Earlier this month, as part of my changed view of emerging markets. I initiated an overweight view of Brazil and noted that I am paying close attention to Chile. As promised, here are more of my thoughts regarding these two emerging market countries.
Why I Like Brazil
There are a number of reasons why I like Brazil beyond what I mentioned in my earlier post.
First, from a valuation standpoint, Brazil looks attractive relative to both its own history and to other MSCI ACWI countries. The MSCI Brazil index is currently trading at 1.4x book value, versus its average of 2.1x book value over the past five years. The MSCI ACWI index, meanwhile, is currently trading at 1.6x book value.
In addition, from September 2008 to July 2009, the OECD composite leading indicator for Brazil was lower than it is today; yet the Brazilian market appears cheaper today than it did during that period on average. Essentially, the fundamental growth story for Brazil seems better today than it was during September 2008 to July 2009, but stocks don’t reflect this fact as investors appear to be discounting a lot of bad news.
The country’s resilient domestic demand should also help support the local stock market. Brazilian large- and mid-cap corporate profitability, as measured by return on assets, is also a little higher than that of the equally weighted MSCI ACWI country average.
Another reason to favor Brazil is evident from credit default swap (CDS) spreads, which measure how costly it is to insure against the possibility that a country will default, and essentially gauge the market’s current perception of a country’s sovereign riskiness. CDS levels for Brazil suggest the country is currently regarded as less risky than emerging markets on average.
Still, the Brazilian market faces a number of substantial headwinds. Brazil is a major exporter of commodities so the country’s market is sensitive to global growth concerns.
Its appreciating currency is also weighing on its exporters. Government measures (think higher reserve requirements for banks and tighter consumer credit requirements) to keep the Brazilian real from appreciating further could lead to a decline in domestic demand.
Capital controls on foreign flows also do not help foreign investor sentiment. Finally, the Brazilian central bank has raised rates five times this year and if inflation doesn’t peak soon, any further hikes could hurt Brazilian equities further.
Still I believe that barring a global recession, these headwinds already seem priced into Brazilian stocks, and the market looks like a good value relative to its own history and the rest of the world (potential iShares solution: EWZ).
Why I’m Watching Chile
I am not yet establishing an overweight view of countries in Latin America beyond Brazil, but I am watching Chile closely.
Based on price-to-book ratio measurements, the country’s valuation had a run-up until the end of 2010 and has been quite expensive since then relative to its own history and the rest of the MSCI ACWI universe. But since mid-July, the Chilean market has dropped 13%, making the market look more interesting. In addition, inflation in Chile was a modest 2.9% in July, and the country’s central bank recently left its benchmark rate unchanged at 5.25%.
But the Chilean market is not without its risks. The main risk for Chile is its exposure to the commodities markets, as copper makes up around half the country’s exports.
In short, while Chile is starting to look interesting and we currently hold a neutral view of it, there is no need to rush in. We would instead start building positions at market dips. You can read more about my country outlooks in the latest Investment Directions monthly market outlook piece (potential iShares solution: ECH).
Disclosure: Author is long EWZ
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.