With its Move to the Top of an Index, Brazil Moves to the Head of the Class For Investors

By William Patalon III
Executive Editor
Money Morning/The Money Map Report

Brazil has displaced China to become the world's biggest emerging market, according to a key index - a shift that will likely attract billions in new month to Brazilian stocks.

Brazil overtook China as the biggest market atop the Morgan Stanley Capital International Global Emerging Markets (MSCI GEM) index on Feb. 20, rising to a weighting of 14.95%, compared to only 14.15% for China, the Financial Times reported. That move will likely have a huge impact on worldwide institutional money managers, since many professional investors benchmark their portfolios against the MSCI GEM index.

The bottom line: Expect money to flood Brazilian shares, says Keith Fitz-Gerald, Investmetnt Director for Money Morning.

"Anytime a country moves to the top of that index there's a strong re-indexing effect," Fitz-Gerald said. "And that will lead to billions of dollars of institutional money being shifted as those professional investors rebalance their portfolios. They're going to move substantial amounts of money into Brazilian stocks."

The MSCI index measures shares available to investors rather than the total market capitalization of all the companies traded on the exchanges in question. By that measure, China is three times the size of Brazil. The combined value of companies listed on the Shanghai and Shenzen exchanges was almost $3.9 trillion in January, compared with almost $1.3 trillion for the São Paulo stock exchange, or Bovespa.

With the U.S. economy wrestling with its worst housing downturn in decades, a massive credit crunch, an eviscerated greenback and even an outside chance for stagflation, this divergence is important for investors to note. An economic slowdown - or worse, a recession in the United States - was once the death knell for Latin American economies, which rely heavily on America as market for their exports. But the U.S. market seems to be loosing that grip as economies in Central and South America gather momentum from a global commodities boom and gain a more-diverse customer base for their goods.

Despite all the turmoil in the U.S. economy, the Latin American region has three of the four best-performing emerging-market currencies against the greenback. And one of those three - Brazil's real - just hit an all-time high against the dollar.

Brazilian Stocks Sizzle

Last year Brazil's main stock market index rose 71% - even faster than India's - suggesting that international investors are awakening to the potential of the South American giant.

Since emerging market equities peaked at the end of October, Chinese share prices have fallen by 28%. Over the same period, Brazilian shares have gained 4.5%. The Standard & Poor's 500 Index had declined about 7%.

The performance of the benchmark Bovespa has been so strong over the past month has been so strong that it has now erased the losses the index posted in January, Dow Jones reported. Those losses in the first month of the New Year were sparked by global uncertainty - especially those related to the ongoing worldwide credit crunch.

Part of the relative swing between Brazil and China shares was explained by a perception that Chinese shares were overvalued, Geoffrey Dennis, Latin American equity strategist at Citigroup Inc. (C) in New York, told The FT.

"Brazilian shares have been trading at 13 to 14 times earnings and Chinese ones at 30 to 40 times," Dennis said. "The frothy ones tend to do worse in a crisis."

Much of the investor interest was focused on Brazil's two biggest stocks - Vale (RIO) and Petrobras S.A. (PZE). Vale is the world's biggest exporter of iron ore; Petrobras has just made the world's second-largest oil/gas discovery in 20 years, deep beneath the waters of the Atlantic Ocean.

But it's renewable resources, not minerals, which are increasingly attracting investor interest.

The Commodity Boom Brings Wealth to Latin America

Investor sentiment has been especially favorable towards Latin American stocks - and Brazilian stocks specifically - because they believe that country and others in Latin America are better-protected from a global slowdown. Indeed, the global rush into commodities of almost every type has attracted a new group of trade partners to the shores of Latin America, and the resource-rich region has used the higher demand and higher resultant prices to amass war chests fat with cash reserves.

"Latin America has far better economic policies and tremendous support coming from high commodity prices," Jonathan Binder, who overseas $1.7 billion of emerging market assets at INTL Consilium LLC, told Bloomberg. "The region will be resistant to the kind of risk correlated to the U.S. [that] people previously expected."

Brazil is particularly fortunate to have strengths in both key commodity sectors - the so-called "soft commodities" created by the agricultural sector and "hard commodities" such as iron ore.

