Brazil Could Lose Its Economic Thrill

Perhaps you, like me, have been getting emails ranging from inappropriate to offensive about our impending election. Well, let's say the worst fears expressed therein come true, just as they did in Brazil in October 2002 with the election of the avowedly leftist Luiz Inácio Lula da Silva. Would you trade our stock market returns since then for Brazil's, and if you would, why?

Brazil's Bovespa index, whether expressed in terms of the U.S. dollar or the Brazilian real (BRL), has run rings around the S&P 500 since that time. It has been embarrassing, really, especially for those of us whose memory extends back to the Jan. 12, 1999, devaluation of the BRL, which in retrospect was the final development in the financial crisis that began in Thailand in July 1997.

Even the BRL, which did not come into its present form until October 1994 and which succeeded a series of failed currencies such as the cruzeiro, cruzeiro novo, cruzado and cruzado novo, has demolished the greenback since Lula's ascension.

The Real And Comparative Equity Total Returns

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Source: Bloomberg

Brazil became part of the BRIC quartet, along with Russia, India and China. For those whose thought processes seldom extend beyond acronyms, this has been a rough year for half of the BRICs. While Brazil has gained 15.4% in 2008 in USD terms, and Russia 5.1%, India has lost close to 30% and China more than 40%.

What has been behind Brazil's success and, more important, what are the prospects for continuation? Part of the answer, given right up front, is that Brazil has been a beneficiary of the dollar carry trade that was discussed here in January. That's right, the dollar carry trade, as opposed to the yen carry trade. Our artificially low interest rates are financing other markets, Brazil's included, and that presents both a short-term gain and a long-term risk for Brazil.

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Short-Term Rate Gap Rose During Credit Crunch

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Source: Bloomberg

Rule Out Rate Gap

The short-term interest rate gap between two countries is often a good place to start any currency analysis, but in the BRL's case, the effect has been opposite the expected answer. Changes in the currency have led the normalized interest rate gap between six-month U.S. dollar and BRL swap rates by six months. This is the gap between BRL and USD rates divided by USD rates.

As the BRL has strengthened, short-term interest rates in Brazil have been able to fall relative to those in the U.S. If this seems to be a virtuous cycle, it is. Funny things happen to countries with responsible monetary policies. Come to think of it, funny things happen to countries with irresponsible monetary policies, too.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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