushered in new governments pledging dramatic economic reforms and led to surging stock markets. In Japan in December 2012, the election of Shinzo Abe and his Liberal Democratic Party led to economic reforms known as “Abenomics” and big stock market gains in early 2013. In India, the election in May of Narendra Modi and his Bharatiya Janata Party also led to higher stock prices. Could Brazil’s stock market similarly benefit from its upcoming election?

Brazil’s poll, which will be held on October 5th (with a possible runoff vote later in October), pits the incumbent president, Dilma Rousseff, against a slew of opposition candidates. The most popular of these opposition candidates is Marina Silva, who only became a presidential candidate when her running mate was killed in a plane crash. Polls have shown Silva tied with or slightly leading Rousseff in a potential runoff vote.

A Silva victory could have large implications for Brazilian stocks mainly because investors tend to dislike Rousseff. Brazil has suffered from weak economic growth and high inflation in recent years, and its stock market has underperformed other emerging markets. Many investors have blamed these occurrences on Rousseff’s policies. Silva has advocated more restrained fiscal policies, reducing the inflation rate, and free trade agreements, all of which tend to be popular with investors.

Of course no two countries are identical, so there’s no guarantee that the Japan/India scenario will replay itself in Brazil. One of the biggest differences is that by the end of their campaigns Abe and Modi were romping to massive victories, while the Brazilian candidates are locked in a tight battle. But if Silva is able to pull out a victory, and has enough of a mandate to initiate investor-friendly reforms, Brazil’s stock market may follow the playbook set by Japan and India.

The Outlook for Inflation

Inflation Rate

The US inflation rate has been extremely low since 2009, averaging only 1.6% per year. That’s below the Federal Reserve’s target of 2%. But recently Fed Chair Janet Yellen warned of a phenomenon called “pent-up wage deflation”, which is a complicated way of saying that inflationary pressure could suddenly surge as the economy picks up steam. So how much risk is there of a spike in inflation?

Despite Yellen’s warning, the answer is that a substantial increase in the inflation rate is still very unlikely. Part of the reason is that many of the factors that have kept inflation so low recently are still applicable: with the unemployment rate at 6.1% (and even more people “underemployed”) there remains some slack in the economy, and an aging population should continue to put downward pressure on the inflation rate.

But even if inflationary pressure builds up, it probably won’t lead to a runaway inflation rate. Inflation has been so low for the past 30 years largely because of the actions of the Federal Reserve: after the inflationary surge of the late 1970’s they realized that they could very effectively keep inflation contained by raising interest rates (or simply by credibly promising to do so). The Fed should therefore easily be able to raise interest rates to prevent inflation from significantly exceeding its 2% target.

That doesn’t mean there would be no effect on your investment portfolio. Investments such as bonds (particularly longer-term bonds) that are hurt by higher interest rates would suffer in such a scenario. But the effect of the inflationary pressure would manifest itself in higher interest rates, not in higher prices for the goods and services you buy on an everyday basis. Even if the economy strengthens, an inflation rate near the Fed’s 2% target is still the most likely outcome.

The Effects of Scotland’s Vote

Scotland Flag

On September 18th residents of Scotland will vote on whether to break away from the United Kingdom and become an independent country. Even if the Scots vote for independence (polls suggest the vote will be close), Scotland wouldn’t actually become its own country until early 2016. But for investors a “yes” vote on independence could have negative effects long before that for British stocks, particularly those of Scottish companies in industries such as banking.

In the event of a “yes” vote, it’s still not clear what currency Scotland would use (like the rest of the United Kingdom it currently uses the British pound). The leading advocates for independence argue that Scotland could simply continue to use the pound as part of a currency union with the rest of the U.K. But there are a few problems with this idea. Even if the rest of the U.K. agreed to the currency union, it would face the same problem that the euro zone has faced in recent years, where a currency shared by governments with different fiscal and regulatory policies led to economic calamity.

Furthermore the U.K. government has pledged not to join a currency union with an independent Scotland. Therefore if Scotland kept using the pound, its monetary policy would be managed by the Bank of England, which in theory wouldn’t be considering the state of the Scottish economy when making its decisions. These problems—and the general uncertainty surrounding the potential Scottish currency decision—could harm the Scottish economy and lead to additional costs for British companies.

There is further uncertainty for companies in highly regulated industries such as banking. Many Scottish banks think that their clients would prefer to have their bank regulated and backstopped by the government of the United Kingdom rather than the government of an independent Scotland (its banks are probably too large for Scotland to credibly backstop anyway). Many Scottish financial companies—including Royal Bank of Scotland and Lloyds Banking Group—have therefore declared that they will move to England in the event of a “yes” vote.