Jim Slater, the well-known British investor, says Brazil is "insulated against the world's main shortages - fresh water, agricultural commodities and energy." And he should know: After making a fortune in the mining, base metals and minerals "super-cycle," Slater is now targeting agri-business as the next big global profit opportunity.

Brazil contains nearly one-fifth of the world's fresh water, available to expand agricultural production and carbon-free electricity generation. Hydropower already provides 80% of the country's electricity needs, and two big new dams are being built on the Amazon River at a cost of $10 billion.

Because Brazil is able to produce alcohol fuel from sugarcane, without subsidies, for prices competitive with petrol, the country has been dubbed "the Saudi-Arabia of ethanol."

"No country is better-positioned to benefit from the agricultural boom than Brazil, with its large and fertile land mass, absence of any desertification, and ample supply of fresh water," said David Fuller, a London-based analyst.

Brazil also is benefiting from an across-the-board rally in the prices of hard commodities.

Last week, the price of oil and gold continued their record-breaking runs. Spot gold rose as high as $964.70 an ounce and crude oil for April delivery climbed above $102 a barrel for the first time. Oil has averaged $93.02 a barrel this year, up nearly a third over the 2007 average of $72.30.

Meanwhile, silver rallied to its highest level since November 1980. Palladium jumped to a 6-1/2-year high, and platinum gained 1.7% - edging ever closer to its record of $2,206 an ounce. Platinum has gained more than 30% in the last month alone.

Since 2001, gold has risen 255% - from $271 per ounce to $961 on Feb. 27. Silver has gained 290%, and platinum has jumped 256%.
Iron and coal, two ingredients central to the production of steel, have also seen their prices soar.

On Feb. 22, Brazil's Vale (RIO), announced that Chinese steelmaker Baosteel Group Corp., in negotiations on behalf of the Chinese steel industry, had accepted a price hike of 65% for iron ore. The move followed a Feb. 18 agreement between Vale and Japan's Nippon Steel Corp. and Korea's Posco (PKX), which also agreed to a 65% price increase.

Price negotiations for 2004 ended with an 18.62% increase, followed by a 71.5% rise in 2005 and a 19% increase in 2006. Vale, as the world's biggest iron ore producer, typically sets the benchmark for contract negotiations. But this year BHP Billiton Ltd. (BHP) and Rio Tinto PLC (RTP) have said they will likely seek even higher prices for their ore. Together Vale, Rio Tinto and BHP control 80% of the iron ore market.

The spot price of iron ore has tripled in the past five years and is currently hovering around $200 a ton.

Coal, which is responsible for 78% of China's energy output and 69% of India's total energy supply, has soared to record highs as well. The price of coal is up 37% already this year, analysts say. And that's after coal prices rocketed 73% in 2007.

GlobalCOAL's monthly index for Newcastle thermal coal prices rose $1.71 per metric ton, or 1.9%, to reach $90.87 in January, the fourth consecutive monthly record.

Soaring commodity prices have helped countries like Peru, Venezuela, Argentina and Brazil generate trade surpluses with their Far East trading partner, bolstering their cash reserves.
But many analysts warn that the exposure to commodities is a risk. And Citi's Dennis warned investors better not risk getting overly euphoric about Brazil's prospects.

"It makes no sense with shares at this level to be complacent," Dennis said. "It's inconceivable that you could have the U.S. economy in recession and a world economy that ignores that. Our concern is that commodities will start to correct."

Non-U.S. Exports on the Rise

One reason the U.S. downturn has yet to inflict any real pain in Brazil and its Latin American brethren is that those countries have broadened their lists of trading partners.

Trade between China and Latin America surpassed $100 billion last year, a benchmark the Chinese government didn't expect to reach until 2010. Commerce between the two regions totaled $102.6 billion in 2007, a 46% increase from 2006, according to Chinese government data.

For purposes of comparison, consider this statistic: Last year, China's trade totaled $302 billion in the United States and $73 billion with Africa.

Brazil sent 6.7% of its goods to China last year, double the amount in 2001. Chile, Peru, and Argentina exported to China twice what they imported from their Asian trade partner. Mexico exported $3.2 billion worth of goods to China last year.

