Brazil had the world’s worst-performing stock market last year, and it didn’t start off 2016 much better. But the country’s stock market troubles go back even further. Since the start of 2011 Brazilian stocks have lost 70% of their value, compared to a 27% loss for emerging markets overall and a gain of more than 25% for stocks globally. Will Brazil bounce back any time soon?
The country’s financial struggles are due to a combination of long-term problems and recent developments. High inflation and low worker productivity have been persistent headaches for the Brazilian economy. Over the past five years it’s been further hurt by the decline in commodity prices, which has accelerated since the middle of 2014. And Brazil has struggled with pervasive corruption, which last year enveloped Petrobras, its most prominent company.
Politics haven’t helped as the government has been riven by debates about whether President Dilma Rousseff should be impeached. And the agglomeration of man-made woes was supplemented by a natural one when the country become the epicenter of an outbreak of the mosquito-borne Zika virus.
Given all these misfortunes, why would anyone invest in Brazil? It’s certainly possible that its stock market could continue to fall, especially if China’s economy slows more than expected. But with so many factors having seemingly conspired to hurt the country it wouldn’t take much to improve the situation.
Until a bounce this past week Brazilian stocks were more than 10% below their financial crisis nadir, suggesting that stock prices already incorporate a fairly dire outlook for the future. A rebound in commodity prices, better economic policies, or even a successful impeachment of President Rousseff could all potentially trigger a turnaround. And if none of those come to pass, there’s still a chance that the attention lavished on the country during the upcoming Olympic Games in Rio de Janeiro could do the trick.
Stock markets around the world have been battered in recent months, but Brazil’s has been hit the hardest. Since the start of July Brazilian stocks have lost more than one-third of their value. This slump is the continuation of a larger trend in which Brazilian stocks have underperformed emerging markets for years, and they have lost about two-thirds of their value since the start of 2010. Is there anything that can turn around the country’s fortunes?
Brazil has long battled economic headaches such as high inflation and low worker productivity, but this year its problems have accelerated. Its economy is in a recession, it’s suffered from the decline in commodity prices, the value of its currency has plunged, and the country’s most prominent company, Petrobras, is mired in a massive corruption scandal. Earlier this month Standard & Poor’s downgraded Brazil’s credit rating to junk status.
Given this litany of tribulations, Brazil’s situation may seem hopeless. But there are a couple key factors that could allow the country’s stock market to bounce back.
One is that Brazil may be less exposed to commodity prices than it has been in the past. After the energy sector’s recent struggles and the crisis at Petrobras, the energy sector now comprises less than 10% of the country’s stock market. This exposure is less than many other countries (almost half of Russia’s market, for example, is in the energy sector) and not that much higher than emerging markets overall. With a weak global economy threatening to keep commodity prices subdued, this lower prominence of energy stocks could reduce the headwind for Brazil’s market.
A second potential boon could be better government policies to steer the country back to economic growth. Brazilian stocks rose in the summer of 2014 when it looked like president Dilma Rousseff might lose her re-election bid to a candidate advocating more investor-friendly policies. Rousseff ultimately prevailed, but her approval rating is now in the single digits. Her unpopularity may force her to either revise her policies or leave office, either of which would likely boost Brazilian stocks.
A lot has seemingly happened in the global economy in recent months, from a plunge in the oil price to a surge in the value of the US dollar against foreign currencies to an election in Greece that led to renewed fears about the possibility that the euro zone would break apart. But what’s been the upshot of all these changes? The latest World Economic Outlook report from the International Monetary Fund provides some data to answer that question.
According to the IMF’s report, the global economy is expected to grow by 3.5% this year. That’s lower than the projection of 3.8% growth that the IMF made six months ago. The change is largely the result of slower expected growth from emerging markets (5.0% six months ago versus 4.3% now). The prospects for developed economies, on the other hand, have actually improved slightly. While the estimated 2015 growth for the US hasn’t changed (it’s still 3.1%), the IMF boosted its growth estimates for the euro area and Japan.
Even though expectations have declined for emerging economies as a whole, not every country has a similar story. Six months ago the IMF expected a positive growth rate this year in Russia and Brazil; now it expects both countries’ economies to get smaller. The anticipated growth rate for China has also declined, although it’s still very high at 6.8%. India has gone in the other direction. Six months ago the IMF was projecting that India’s growth this year would be 6.4%. The latest estimate is 7.5%.
It’s important to remember that there’s only a weak link between economic growth and stock market performance, so simply buying stocks of fast-growing countries (or stocks of countries where the economic outlook has improved) probably isn’t a good idea. In fact, China and Russia have been among the best-performing stock markets so far this year. Still, thinking about the global economy in terms of these numbers may make the big-picture trends more apparent.
