He argues that places with reasonable P/E valuations, such as Brazil, are a better place to be in during uncertain and volatile times because it decreases the odds of a contraction in trading multiple. "You might see China go from 40 times to 20 times earnings," he says, "but I doubt that Brazil will go from 12 to 6. And so far this year you've seen it hold up well."
Along with Petrobras and Banco Bradesco, his top Brazil pick is Bovespa Holding, which controls the Sao Paolo Stock Exchange. The exchange accounts for 70% of all Latin American trading volume and is the world's third-fastest growing exchange in terms of average daily trading volume. Bovespa Holding went public last year, and in February began merger talks with BM&F, Brazil's main futures exchange. If the deal goes through, it would create Latin America's largest exchange group and would strengthen Bovespa Holding's hand in the country's vital commodities sector.
Piggybacking Commodities
The commodities boom has been Brazil's friend, but the flip side could be less friendly if global growth slows and commodity demand tapers. Take, for example, the iShares MSCI Brazil Index, a Brazil-focused exchange-traded fund that skyrocketed 75% last year versus the 44% gain for the Bovespa index. The fund got a tremendous boost from its heavy reliance on Petrobras and Vale, which combined comprise half of its holdings. Both companies currently enjoy all-time high prices for their chief products, oil and iron ore, respectively, so comedowns in those commodities could leave the fund vulnerable to a decent pullback.
Brazil's outsized role in Latin America-it makes up more than 65% of the MSCI Emerging Latin America index-has been a boon to funds that track the index. Both the BlackRock and T. Rowe Price Latin America funds, for example, posted average annual gains of 54% during the past five years thanks to their large Brazil stakes. "It's probably safe to say that Brazil is a commodity-based economy," says White, the T. Rowe Price portfolio specialist. "But increasing consumer demand will probably provide a bit of a buffer" if commodity prices drop. Nonetheless, T. Rowe Price recently trimmed the Brazil overweight position in its global emerging markets portfolio from 5% to 2%.
Making The Grade
Brazilian equities have been hot, but the fixed-income side is also generating a buzz. For starters, the country's benchmark lending rate as of late February was 11.25%, one of the highest rates in the world. "Brazil is our largest position in the local emerging markets space," says Kristen Ceva, who runs the fixed-income group at the investment management firm Payden & Rygel.
Ceva owns bonds denominated in the local currency, the real, which were sporting yields of 12.5%. She believes that Brazil's underlying fundamentals are solid, including a strong currency and concerted efforts to maintain fiscal and monetary responsibility. On a macro level, Brazil should get a huge lift if rating agencies place an investment-grade rating on the country's foreign sovereign debt. For starters, investment grade will bring in a whole new class of investors because some funds can't invest in speculative-grade securities. It would also give Brazil a wider pool of capital and could mean better interest rates as the government tries to raise funds to pay for needed infrastructure projects.
"It's not just one thing that will move Brazil to investment grade," says Lisa Schineller, a credit analyst at Standard & Poor's. She says S&P in 2002 downgraded Brazil from BB- to a B+ rating with a negative outlook due to its debt, its poor exchange rate versus the dollar, and fears that the incoming leftist Lula administration would stop debt payments and subsequently default. Schineller says S&P has had a positive outlook on Brazil since 2003, and after a series of upgrades the country's foreign currency rating is now BB+, its highest rating ever and just a notch below an investment-grade rating of BBB-. She adds that while S&P is impressed by the country's favorable economic backdrop, attaining investment-grade status isn't a sure thing because Brazil still has issues: It has to expand its transportation infrastructure, simplify its complicated tax system and continue debt reduction.
One of the key tests to Brazilian economic resiliency will be how it fares if the U.S. economic slowdown impacts the rest of the world. It helps that just 12% of Brazil's economy is U.S.-related, but a broader slowdown could deliver a hit to its important commodity exports.
A longer-term test will come after Lula leaves offi ce in 2010, and whether Brazil can maintain its fiscal and monetary discipline. "There is a sense of political transition where its political institutions are among the better-tested in the region," Schineller says. "I think it will last over time."