Brazil hurtles towards its worst recession in 25 years – but I’m still buying

Dilma Rousseff's government has faced mounting opposition

It's been a tough weekend for Brazil's president Dilma Rousseff. On Sunday, half a million Brazilians took to the streets demanding that she step down.

The protestors are angry at a massive corruption scandal that involved much of the country's business and political elite and perhaps even Rousseff herself.

The markets are protesting too and if anything, they have even more reason to be angry than Sunday's marchers. Brazil's currency, the real, has slumped to 12-year lows against the dollar, ratings agencies are threatening to downgrade Brazil's debt to junk bond status and the country is facing its most severe recession for 25 years.

In short, Brazil's economy is a mess, and it's only going to get worse.

Regular readers will know that for years I warned investors to stay away from Brazil preferring to watch this tragicomedy rather than become part of it. But a few months ago I changed tack and decided to tip Brazil for the first time.Why?

Because things were so bad, and the market so cheap, that I saw an opportunity. Brazil might be lurching from crisis to crisis, but we can still make money there.

Rousseff is clinging to power by a straw

The scale of Brazil's corruption scandal, known in the media as "Operation Carwash" (because of a petrol station used to launder some dodgy money) is scary. Executives at state oil producer Petrobras overpaid providers for a series of huge contracts in return for bribes. Some of the proceeds of the bribes were then passed onto prominent politicians. The unveiling of this complicated saga is ongoing, but so far, Petrobras has written off $17bn for corruption-related costs and inflated contracts.

But it's not just the size of the scheme that's scary. It's also the fact that it goes right to the top. The CEOs of Brazil's two biggest construction firms, Odebrecht and Andrade Gutierrez, are currently in jail facing charges. These guys manage billion-dollar companies and are highly respected business figures.

Rousseff denies responsibility, but as the then energy minister, she was chairwoman of Petrobras during the time when 'Carwash' was at its peak. Moreover, her party is accused of receiving $200m of funny money from the scheme.

The massive operation to weed out criminal elements in the country's political and economic elites is also starting to impact the general economy.

As Neil Shearing from Capital Economics points out in a recent note: "The crisis has contributed directly to a collapse in construction and fixed investment, as companies implicated in the investigation have halted projects and Corporate Brazil more generally has been paralysed."

It's also weakening the government. Even if she avoids being impeached, Rousseff is increasingly looking like a lame duck despite the fact that she's at the start of her second term. She has an approval rating of just 8% a record low for a Brazilian president and is losing allies in Congress. This will make it even more difficult for her to solve the horrendous economic problems I'm about to describe below.

The perfect storm

Of course, not all of this is Rousseff's fault.

Economies are cyclical and it's her bad luck that certain cycles are working against her now. The Brazilian consumer is maxed out, household debt levels are at record highs and credit can no longer sustain the country's shopping boom. The commodity cycle is also going the wrong way, with prices of iron ore, Brazil's biggest export, at five-year lows and falling.

Not that the Brazilian business elite cut her much slack. I was speaking to a Brazilian fund manager a few weeks back and he was scathing about the government's economic policy. Interference, lavish subsidies and protectionism have all created huge distortions in the economy and hindered Brazil's ability to react to events.

What's more, Brazil isn't coming into this downturn in a healthy position. The government's budget deficit is running at 8% of GDP, while gross government debt stands at around 70% of GDP.

To her credit, Rousseff made some big changes at the start of her second term. New finance minister Joaquim Levy was poached from an investment bank and his hawkish determination to cut spending in a previous government earned him the nickname Scissorhands'. But even Levy seems to be struggling to deal with this crisis, recently admitting that he won't be able to produce the primary budget surpluses that he had promised for this year and the next.

And that's why the ratings agencies are circling. S&P have put Brazilian government paper on a negative outlook. If the debt continues to grow the most negative scenarios have it hitting 80% in the next few years then Brazilian bonds will be downgraded to junk bond' status.

And as if all of that wasn't bad enough, Brazil still looks no closer to solving its long-term structural problems. A creaking, chaotic infrastructure system and poor state education provision both hamper productivity. Meanwhile, a strong streak of protectionism is eating away at the international competitiveness of Brazilian companies.

So why would you want to invest in Brazil?

Given the economic nightmare I've just described, you may be wondering why on earth I want to invest in the place. The main reason is that Brazil is cheap. Its ongoing problems have brought the equity market to lows not seen since the Financial Crisis, giving us an interesting buying opportunity. To be honest I expect the situation in Brazil to get worse before it gets better, but things should start to pick up in 2016 or 2017.

Timing these things perfectly is impossible but as a medium to long-term investor, I like to get in when I see an opportunity and then wait it out. When you're planning on investing for a few years you want to keep your costs as low as possible so in this case my favoured way to play it is an ETF for example the iShares MSCI Brazil UCITS ETF (LSE: IBZL).

My own view is that the market is already pricing in the downturn and I want to have a position when the market starts to look ahead and rise on the hopes of a recovery in the future.

I first decided to buy into Brazil back in February and the market rose around 20% before falling back down to where it is now. If you bought in then hold on to what you have, but if you didn't, now is another good time to get on board.

Of course, if you are feeling particularly clever, you could try to time it and wait to see what happens with the ratings agencies.

As Rafael Fonseca notes in the FT's Beyondbrics blog, about a fifth of Brazil's government paper is held by foreign investors. Many of them will be forced to drop it if it becomes junk because of the mandates of the funds they run. This would lead to a sell-off across Brazilian financial assets, which would present an even better buying opportunity. That's a bit too uncertain for me though. I prefer to buy in now and leave it for a few years.