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.
One important trend in global financial markets during the last few years has been a rise in political risk, a concept referring to political changes that could affect the value of an investment. The number of events associated with political risk—such as elections, mass protests, and military interventions—has increased by 54% since 2011, according to a study by analysts at Citigroup. This kind of increase has a couple key implications for investors.
The first is that it can affect the relative performance of emerging markets versus developed markets. Interestingly, while political risk has historically been most closely associated with poorer countries, in recent years it has appeared in some of the wealthier emerging markets and even developed ones.
In emerging markets there have been protests in a wide range of countries, including Brazil, Russia, South Africa, Thailand, and Turkey. In developed markets, political posturing opened up the possibility that the United States government would default on its debt in the summer of 2011, and extremist parties opposed to the European Union did well in recent elections for the European Parliament.
A continued increase in political risk would likely hurt emerging markets more than developed markets, even if the risks aren’t isolated to emerging markets themselves. Investment typically flows from emerging markets into “safer” markets (such as the United States, Switzerland, and Japan) when perceived risk increases. This shift can take place even when the risk originates in the developed countries, as was the case when emerging markets were pummeled during the 2008 financial crisis.
A second implication of increased political risk is that it may lead to more divergence in the performance of stocks in different countries. This trend is already evident in some of the countries that have recently experienced notable political events. For example, Russian stocks have lost 8% so far this year (and at one point were down close to 25%) as the country became involved in territorial battles with Ukraine. Indian stocks, by contrast, have risen more than 20% this year as political power shifted in the country’s May elections.
In a recent post we discussed the weak performance of Brazilian stocks over the past few years. But how do you know what your exposure is to Brazil (or any other country)? Unfortunately having only a general idea about the types of investments you own doesn’t answer that question.
Obviously if you own individual stocks in Brazilian companies, or a fund that invests solely in Brazilian stocks, those holdings will give you exposure to Brazil. But many other types of funds have Brazil exposure as well. Brazil makes up over half of the market value of Latin American stocks overall, so a fund designed to invest in Latin America will likely have a large exposure to Brazil. The same is true for broader emerging market funds: based on market value Brazilian stocks account for about 13% of emerging markets overall. More general international and global funds often have a small exposure to Brazil as well.
Yet even within these categories, the exposure to a specific country can vary dramatically. For example, the Invesco Developing Markets Fund and the iShares Emerging Markets Minimum Volatility ETF are both funds that invest in emerging market stocks. Yet Brazilian stocks make up almost 20% of the former and only about 6% of the latter. Furthermore, these numbers will change over time as markets move and as the fund managers change their views about which stocks they should be invested in.
There are even more dramatic differences for other countries. The two largest emerging markets funds by assets, the Vanguard Emerging Markets ETF and the iShares Emerging Markets ETF, are both “passive” funds that simply try to mimic a benchmark index of stocks. But they’re far from identical. Because they have different definitions of which countries qualify as emerging markets, South Korea is the largest country in the iShares fund and has a 0% weighting in the Vanguard fund.
For most investors, taking the time to investigate these details for every holding isn’t a reasonable option. Instead, having tools that allow you to easily understand your geographic exposure and let you know when it gets out of alignment can be a better alternative.
Emerging market stocks haven’t done particularly well in recent years, but Brazilian stocks have done especially poorly. From 2010 through 2013, Brazilian stocks substantially underperformed emerging markets as a whole in each calendar year. So far this year, however, Brazilian stocks have outpaced their emerging market peers. Does this reversal herald a comeback for Brazil’s stock market?
The struggles of Brazilian companies have a number of causes. The country has been battling persistently high inflation, currently above 6% per year. Worker productivity in Brazil has been weak due to factors such as poor infrastructure, a low-quality education system, and inefficient regulations. And declining commodity prices in recent years have hurt the country’s commodity producers.
Often times when a country’s stock market dramatically underperforms over a number of years, stock prices fall so far that they subsequently look cheap. By conventional valuation metrics such as price-to-earnings ratio and price-to-book ratio, however, the valuation of Brazil’s stocks isn’t much different from emerging markets overall. Other valuation measures, such as the ratio of the size of the country’s economy to the size of its stock market, suggest that Brazilian stocks may indeed be undervalued, but less so than other emerging markets such as China.
Since Brazilian valuations don’t seem especially attractive, the country’s stock market will likely need something else to provide a boost if it’s going to build on the gains achieved so far this year. Perhaps elections in October will provide the impetus for pro-growth economic reforms, or a stronger global economy will lead to higher commodity prices. If not, the stock market gains so far this year may be an aberration rather than the start of a trend.