These uncertainties lead to higher costs (and therefore lower profits) for companies as they have to prepare for the various possible outcomes. If the independence referendum succeeds, these uncertainties and the associated costs will only increase further.

How to Determine the Right Amount of Risk

Risk Level

We recently discussed the importance of sticking to a set risk level. But what should that risk level be? Since more risk can result in larger potential gains but also larger potential losses, correctly answering this question is one of the most important parts of successfully managing your wealth.

There are two key factors that should determine your risk level. The first is how much risk you are able to take. The second is how much risk you are comfortable taking. While these two ideas sound similar, they can often be very different.

How much risk you are able to take depends the details of your financial goal. You can take a lot more risk if you don’t need the money for 40 years than if you need the money in the next few years. You can take a lot more risk if the amount of money you need for your goal is somewhat flexible rather than a fixed amount. And you can take a lot more risk if your goal is something that would be “nice to have” (like a nice yacht) rather than something you consider absolutely necessary (perhaps a child’s education).

How much risk you are comfortable taking depends on how you react to the ups and downs of financial markets. If you can handle sizable drops in your wealth without losing sleep, you can take on more risk than if every market dip caused you to panic.

So when these two factors don’t align, which one should determine your risk level? The answer is whichever one suggests a lower amount of risk. If you’re not comfortable taking much risk for one of your goals, for example, it doesn’t really matter how much risk you’re potentially able to take: you shouldn’t lose sleep over your investments just because you “can”. Conversely even if you’re comfortable with a high amount of risk, if you need the money in the near future your risk level should probably be fairly low.

Can Australia’s Winning Streak Continue?

Australia Stock Returns

The past two decades have been tough for most international developed economies. Japan has experienced mediocre economic growth for the past 25 years. Europe has recently suffered through two recessions as it battled the global financial crisis and then a sovereign debt crisis. Australia, by contrast, has been a star of the global economy: it hasn’t had a recession since the early 1990’s. Its stellar economic performance is a key reason why its stock market has returned an average of 12.4% per year over the past 10 years, compared with 6.8% for international developed markets overall. Can its winning streak continue?

There are two common explanations for Australia’s success. One is that Australia’s central bank, the Reserve Bank of Australia (RBA), has done a masterful job of managing the country’s economy. The other is that Australia simply piggybacked on the booming economic growth of China, its largest trading partner.

If Australia’s success was just a side effect of China’s economic surge, that may not bode well for Australia’s future prospects. China’s growth rate has slowed from over 10% a year for much of the previous decade to less than 8%, and it may fall further as the Chinese government seeks to rebalance the country’s economy.

If the cause was instead the RBA’s adroit central banking, perhaps the outlook for Australia’s economy is sunnier. In theory the central bank could manage the fallout from a slowdown in China’s growth, though there’s certainly no guarantee that successful economic management in the past will mean successful economic management in the future.

There’s probably some truth in both explanations for Australia’s success, though the RBA’s job is likely to be more difficult than it was in the past. Its benchmark interest rate is at a record low level, giving it less room to further reduce interest rates in order to boost the economy. If China’s economy continues to slow, Australia will struggle to keep its economic winning streak alive.

Sticking to a Set Risk Level

Money Tightrope

When the stock market is rising—as it has been for much of the past 5 years—it’s common to think that you should be taking more risk with your investments. When the stock market goes down, it’s common to think the opposite. But constantly shifting around the amount of risk you’re taking in response to how financial markets are doing is a recipe for poor long term performance. A better idea is to take a longer-term view of the risk you want for your portfolio and stick to that risk level.

There are two main problems with constantly shifting around how much risk you’re taking. One is that it’s very difficult to do successfully. It’s natural after markets have rallied to regret not having taken more risk. But the better time to take more risk would have been before the market went up, not after. Increasing the risk of your portfolio after markets have gone up simply puts you in a position for larger losses when the markets reverse course.

A second problem with shifting your portfolio’s risk in response to what markets are doing is that your portfolio can easily become disconnected from your real-world financial goals. If you’re investing money that you plan to use in the near future, it may be a good idea to take less risk to ensure that your portfolio won’t lose a large amount of its value shortly before you need the money. Remembering this may be more difficult when you’re constantly shifting around your portfolio’s risk level. If your financial goal has a short time horizon and you happen to take on more risk right before markets decline, you put yourself in danger of not being able to reach your goal.