The United States now absorbs less than 20% of the exports coming out of Brazil, Argentina, Chile and Peru.

The government of Brazil recently made plans to establish a permanent commercial center in the United Arab Emirates to promote investment between the regions.  The UAE is home to the Abu Dhabi Investment Authority, or ADIA, a sovereign wealth fund with an estimated $875 billion in assets. Brazil is the world's sixth-largest economy and home to an internal market of approximately 190 million consumers.

The new center will serve as a permanent exhibition of products from Brazil and Latin America, and tap developing investment and marketing opportunities between the regions.

It will also enhance Arab-Brazilian relations through the presence of future Gulf investments in Brazil, Ahmed Yassine, president of the Trade Exterior Chamber of Brazilian-Arabian Gulf and North Africa, told the Emirates News Agency (WAM). Yassine led a delegation of Brazilian businessmen on a tour of the region.

"An estimated 20 million people of Arab origin live in Latin America and 7 million of them are in Brazil," Yassine said.

In 2007, Gulf countries imported $4.6 billion in goods from Brazil, an increase of 4.8% from 2006.

The amount of the region's debt denominated in foreign currencies fell to 24.7% of gross domestic product in 2007, down from 44.1% in 2002, according to the International Monetary Fund.
In the 1990s some emerging markets ran out of foreign reserves and defaulted on debt. But trade surpluses brought about by soaring commodity prices have resulted in a bounty of foreign reserves for emerging markets.

Emerging markets have an estimated total of $4.1 trillion in central bank reserves The Journal reported. That includes a cushion of $185 billion in Brazil, $49 billion in Argentina, and $80 billion in Mexico.

Two Profit Plays to Make Now

Brazil does have some problems. Inflation is a major issue, and there's always the worry that the bull market in commodities could taper off - at least for awhile.

But Money Morning's Fitz-Gerald sees some strong investment opportunities. Two in particular stand above the others:

Banco Bradesco SA (BBD): With a market capitalization of nearly $63 billion, the Brazil's second-largest bank markets banking, securities, credit-card and insurance services through its network of 3,008 branches. After soaring 28% last year, profits are expected to advance 25% this year and 15% in 2009.

According to Fitz-Gerald, "strong financial institutions are at the heart of any powerful economic surge. As Brazil continues to expand, Banco Bradesco can't help but expand its profits" as it helps finance the economic growth in the country, as well as in the broader Latin American region. On Feb. 22, The Bear Stearns Cos. Inc (BSC) upgraded Banco Bradesco from "Peer Perform" to "Outperform," with analysts Saul Martinez and Matias Sacerdote writing in a report that Bradesco will benefit from improving profit prospects in its insurance and private-pension businesses.

What makes that upgrade noteworthy is the fact that the two analysts simultaneously downgraded Banco do Brasil SA - Brazil's largest bank by market value - from "Outperform" to "Peer Perform."

Petroleo Brasilero SA (PBR): Latin America has an insatiable appetite for electricity. And right now, about 75% of the country's power comes from hydroelectric facilities. That percentage will increase in 2012 when the region's largest hydroelectric project, the Santo Antonio Dam, begins producing electricity. This is the first of three Amazon River however, Brazil's state-controlled oil-and-gas dams the government hopes will decrease Brazil's reliance on fossil fuels. Until then, Petroleo Brasilero - better known as Petrobras - will help meet demand. With a market cap of more than $257 billion, the Rio de Janeiro-based firm was a major factor in Brazil's ascension to the top of the MSCI GEM index, Dow Jones reported. Dennis, the Citigroup analyst, and colleague Jason Press wrote that "the recent rise in Petrobras … has been key to the surge in Brazil's overall weight."

One of the reasons that Fitz-Gerald likes both these companies - and Brazil in general - is that the country is doing more and more business with China, a market with tremendous long-term prospects.

The same holds for Brazil, Fitz-Gerald says.

"Brazil has tied its fortunes to China, and has a bunch of companies that do business with China," he says. "And in the long-term, that holds out the potential of being an exceptional value."

Money Morning Editors Jason Simpkins and Mike Caggeso contributed to this report.

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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