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Why Is Brazil Falling Like a BRIC?

Thursday - 7/11/2013, 2:42pm  ET

Since the beginning of 2013, the iShares MSCI Brazil Index ETF  is down over 25%, with very little reason to believe this should abate.

Let's face it, times are tough in Brazil right now. Commodities have declined in price, speculation that stagflation is taking hold has hurt financials, credit downgrades loom threatening junk status, and the political unrest seems to grow daily.

At the end of June, Brazil's inflation rate was 6.7%, well above the desired target. The recent 500-point increase in the funds rate to 8% seems to have done little to stop this trend but threatens to put a damper on lackluster 2% GDP growth. With unemployment holding at 5.8% (an official figure that I personally question) this formerly booming economy has some very difficult times ahead.

A slippery slope

When you add up common and preferred holdings, Petrobras  is the iShares MSCI Brazil Index ETF's largest holding at 10.81%. While I cannot argue against the potential value in this position, I also cannot imagine that the government will relinquish the control it has exerted recently. The government holds a 54% common voting stake in this company. It is widely known that oil and energy price fluctuations create huge distortions regarding inflation. It is also well known that the Brazilian government uses Petrobras (through mandated diesel and gasoline prices for example) as inflation control. As noted above, Brazil's inflation rate is now well beyond the government's target rate, so look for increased government restrictions on pricing. Since domestic sales make up the majority of profits, it stands to reason that further government action will drastically impact an already-shrinking bottom line.

Right place, wrong time

Vale  is the iShares MSCI Brazil Index ETF's second largest holding when adding both common and preferred shares. Over the last six months, Vale has taken a beating of 36% to the downside.

Once again, I cannot argue that there is potential value behind this position. However, I can argue that global macroeconomic conditions will continue to put pressure on this stock. Copper, coal, steal, ore, fertilizers, as well as gold and silver seem to be lacking any catalyst for a turnaround, but that is really the only bad thing I can say about this position. Reading through the latest quarterly and annual reports I am impressed how management is cutting costs, reinvesting for the long run citing numerous projects in development, and maintaining a solid balance sheet.

I hate seeing well-run companies fall victim to circumstances beyond their control, but that is precisely what is happening here. Analysts are looking for a 7% decline in earnings growth into fiscal 2014. For those thinking the 6.90% dividend might provide some insulation against a further decline, think again. The 108% payout ratio will become a greater liability into the coming quarters as earnings decline and may lead to dividend decreases. Until the commodity market begins to show some life I cannot recommend an investment in this position, nor the ETF that has 8.9% of its assets in this position.

No way out

A mixture of financials compose approximately 25% of the iShares MSCI Brazil Index ETF. Those will come under increasing pressure as inflation takes its toll on real (vs. nominal) loan returns. Look for credit contractions on the part of banks to avoid that risk. This will further hurt growth. The financial sector will find themselves trapped between increasingly volatile currency, low growth, and political uncertainty. All the ingredients needed for stagflation. The Brazilian domestic banking sector is going to be the least desirable investment during this turmoil. There is no quick or easy way out from this hot mess.

Conclusion

Approximately 45% of this ETF's composition was just discussed and shown to be a highly questionable investment at this time. Adverse government involvement, commodity price pressure, and potential stagflation are all going to weigh on the iShares MSCI Brazil Index ETF for some time to come. Until these issues are resolved, it would be wise to avoid this position.

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This article was originally published as Why Is Brazil Falling Like a BRIC?on Fool.com

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